Where to save your next dollar is one of the most common questions posed to financial advisers. And if you’re a saver with some extra cash, you already know that there is no shortage of options to consider. Should you pay down loan balances? Add to your emergency cash savings? Make a contribution to a retirement account? Fund a college savings plan? Pre-pay your mortgage? The long list of options can seem overwhelming.
And to make matters even more complicated, the solution to this universal question is not the same for everyone. For example, not everyone is eligible for every kind of investment account, contribution limits often depend on income levels, interest costs and debt levels can vary widely, and investment time horizons and marginal tax rates are not the same for each household.
Despite those caveats, it is possible to create a framework for exploring the broad options available for extra savings and to rank those options generally in order of importance (most to least). Note that not every item on the list will be applicable to everyone. This list is not exhaustive, nor is it intended to be financial advice or a recommendation to follow any specific course of action. Before embarking on a savings plan, we recommend discussing your financial situation with an adviser that you trust.
- Build and maintain an emergency cash savings. Many financial plans are wrecked by unexpected financial emergencies. The early days of the Covid-19 pandemic exposed the financial fragility of millions of Americans who were living paycheck-to-paycheck. Having a few months of living expenses in safe, liquid form (e.g. a bank savings account or high-yield money market account) goes a long way to avoid forced asset sales or taking on additional debt.
- Make sure you are contributing enough to your employer-sponsored retirement plan (401(k), etc.) to receive the maximum employer match. This is essentially free money to you, and it would be a mistake to leave that on the table.
- Pay down high interest rate debt. Credit card debt and other high-rate borrowing is one of the costliest decisions a consumer can make. Paying off a credit card with an interest rate of 20% is the equivalent of earning a guaranteed 20% return on an investment. High-cost debt should be considered as a last resort, and credit card balances should be retired as soon as practicable.
- A Health Savings Account (HSA), if eligible. HSA accounts are associated with high-deductible health insurance plans and not available for everyone. For those who are eligible, there is no more tax-favored account than the HSA. It is triple tax-advantaged, allowing for tax deductible contributions, tax-free earnings and growth, and tax-free withdrawals (if used for approved medical expenses).
- Retirement savings accounts. This can be either pre-tax (e.g. 401(k), IRA contributions) or post-tax (Roth) contributions. Both offer tax-advantaged savings. Which makes more sense (pre- or post-tax) often depends on your current marginal tax rate and how that may compare to the tax rates you’ll face during retirement. (Be aware of income limitations and phase-outs for non-employer sponsored retirement accounts.)
- College savings (529 plans). For parents with college-bound children, this educational savings account can offer tax-free growth and withdrawals. In some states, contributions can be deducted from state income, up to prescribed limits. Note that I’ve ranked 529s below retirement savings – you can borrow for college if necessary, but there’s no borrowing for retirement!
- Taxable brokerage accounts. When retirement plans are maxed out and you’ve got future college costs covered, this type of general investment account can make sense for non-retirement savings. There is no limit on the size of contributions or withdrawals on these individual or joint accounts, but as the name implies, taxes are owed each year in which there are distributions of income or capital gains, or when investments are sold at a gain.
- Lower interest rate (non-deductible) debt. Even low-rate debt (student loans, auto loans) incurs interest costs, and it can make sense to retire these loans early if extra funds are available. The urgency to pay these loans off early declines along with the interest rate, though, especially if that rate is below the rate of inflation.
- Pre-paying your mortgage. For most people, this lands at the bottom of the list. Historically, mortgages have been one of the least expensive ways to borrow. The interest can be deductible (if itemizing), and most fixed rate mortgages are below the current rate of inflation. The pre-payment decision also involves many other factors, which I wrote about in an earlier post.
If you find yourself with an extra $1,000 to save, congratulations! Now comes the hard part – deciding what to do with it. The “optimal” choice may not be the same for everyone and often depends on one’s income, tax bracket, interest rate(s), and time horizon. The list above will hopefully help you rank your choices and ensure that you’ve considered what we see as most compelling options first.
Disclosure: The opinions expressed herein are those of Elevate Wealth Advisory (“EWA”) and are subject to change without notice. EWA reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This should not be considered investment advice or an offer to sell any product. EWA is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about EWA, including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.