Investors often ease into their saving strategy with small investments into their 401k plans. Later, as their finances allow, they “graduate” into other investment vehicles, such as HSAs, IRAs, and taxable accounts. Then, as their financial lives become more complex, many will ask, “If I have a fixed sum of money to invest every month or every year, which accounts should I consider if I want to save more?”
Since many households are also juggling various debt obligations and spending requirements, it becomes imperative that they recognize how those may compete with – or complement – their savings goals. Because knowing this allows them to prioritize their available cash and choose the direction the cash should go to maximize the growth of their net worth over time. Consider these questions:
- Would it be best to invest more in a 401(k) or focus on paying off the mortgage early?
- Would it be best to increase liquid cash savings or invest more in a Roth IRA?
To answer the myriad of questions like these, we require a decision-making framework which allows us to prioritize our available cash and match it to the appropriate opportunity or debt payoff strategy. The objective of this framework should be to maximize growth of our net worth considering our savings goals, debt obligations, and spending needs.
To maximize the growth of your net worth over time, it’s imperative to understand the differing tax advantages between savings opportunities. The price you’ll be paying for the highest after-tax return rate will be a decrease or loss of flexibility in how the money can be spent. Furthermore, variations in company retirement plans, tax situations, and time horizons mean that a choice for one savings opportunity over another may make sense for some but not others.
With those spending constraints, you must also be mindful of your need for liquidity. Liquidity means that you can spend money from your savings without incurring a penalty or the need to add financing (debt). To that end, the objective to maximize growth of your net worth over time must be able to accommodate your spending ability before retirement.
In some cases, it makes sense to give up preferable tax treatment altogether to maintain your spending ability for near-term goals and unexpected financial events. For example,
- Expected after-tax rates of return achievable from investing in a tax-advantaged 401k may enable more spending in retirement, but withdrawals are subject to penalties prior to age 59½. This spending constraint renders this opportunity unsuitable for short-term, pre-retirement goals.
- Taxable accounts tend to be well-suited to a variety of investment goals as there are no limitations or penalties associated with withdrawals.
- Roth IRAs are a desirable choice for tax-advantaged growth while preserving some liquidity, because contributions can be withdrawn tax- and penalty-free.
- HSAs can be a valuable savings opportunity since withdrawals are penalty-free once you reach age 65 even if you don’t use the funds for health care expenses. The immediate ability to make penalty- and tax-free withdrawals for any qualifying expense adds to the HSA’s flexibility and value as an opportunity.
A helpful resource
As with many financial planning questions, there are no one-size-fits-all answers. That is why I encourage you to get a copy of my checklist, “What Accounts Should I Consider If I Want To Save More?” This checklist provides a structured outline to guide your considerations regarding available and appropriate saving opportunities, along with a framework for prioritizing the appropriate account type for your financial situation.
The checklist covers accounts across the following categories:
- Foundational Savings
- Healthcare Savings
- Retirement Savings
- Employer-Provided Benefits
- Business Owner Savings
- Accounts To Help Future Generations
- Tax-Deferred Insurance Options
- Other Account Considerations
Debt and Liquidity
In addition to investing, you may wish to consider paying down the principal on one or more outstanding debts. In this context, payment of debt can be thought of as an investment with a guaranteed rate of return. Paying down high interest rate debt such as revolving credit cards is typically one of the first places to direct available cash, because an equivalent rate of return in the markets can be hard to achieve. The decision to prioritize the payment of debt over investing can be complex, and investors should consider the following factors:
When deciding between the prepayment of debt and investing, investors should consider how they would use their available dollars after the debt has been paid. You know yourself better than anyone. If the prepayment of debt might result in higher consumption rather than an increase in savings, then you may wish to prioritize investments with the goal of creating wealth.
Comfort level with risk and volatility
You should also consider how comfortable you are with your savings dollars invested in the markets where there are varying degrees of uncertainty of outcome and price volatility. Given the known fixed interest rate of a debt obligation, a risk-averse investor will often find paying down debt more favorable than a more aggressive investor expecting higher rates of return from their riskier investments in the markets.
It may be an ideal wealth-maximizing strategy for you to prioritize paying down your debt as soon as possible. However, this puts constraints on the dollars you will have available to spend in the near term, and that should be a primary concern especially when the debt is long-term. You must find a balance between growing your net worth and maintaining adequate cash for spending. Without the necessary freedom to spend, you may have to delay a major purchase or take on additional debt at a higher cost.
Putting it all together
In order to maximize the growth of your net worth while meeting savings goals, debt obligations, and spending needs, you’ll need to prioritize where your available cash should go. You will be facing competing savings and spending goals such as your desired retirement lifestyle, buying a home before you retire, and maintaining adequate emergency savings. To balance the cash demand for all your financial goals, investors can take the following steps:
- List out in descending order the expected after-tax rate of return of your savings and debt opportunities. For example: credit card rate – 16%, 401k with employer match – 8%, HSA with superior tax advantage – 7%, IRA with low fees – 6%, 401k without company match – 5%, mortgage – 5%, taxable account – 4%. You’ll have to make sure which opportunities are available given your circumstances before you can make out your list. You’ll also need to determine how comfortable you are with market volatility before you can appropriately set the expected after-tax rate of return.
- Make sure to have adequate emergency savings to meet potential spending shocks. Consider having enough cash to cover 3 months of critical expenses for dual income households and 6 months for single income households. Without stable savings, an investor may be forced to take on additional debt under unfavorable conditions at inopportune times.
- List out and prioritize your financial goals taking into consideration the time horizon for each. You can then begin choosing the appropriate savings opportunities to make the most appropriate cash flow decisions for your household. The priority you should place on any single goal will be an individual choice, so it helps to discuss this with someone familiar with your situation like a trusted financial advisor.
This decision-making framework involves understanding the return potential as well as the limitations associated with savings opportunities and debt reduction options. The “What Accounts Should I Consider If I Want To Save More?” checklist will help you apply this framework when choosing an appropriate savings opportunity. This resource will be a good starting point for many investors.
Final thoughts about saving opportunities
With the preceding decision-making framework, we’re able to visualize the potential growth of our net worth over time. We can look through multiple savings and debt payoff strategies for the best way to maximize this growth considering all our savings goals and ongoing spending needs.
I would like to discuss how the “What Accounts Should I Consider If I Want To Save More?” checklist can help you to decide the appropriate savings opportunities given your circumstances, so you can take control of your finances.