There are many different places that we use to place our money and each has its own specific purpose. Some of these “buckets” are needed immediately and used for our normal monthly spending, some buckets are saved for bigger annual expenses such as vacations and taxes, and then others are for the long haul such as retirement/general investment and emergency savings. Here is where we keep our funds:
Brick and Mortar Free Checking
The first bucket we use is just a brick and mortar free checking account. You want to make sure that it is actually FREE checking – you shouldn’t have to pay a penny for this account, and if you have a bank that charges you anything, you need to look elsewhere. There are online checking accounts but it is nice to actually have a bank to go to in the event that you have to do a large financial transaction and need a money order or if you need to make a large deposit. This account is used to pay the monthly recurring bills such as the mortgage, utilities, internet, gasoline, streaming TV, etc. We aim to carry the smallest balance possible in this account because it pays zero interest and any balance kept in this account loses around 2.5% each year due to that hidden tax on savers, inflation. The portion of our paychecks not automatically deposited into retirement accounts comes to this account each month. This account is linked to all other savings and investment accounts, which enables us to make quick transfers between all accounts.
The next bucket is our online savings accounts. We use this to keep our large annual expense items such as our annual property tax payments, vacations, and any other large expenses we plan on for the year, such as home repair and maintenance. Normally these accounts will hold a total of about 1 year of living expenses, but not used as an emergency savings account. We actually use 3 different banks for this purpose, Capital One, CIT Bank and Ally Bank. CIT’s Money Market account is currently paying 1.85% interest and where the bulk of our savings is held. All of these bank accounts are linked together and every quarter I revisit which is paying the best interest rates. I will keep a minimum of $1,000 in each and move the remainder to the one which has the highest return. It is important to remember that as long as your rate of return is below inflation, you are still losing buying power due to inflation, so in my case I am losing about .65% per year in these accounts; therefore, we try to max out every percentage point we can on these returns.
Emergency Savings, CDs
At this time, I still hold an emergency savings bucket but I am beginning to rethink emergency savings since we have reached a certain level of financial security. I have used a CD ladder strategy to keep our emergency savings over the last 10 years. We keep approximately 1 year of living expenses in this CD ladder. To begin this savings, I took a lump sum of one year of expenses and divided it into 5 equal parts, and then opened up 5 CDs – a one year CD, a two year CD, a 3 year CD, a 4 year CD, and finally a five year CD. Each year, as one CD matures, I use that money to open up a new 5 year term CD. Generally the longer the CD term, the higher the rate, so it benefits us to get each CD to a 5 year term CD.
This strategy has several advantages:
- Access to 1/5 of my savings each year as one CD matures.
- If I don’t need the money from the CD that matured, I open another 5 year CD to maximize my returns.
- If CD yields go up, it allows me to take advantage of the increasing rates.
- After 5 years, I have five, 5 year CDs with one maturing each year.
- Access to the full amount in case of emergency (but you will have to forfeit some of the recent interest returns as a penalty for taking your money out of the CDs early).
It is important to look at other savings vehicles such as online savings when each CD matures, because sometimes you can get a better rate than just opening another CD, which is what happened for the first time this year for us.
After-Tax Investment Savings
It is important for those of us seeking early retirement to have money in an after-tax investment account. We will need several years of expenses accessible to us that isn’t subject to any restrictions. Any money not needed for yearly expenses or emergency savings that isn’t in a retirement account is placed into this bucket. The funds in this account are not needed in the near term and as such is invested very aggressively to maximize the returns. We use Vanguard as our low cost broker for our after-tax investment savings and invest 100% of these funds to index funds. Specifically we are 100% in equities and we use a total US equity stock index fund, VTSAX. Since 2000, this fund has returned 6.5% annually. We have held bond index funds in the past, but when interest rates rise, bonds lose value and we are in a period where the Fed is raising rates. In addition, bonds pay dividends and that is a taxable event, and we are seeking to reduce or delay taxes to the greatest extent possible.
Each year, we watch this account for any opportunity for tax loss harvesting in case any of the investments have lost value to reduce our tax burden. It is also important to understand capital gains implications if you do decide to sell any of the funds; as a rule you should hold each investment at least 1 year prior to selling to ensure you don’t incur the short term capital gains taxes. Long term capital gains are taxed per the graphic below while short term capital gains are taxed at your ordinary income tax rate.
The majority of our net worth resides in tax advantaged retirement savings, and we maximize our contributions in the most tax advantaged way possible and prioritize retirement vehicles with any employer matching contributions.
There is a ton of information online about each of these retirement accounts so do your own research for any more information. I will just briefly touch on the account types we use and a quick summary of how we use them. In general, this money can’t be touched until you are 59.5 years old without paying taxes and a 10% early withdrawal penalty, but there are a few ways to get to this money sooner, which is a topic for another post.
The 401k – Most employers have a 401k account as a benefit of your employment, typically employers will match a percentage of your contributions to entice you to save. I would suggest that the first money you invest would be the percentage of that you employer matches, after all that is free money! My employer matches dollar for dollar for the first 3% and 50 cents on the dollar for the next 3%. In 2018, you can invest up to $18,500 into your 401k.
You can invest in both Roth 401ks and traditional 401ks. The Roth option uses after-tax money and the principle and all gains can be withdrawn tax free for life, whereas the traditional 401k uses tax-deferred money, but the principle and earnings are taxed when withdrawn. You have to look at your current marginal tax rate to determine which option is better for you. If you are early in your career or under $40,000 in earnings as an individual or $78,000 for a married couple, the Roth is the way to go.
We currently put all of our investments in the traditional 401k to defer the taxes to later since we are in the highest tax bracket we will be in during our lifetime and our income will be very low in a few years.
You can invest up to $5,500 per year into a traditional IRA if your modified adjusted gross income (MAGI) is less than $101,000 for married couples filing jointly, and there is a phase out up to $121,000. If you are over 50 years of age, you can bump the maximum contribution up by an additional $1,000 to beef up your savings. The traditional IRA is funded with pre-tax dollars and both principle and earnings will be taxed when withdrawn.
You can invest up to $5,500 per year into a Roth IRA if your MAGI is less than $189,000 but phased out up to $198,000 for married couples filing jointly. There is a $1,000 catch-up contribution if you are over 50. The Roth IRA is funded with after-tax money and both the principle and interest can be withdrawn tax free. One great benefit of the Roth IRA is that since you have already paid taxes on the contributions, you can withdraw your principle at any time without penalty.
The 403b account is basically the same as the 401k and they are used by nonprofit companies, school districts and governmental organizations. The plan’s administrative fees are usually a little smaller than 401k plans. There are typically both Roth and Traditional options.
The 457 plan is a unique option that you should read up on here and, like the 403b, it is offered by nonprofits, schools and government agencies. A couple of interesting notes: you can maximize both your 403b and 457, allowing you to save up to $37,000 total, and when you leave your employer, you can withdraw 457 savings without a 10% penalty.
Health Savings Accounts (HSAs)
Health savings accounts are another great way to save and avoid tax implications. You can put $3,450 as an individual and $6,850 tax deferred. If you have the option for this type of insurance coverage, it is really a great deal and your employer likely tosses in a $1,000 or so (more free money!) to entice you. If you are a healthy family, this type of account is likely your best option for health insurance coverage and it allows you to bump up your net worth while getting those free dollars from your employer. A cool feature of the HSA is that after 65 years old you can use HSA savings for non-medical expenditures without penalty, so this can really be used as another tax sheltered retirement savings account.
That is the list of accounts we use! We determine which type of savings vehicle is used for what savings purpose by the need for liquidity of that money and maximizing our returns. In terms of retirement savings, we prioritize accounts that offer free money, such as 401k employer matches and HSA matches. The priority after that is to gain the biggest tax advantage by putting the rest of our savings into pretax accounts. Though we have many accounts, it isn’t a complicated system to keep track of when you use a program such as Quicken where all of our accounts are linked, tracked and updated in one location.