Short-term savings

The top 5 places to invest your cash right now

Where should you put your next investable dollar? This is often the key question I answer for clients, and clarifying this for yourself will do wonders for your financial situation. Here’s where I think most people should put their money in order of priority. Generally you should max out the first item on the list before going down to the others, but your situation could vary, so make your own assessment or get help from a competent advisor.

Courtesy of Reddit (via the film Idiocracy)

Assumptions

1) You have some cash to put towards these things. If you don’t, you need to start here so that you can fix and automate your spending, then save some money to free up cash to invest or pay down debt.

2) You are not endangering your health, have proper levels of insurance, and aren’t making yourself miserable by living like a total pauper because you’re following my wealth-building suggestions to the extreme.

3) You’ll tailor this order to your own personal situation. That said, I strongly recommend following items 1 & 2 in that exact order.

Where you should be putting your money

Okay, ready? Numero Uno for where your money should go is….

1) Employer 401k matching

If you’ve read my articles on retirement, you’ve heard me say this before: don’t leave free money on the table! What type of return do you historically get from a risk-free investment? Treasury bonds return about 1-2% as of writing. What is your employer match return? If you get matching of 50 cents on the dollar up to 6% of your salary, your return on that first 6% saved is an instantaneous, huge, risk-free 50%!!! There’s no better investment in the world that I’m aware of. Max this out no matter what!

2) High-interest debt, like a credit card

Some readers might quibble with this as #2. I can hear them now: “What!? Paying off your credit card balance is always the first thing you should do!” There may be emotional benefits to making this #1 that you should consider, but if your employer matching is 50% instantly, and your credit card rate is 25% annually, you’ll do way better to first max out your 401k matching. After that, put the rest of your cash towards that VISA balance.

Other readers might take the opposite tack: “I’ve saved for X instead, why should I ‘lose’ that money paying off my debt?” Paying off high-interest debt is the best investment you can make. Where else can you get a guaranteed return of double-digit interest? You can’t! You should do this immediately even if it means depleting a cash cushion such as an emergency fund, having to build back up a house downpayment (you’re not ready to buy if you have credit card debt!), or postponing some other purchase. You can always put things back on your credit cards if you must.

3) Emergency fund (a couple months’ living expenses + your auto and health insurance deductibles)

You need to have some money socked away for unforeseen expenses or losses of income. A short-term stash of cash to tide you over if you lose a job, get sick, or have to replace something valuable, like a car, is invaluable for financial stability. The general rule for insurance is to insure things which you wouldn’t be able to replace relatively quickly and that would cause you hardship if you had to go without them. This includes your home, life, health, and your car or jewelry, depending on the retail value of these items and your personal savings. (Make sure to avoid useless insurance.)

Expenses you can afford should be ‘self-insured’ by your emergency fund or other savings. Raising insurance deductibles and banking the difference in premiums is a good way to self-insure against small losses ranging from a few hundred to a few thousand dollars. Store emergency money for unexpected car repairs, insurance deductibles (which can be large if you have catastrophic, HSA-eligible health insurance), or high vet bills for your disgustingly-cute Cavalier King Charles spaniel.

Whether you need more or less living expenses saved depends on how steady your income is & how many liquid assets you already have (like non-retirement stocks that you could tap.) The more financially secure you already are, the less of an emergency fund you need: a self-employed person with few liquid assets needs more emergency funds than a union schoolteacher with 20 years seniority and a sizable investment account.

Like all short-term (less than 3-5 year) savings, your emergency fund should be investing in cash or a short-term bond fund. High-interest savings accounts like the kind from Capital One 360 are great for very short-term savings since the principal is guaranteed by the FDIC. Bond funds, which may vary slightly in principle but generally yield a higher return than savings accounts, work better for money that might sit there longer than a year.

For those with incomes low enough to be able to contribute to a Roth IRA, I strongly recommend dumping your emergency fund into a Roth IRA and investing in cash to kill two birds with one stone: simultaneously taking advantage of tax-advantaged retirement savings but also giving yourself the ability to withdraw the contributions (but NOT the earnings) at any time with no penalties or taxes. I describe this tip in more detail here.

4) Tax-advantaged retirement accounts (401ks, Roth or Traditional IRAs)

After you’ve maxed out your employer retirement matching, paid off your high-interest debts, and stored money for emergencies, it’s time to go back to saving for your retirement because of the huge tax advantages offered. In rough numbers, if you’re making less than $100 K as a couple or $50 K as an individual (i.e.: likely in the 12% tax bracket for 2021), max out your Roth IRA and/or Roth 401k at work. If you make more than that/are in the 22% or higher income brackets, I would max our your regular 401k first, then switch to maxing out your Roth IRA next if your income is low enough to qualify (your tax software will tell you this at the end of the year. You can still contribute for last year up until your tax filing date.)

If you make too much to contribute to a Roth IRA, use the backdoor Roth IRA [article coming soon] method IF you either have no Traditional IRAs with pre-tax money in them or can put all your Traditional/Rollover IRA money into your 401k plan to avoid paying taxes on it.

If you don’t have a retirement plan at work, use the appropriate IRA (Roth or Traditional) instead. If you’re self-employed, open an Individual 401k.

Read this to know what investment option to choose.

After maxing out your 401k and Roth IRA/backdoor Roth, if you also have HSA-eligible health insurance, max out your HSA as well. If you make enough to be in the 22% tax bracket or above, put the HSA ahead of your Roth IRA in terms of priority.

Putting money into a tax-free retirement vehicle is critical to building up a nest egg for the future. Assuming you’re in the 24% tax bracket, an investment in a tax-advantaged retirement account made when you’re 25 will be worth about 50% MORE in real dollars when you’re 65 than would an equivalent investment in a taxable account.

To complete step 4, if you’re under 50, in 2021 you’ll be investing $20,500 in 2021 in your 401k if you’re under 50, $6,000 in your Roth IRA, and $3,200 in your HSA if you have single coverage, or $7,200 if your family is covered by your HSA insurance for the entire tax year in question (generally speaking.)

That’s around $30 K in annual savings, which is rarefied territory for more Americans, but very doable for anyone making at least $75 K or more as an individual, or couples making more than $150 K. You just gotta save more.

5) ‘Regular’ taxable investment accounts & short-term savings for big purchases

After you’ve maxed out your retirement options, it’s time to open a plain ol’ taxable investment account for long-term savings. I like to think of these as early retirement accounts; the more you sock away now, the quicker you can exit the rat race.

You should also be saving regularly for big purchases like a house, wedding, vacation or new car. For these shorter-term items, use the banking system I recommend and create a savings account for each major purchase, and label it accordingly.

You might rank a short-term savings goal as higher priority than maxing out your retirement accounts. For example, maybe you want to buy a house and can’t save up the downpayment while maxing out all your tax-advantaged sources. That’s fine, but do NOT neglect your retirement. Investing early, even with just a little bit of money, is the most important factor to building wealth. Saving for retirement will be way easier if you start today with whatever you can.

Now go do it!

Take each step one at a time until you’ve finished it, then move on to the next one. If you’re maxing out steps 1 – 4 and contributing something in step 5, you’re doing very well and on your way to financial independence.

Now that you know where to put your money, find out WHAT to invest it in here.

Automating your finances (Ramit Sethi-style)

I’m a big fan of automation, especially for personal finance & investing (think automatic 401k withdrawals.) A ‘classic’ video from Ramit Sethi is at the bottom of this post, outlining his approach to automating your money. I recommend watching it (12 minutes) and trying to automate your own money to the extent possible. It takes a little up-front effort (which you never have to leave your computer chair for), but it pays off big time in making life simpler & helping you effortlessly hit your financial goals.

Using INGDirect for online banking is a big step in the right direction on the automation front. I use them to automatically mail out my monthly rent checks, and to automatically put pieces of my direct deposited-paycheck into various high-interest savings sub-accounts. Here’s how I do it.

How I automate my money

I generally have a ‘cycle’ of automatic things that happen per each paycheck. A certain percent goes to my 401k at Vanguard (and invested according to the index funds I picked.) The remainder (minus taxes and insurance premiums) is direct-deposited into my ING checking account online. Of that, a fixed dollar amount goes into a vacation sub-savings account, an account for money that I spend on myself to make more money, and to my no-ATM-fee Charles Schwab checking account that I use for miscellaneous cash needs.

Once a month, my rent check is automatically mailed out to my landlord from my ING checking. All my other bills (including utilities, cell phone, internet, etc) have been set up to be automatically paid by my credit card. Thus, I just have one automatic credit card payment out of my ING checking that occurs monthly. (Some bills can be set up to automatically come out of your bank account if paying by credit card is not an option; but I prefer the latter for the simplicity.)

Anything left over is available for me to either spend (without feeling guilty since I’ve hit all my savings goals), or add to my savings. If you know me, you can guess that I generally choose the latter, but every once and a while I loosen the purse strings and splurge on myself in the form of good beer or relatively-inexpensive travel. (I know, I know, I’m a wild man when it comes to my spending sprees.)

Below is a picture from Ramit’s post (linked below) that illustrates how this works:

Having my money automatically going to various savings places BEFORE I get to spend it on discretionary items is part of the idea. I’m ‘paying myself first’ as the mantra goes. Of course, you’ll want to have a rough idea of your more ‘mandatory’ spending like rent/mortgage, utilities, gas, groceries, plus a little spending money so that you can estimate how much you can sock away. If you want to have more money to save, scroll down to the 30 excellent tips in this post.

Ramit’s more detailed explanation

Ramit outlined the approach he discusses in the below video in a blog post here as well.

Do you know how much you need to save for retirement, college, or a home?

This handy savings calculator from Lifetuner.org helps you answer that question. Just plug in a yearly savings amount (like $200/month = $2400/year), the ages you start and stop investing, your desired retirement age, and an interest rate. For this last assumption, I would use 6.8% (or 7% if decimals are too much to handle) to match the historical, real (inflation-adjusted) stock market return. That way you won’t fool yourself into thinking you’ll have more purchasing power (which is what matters) than you really will have.

You can run up to three side-by-side simulations. Compare starting ages, amounts you save, or the difference due to small interest rate changes. This is a great calculator for estimating the return from regular investing, or the difference in gain from, say, a 0.5-1% increase in return due to switching to low-fee index funds, which beat the returns from (higher-fee) actively-managed mutual funds 70 – 80% of the time.

You can use this to calculate ANY regular investment, not just one for retirement. For example, if you want to have a house downpayment in 3 years, assume a bond fund return of 3-5% (rates are low today) and then see how much you’d need to invest yearly to achieve your goal. The longer you can wait, the more you’ll have.

Or, to calculate savings for your kid’s college (new parents, pay attention!), enter your kid’s current age as the ‘start saving’ age and 18 as the ‘stop saving’ & “retirement” ages. (“Retirement” in this calculator just means the date when you want to know how much you’re investment will be worth.) Use the historical, real, stock market return of 6.8% if you have a long time (>5 years) to invest, since that’s where your college savings should be.

Hack your Roth for tax-free short-term savings (Re-thinking the Roth IRA – Part 2)

You may remember my admonitions that ‘retirement savings are for retirement!’, but today I’m going to show you how to use your Roth as a sort of savings ‘hybrid’: you can use the Roth as short-term savings vehicle AND get the benefits of tax-free interest for retirement. Before we get any further into this, make sure you understand how the Roth IRA works.

You may have decided that investing in a Roth IRA isn’t the best move for your retirement (opting instead for a 401k perhaps.) Contributing to a Roth may still be a smart move, even if you want to use the money sooner rather than at retirement. (Anyone with earned income whose modified adjusted gross income is less than $105,000 can contribute to a Roth IRA, regardless of age or participation in other retirement plans, like a 401k.) Before we delve into the details, I want to let you know that this is an ADVANCED (though not hard) technique. Make sure you understand all the details before deciding to use it. (Post a comment with any questions you have.)

Recall that a Roth IRA lets you contribute after-tax dollars to a variety of investments including index funds, individual stocks and bonds. The benefit over a ‘normal’ taxable account is that the money then grows tax-deferred, meaning you don’t pay interest on reinvested dividends or interest. Plus, if you take out the gains AFTER age 59 1/2, you don’t pay any taxes on those either! The catch is that if you DO take out any gains before turning 59 1/2, you generally must pay a 10% penalty on top of regular income taxes. BUT, because you’re contributing after-tax money already, you can pull out amounts up to the value of your contributions with NO penalties/taxes at any time you want!

For example, say you contributed $2,000 to a Roth IRA in 2007, then another $4,000 in 2008. You can take out up to $6,000 with no penalties/taxes. IF however, your account increased to $7000 in value due to appreciation, you can still only take out up to the $6,000. The extra $1000 gain must remain in the account until you’re 59 1/2 to avoid penalties (with a few exceptions detailed here.)

Since your money accumulates tax-free, you earn a higher after-tax rate of return in a Roth than in a taxable account. If you’re earning say, 6% interest on $5000 and you’re in the 25% tax bracket, your after-tax return is only 4.5% ($225 per year) in a taxable account. If you had that money in a Roth IRA instead, you’d earn the full 6% ($300), which equals 33% more money per year. Over time, small differences in interest rates make a huge impact on your wealth due compounding interest as shown by the below graph.*

Roth IRA vs taxable account - real growth difference

After 5 years, your Roth IRA will have $400 (7.5%) more in it, in 10 years, about $900 (15%) more. When we combine the two facts above, being able to take out contributions at any time plus tax-free growth, we get a great way to use the Roth IRA as BOTH a short-term savings vehicle AND a way to earn higher returns on that money.

First, open a Roth IRA account that is completely SEPARATE from any Roth IRA account you might have designated for retirement. This is because you do NOT want you to think of any Roth money you set aside for short-term savings as retirement money. This makes it easier to keep track of your contributions that you plan to take out. I have two Roth IRA accounts at Vanguard, one for retirement (invested 100% in stock index funds) and one for short-term savings, like emergencies, invested 100% in a diversified bond index fund. Here’s how it looks:

Roth IRA - 1 is for retirement (hands off!) and Roth IRA - 2 is for short-term savings

Next, use an Excel spreadsheet, like the one I developed here, to track your Roth IRA contributions. Your spreadsheet should have at least two columns: one that shows the amount of money you either contributed or took out of ANY of your Roth IRA accounts and one that shows the date of the transaction. To find past contributions, the financial institution where you have your Roth IRA should keep records of these transactions for a few years (or check all Form 5498’s that you might have received from your financial institution(s) over the years.) Make sure you never take out more than you’ve contributed, or you’ll likely face taxes or penalties.

Next, fund your separate, non-retirement Roth IRA with money that you need in the short (or long) term. If you’re saving for the short-term, like an emergency fund, choose a relatively safe investment like a bond or money market fund. The beauty of using a Roth for an emergency fund is that you get the benefits of easily-accessible principle (your contributions) with the added bonus of tax-free growth that can be used for retirement.**

This is great because your emergency funds might be invested for a really long time, if you’re lucky enough to avoid costly emergencies. In light of this, you’d like to maximize your gains by avoiding taxes while the money sits there. You can use a similar strategy when saving for a down payment on your first home. If (and ONLY if) you’ve had a Roth account open for at least 5 years, you can use up to $10,000 of Roth IRA gains towards a first-time home purchase tax- and penalty-free. So in this special case, you can even use the earnings (plus all the contributions) from your Roth IRA.

(Remember, you must have opened a Roth IRA account and deposited money into it at least 5 years ago to use this exception. There is a similar exception for qualified education expenses, except the earnings withdrawals are NOT tax-free, only 10% penalty-free. However, there are better ways to save for education.)

As a final note, remember that the IRS doesn’t care which IRA accounts you deposit to or take money out of, all that matters is your total contributions & distributions from all your Roth IRA accounts combined. (Even so, I strongly recommend keeping Roth accounts you intend to use for short-term events separate from retirement-designated Roths.)

Start using this strategy today by opening a Roth IRA online at a reputable mutual fund house like Vanguard, Fidelity or T. Rowe Price. With minimum initial deposits as low as $50 for T. Rowe Price, there’s no excuse for not starting a Roth.

* The graph is inflation-adjusted because we always want to talk about ‘real dollars’, aka purchasing power. Another way of saying this is that we don’t really care about how many dollars we have, but how much stuff we can buy with them. If we didn’t factor in inflation, we would actually understate how valuable the tax-savings from a Roth are.

** If you really want to optimize your investment performance, you could periodically (perhaps annually) move the gains on your non-retirement Roth into a Roth you’ve designated for retirement. You would do this in order to move these gains (which shouldn’t be taken out until retirement) into a more volatile long-term investment, like a stock index fund, rather than having them sit in a stable, but lower expected return, short-term investment.