Get Smart About Savings

by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
November 20, 2008

Reprinted from the November 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

With the stock market in bear terrain and the economy in turmoil, it's tempting to pull back on your savings. But that could actually be the single worst financial decision you can make. After all, you can't control the market, but you can control how much you save or put toward reducing debt. A debt-reduction and savings discipline is likely to be the most powerful way you can keep your net worth growing, especially if the markets continue to decline or stay flat for an extended period.

Of course, finding extra dollars to save can be particularly challenging in times like these. So it's all the more important to get smart about how you save, including balancing competing goals. For example, should you contribute to your retirement first, or pay off debt? What about other major goals, such as home ownership?

Consider the three-step plan below as a general road map that you can adjust along the way to meet your needs and circumstances.

Take care of the priorities. Have you ever played Monopoly? Think of your savings priorities as the equivalent of "Do Not Pass Go" until you've taken care of them. Among them: Make sure you first take full advantage of any available employer 401(k) matching contribution, pay off high-cost non-deductible debt, create an emergency fund and then make retirement security a priority.
Focus on other major goals. With your priorities taken care of, you're ready to move on to other important long-term goals, such as paying for your kids' education or buying a home.
Build your wealth. Once you've addressed your priorities and other major goals, you can further build your personal net worth by paying down other debt and continuing to save and invest.

Before starting your savings journey, you'll want to do some basic budgeting and financial planning. That way you'll know how much of your income goes to routine monthly and periodic expenses, and how much you should be saving toward your major goals (see Cash Flow Planning for Life). Here's a three-step guide for how and when to allocate your savings dollars to make the most of them.

Step 1: Get the Priorities Straight

Lock in your employer's 401(k) match
Be sure to contribute enough to your employer-sponsored retirement plan so that you receive your employer's maximum matching contribution every year. Subject to a vesting schedule, that matching contribution is like free money. Your employer's match and the taxes you defer on your own qualified contributions give you an immediate return on investment that beats any conceivable alternative after-tax investment or the "opportunity cost" of forgoing other uses for savings, such as paying off high-cost debt.

Pay off non-tax-deductible consumer debt
Eliminating nondeductible consumer debt like credit cards (which may charge double-digit interest rates) amounts to a risk-free rate of return that's virtually impossible to replicate—with the possible exception of a "free money" 401(k) employer match.

Try consolidating debt into a lower-rate, tax-deductible loan, such as a home equity line of credit (HELOC)—but only if you can control the debt and aren't putting your home equity in jeopardy. If a HELOC isn't an option, try negotiating lower interest rates with your creditors. Then begin paying off your debts, starting with those with the highest interest rates. For more information, see Borrowing Smart.

Create a rainy day fund
For your well-being and peace of mind, we urge you to have enough savings to cover at least three months of essential living expenses. Although having a good job, a two-earner household or a standby line of credit could mitigate the need for a large rainy day fund, an emergency could still derail your long-term investment plans.

Having an adequate emergency fund can help you weather short-term setbacks and thus keep your long-term plans on track. When you have an emergency cushion, you're less likely to withdraw retirement funds prematurely or borrow at unattractive rates.

Of course, if the interest rate you get on your savings or money market account is lower than the rate you pay on your non-tax-deductible debt, then eliminating that debt should take priority over creating a rainy day fund. If an emergency strikes, you can tap back into a credit card or other type of debt.

Finally, we recommend that long-term investors have at least a three-year time horizon for money they commit to volatile markets. An emergency can occur at any time, so the stock market isn't a safe place for rainy day money. Instead, keep emergency funds in relatively safe and accessible (liquid) vehicles such as money market funds, demand deposit accounts and/or other short-term fixed income investments.

Max out your tax-advantaged retirement accounts
Contribute up to the maximum allowed to any tax-advantaged retirement accounts—traditional deductible IRA, Roth IRA if eligible, and/or employer-provided accounts such as a 401(k), 403(b), 457 and SEP-IRA. In most cases, the up-front income tax deduction of a traditional IRA or a qualified employer plan is sufficient to overcome the ordinary income tax treatment of withdrawals in retirement.

If you expect to be in the same or a higher tax bracket at the time of withdrawal (for example, if you're a younger worker who's yet to reach your peak earning years), you'd likely do better investing with a tax-free Roth IRA, if eligible, or Roth 401(k).

Step 2: Save for Education or a New Home
After you've taken care of the must-dos, you're ready to move on to your other important long-term goals.

Save for your loved ones' education
If you have children (or grandchildren), consider saving for their education in a tax-favored Coverdell Education Savings Account, if eligible, and/or a 529 College Savings Plan. In both cases, your money grows tax-free and you pay no taxes on earnings if you withdraw the money to pay for qualified educational expenses. 529 plans allow anyone (regardless of income) to invest for a child's college education, and have lifetime contribution limits per beneficiary that vary by state—more than $200,000 in most cases. A Coverdell can be used for certain elementary or secondary school expenses, as well as higher education. You can contribute up to $2,000 annually if you qualify.

Save for the down payment on a home
Avoid withdrawing money from a Roth IRA or a regular IRA even if you can avoid penalties for your first-time home purchase. We recommend that you avoid tapping retirement accounts for any non-retirement purpose, except as a last resort. With annual limits on how much you can contribute to these accounts, it's hard to make up for withdrawals, so you'll have that much less to live on in retirement.

Try to avoid borrowing from your 401(k) as well. You'll end up paying your 401(k) back with after-tax dollars, incur a potential opportunity cost while the money is outside your account, and run the risk of defaulting on the loan in the event you get laid off and fail to repay it on time. It's better to utilize taxable accounts for major purchase goals, investing appropriately for the time frame and risk tolerance connected with the goal.

Step 3: Focus on Building Wealth
Once you've addressed your priorities and major goals, you can optimize your personal balance sheet by paying down other debt and continuing to save and invest.

Pay down other debt
Compare your mortgage or home equity interest expense to current rates. If refinancing isn't an option, consider paying off high-rate tax-deductible debt. After all, paying off your high-cost debt—even deductible debt—amounts to an equivalent risk-free rate of return.

Then, focus on paying down your overall debt to a manageable level. Whether the cost of debt is high or low, deductible or not, the total cost of servicing that debt should not exceed what you can comfortably afford. For example, lending industry standards generally assign a red flag when home-related debt payments (principal, interest, property taxes and insurance) exceed 28% of gross monthly income; that figure is 36% for all debt. Reducing your debt outlays to a manageable level will provide for financial stability and a higher credit rating, typically leading to lower interest rates.

Continue to save and invest in your regular taxable accounts
Once you've prudently used all of your tax-advantaged investment options, taken control of your debt, built an emergency fund and addressed major purchase goals, invest what's left over in taxable accounts—tax-efficiently, of course. You can enjoy that money during your lifetime or build your estate for the people and charities that are most important to you.

What about a deferred variable annuity or non-deductible IRA?
In both cases, there's no up-front deduction, and earnings will be taxed as ordinary income when you withdraw them. So neither is an overly compelling choice compared to investing your excess savings in a taxable brokerage account, where you can take advantage of the preferable long-term capital gains and qualified dividend rates.

The only real tax advantage to a deferred variable annuity or non-deductible IRA rests on the benefit of tax-deferred compounding. But you could effectively defer taxes on stocks in your taxable accounts by trading infrequently or buying an index fund (and end up paying lower long-term capital gains taxes when you eventually need the money, versus higher ordinary income taxes). If you're in a high tax bracket and want to hold bonds in your taxable account, you could always buy municipals, the interest on which is tax-free.

The annuity option is analogous to a non-deductible IRA contribution but, we believe, is generally less attractive from a savings perspective because of the typically higher costs and limited investment selection. There are certain other features to consider, however:

Most deferred variable annuities have an optional death benefit, so your heirs would get what you put in even if your investments lost value. This benefit is dubious, however, given the additional costs versus the statistical unlikelihood that a diversified portfolio would lose money during periods of 10 to 20 years or more.
There are no required minimum distributions.
You have the option to annuitize your balance—handy if you want a regular monthly check at some point during retirement. However, a single-premium immediate fixed annuity, in combination with a traditional portfolio, would be a more cost-effective way to provide for a level of guaranteed income—if that's your goal.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Any investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Examples provided are for illustrative purposes only and are not intended to imply future results. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Before making an investment decision in a 529 plan, carefully consider its investment objectives, risks, tax implications and expenses, which can be found in the plan's agreement. By investing in a 529 plan outside of your state, you may lose tax benefits offered by your own state's plan.

Charles Schwab & Co., Inc. is a licensed insurance agency and distributes variable annuity contracts that are issued by leading insurance companies that are not affiliated with Schwab. Not all products are available in all states.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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