Saving and investing are two different ways to prepare for the future. In my opinion, the difference between saving and investing boils down to risk tolerance and time frame.
Generally, savings should be used for short-term planning and investing for long-term planning.
Strong financial planning calls for a mixture of both saving and investing, and today’s question is about how to balance cash savings and investing for retirement.
Cash Savings vs. Retirement Savings
Q: Hello, Ryan. I have a question for you about cash savings vs. retirement savings.
I visited a financial planner a few weeks ago because my office offered a service to go visit one for free. I sat down and gave her a sketch of our finances:
- Take home pay: $8100/mo (after taxes and 401(k) contributions)
- Savings: $23,000 (5 mos living expenses)
- Retirement: $75,000
- Mortgage: $270,000 @ 5.6%
- Student Loans: $14,000 @3.5% and $42,000 @ 2.5%
We have no other debts and are able to save about $1500/mo right now. I’m 29 and my husband is 33. We both work for the government and have stable jobs.
One major financial goal is to increase our retirement savings. I think we got off to a slow start and we’re trying to catch up now. Another goal is to increase our cash savings since we live in a small condo and might have kids in the future (next 2-4 years most likely). We would likely have to move and might even need to add a car if we had a kid.
The financial planner advised us to decrease our 401(k) contributions to 5% in order to get the full employer match and then put the money saved in a Roth. Our income would increase by about $700/mo if we do this. My concerns are:
- Our money won’t go as far since it will be after tax, so our retirement contributions for the year will go down.
- If we do the Roth, I’d like to put our money in Vanguard Lifecycle Funds, but you have to put in $3,000 to open an account ($6,000 for both of us). That’s a lot of money that we’re putting into the market all at once. I’d rather spread our risk by spacing out the contributions but it doesn’t seem to be an option with Vanguard.
- I’m not sure opening a Roth is even the right thing to do. I know it has great advantages in the long term, but maybe we should do that another time…
Should someone in our situation just try to amass as much cash as possible? Or should we focus on paying down our student loans instead?
I know that I’m not getting professional advice here, but I’m curious as to what everyone’s opinion is… I don’t really talk about finances with my friends so it would be nice to bounce this off of some other people. Thanks for your consideration!
Where Should You Focus?
A: Hi Penelope, thanks for contacting us. I’ll start off by saying you’ve done a good job so far by making smart financial decisions and not amassing any consumer debt.
With some additional planning, you should be in a nice position to meet your goals of increasing both your retirement savings and your cash savings.
Let’s look at a couple of options, and hear the opinions of two other members.
As you mentioned, we are not professional financial advisors, so this is just a look at your options, not advice telling you what you should do! I recommend visiting a fee-only financial planner for more specific information.
Goal 1: Increase Retirement Savings
If you got a late start on your retirement investing, you’ll likely want to catch up as much as you can while you and your husband are in your prime earning years and don’t have any children or other major expenses.
401k vs. Roth IRA
I think Roth IRAs are a great deal, and I recommend opening a Roth IRA if you fall in the income limits. It’s important to understand their advantages.
Take some time to read about and understand the differences between 401k plans and IRAs.
For many people, it is best to invest for the 401k match, then work toward maxing out your Roth IRA because of the long term tax benefits that Roth accounts offer.
Investing in both a Roth IRA and a 401k helps diversify your taxes in retirement years. Here are some more tips about maximizing your 401k plan contributions.
How You Can Contribute To An IRA
Each person can contribute up to $5,500 in an IRA and there are several ways you can max out an IRA if you choose to (or contribute any amount up to the max). Decreasing your 401k contributions is one way.
You can also use some of the $1,500 in cash savings you accumulate each month. If you want to make the contributions all at once, you can use a portion of your emergency fund to partially fund your IRA, then set up automatic investments to use dollar cost averaging to max out your IRA over the course of the year.
It would take $458.33/mo. per person ($916.66/mo. for both people) to max out an IRA with monthly contributions. You can repay your emergency fund over the next few months.
I don’t normally recommend people use their emergency funds to invest, but you can probably afford to do this as you and your husband both have stable jobs and your excess cash flow should make it relatively easy for you to build your emergency fund back up over just a couple months.
Don’t let the $3000 minimum stop you from investing in the Vanguard Lifecycle funds if that is the plan you wish to invest in. You have a substantial emergency fund and stable jobs, so you could afford to invest the $3,000 or $6,000, then repay your emergency fund over the next couple months.
Alternatively, you could save each month until you reach the $3,000 required to open a fund. I don’t think making a $3,000 or $6,000 initial investment instead of making monthly installments will hurt you over the long run.
In fact, many studies show that lump sum investing outperforms dollar cost averaging in the long run. So making a large lump sum investment is actually a good idea.
Goal 2: Increase Cash Savings
My wife and I just had our first child and we are in a similar position as you imagine you and your husband might find yourselves. We are looking at the need to upgrade on a vehicle in the next few months, and move out of our condo in the next year or so.
We started saving for this about 2 years ago, and we are glad we did – there will be a lot of unexpected expenses along the way! Starting early is the right way to go.
To meet your cash savings goals, try to determine what your needs might be: what size car, housing needs, stay at home mom or working mom, etc. It’s tough to answer these questions because the answers are unknown until you get there, so do the best you can, knowing that things may change in the future.
If it makes you feel better, err on the side of caution and save a little extra cash. You may also start looking for other methods of saving money so you can increase your monthly savings (eating out less often, dropping premium cable services, etc.).
These questions can help you determine your comfort level regarding how much cash you need to keep in your emergency fund.
How You Can Meet Both Financial Goals
Save For Retirement and Cash Goals
Your current salaries allow you to save $1,500 per month, which means you can continue your current 401k allotments, fully fund your IRA, and stick the remainder in your cash savings.
You may find it helpful to earmark your savings for specific goals so you can track progress as you save. For example, Capital One 360 offers sub-accounts, which makes it easy to direct your saving toward specific goals.
It’s OK For Your Goals and Situation to Change
If you ever feel the need to increase your cash savings, then you can decrease your 401k or IRA contributions, then direct the remaining amount toward cash savings.
Or you can contribute in any combination in between. Do whichever arrangement makes the most sense for your needs.
In the meantime, you can maintain higher cash flow if you remain in your current house and drive the same cars until you need to upgrade if you have children.
Remember, having a smaller home is more affordable than upgrading before you are ready or before you need it. Keeping your expenses lower now will give you more financial flexibility and help you better meet your financial goals.
Determine How Much Cash You Need, Then Invest the Rest
It’s good to keep some cash liquid. This is important for your emergency fund and paying for any short term needs. But if you want to make money, you need to invest it, not keep it in a savings account.
Even the best online savings accounts only offer a little over 1% interest. That’s fine for the money you might need quick access to (your emergency fund), but it won’t make you a millionaire or help you grow your wealth.
Where to Store Cash Savings
With savings and investment goals in mind, you need to determine the best place to put your funds. Let’s take a quick look at some of the best places to store your cash savings.
Online High-Yield Savings Accounts
While traditional savings accounts are a safe bet, you won’t be garnering the interest that you could with an online account.
Because online banks don’t have brick and mortar establishments to fund, their fees are lower and their interest rates are higher.
The top online high-interest savings accounts offer high returns, little to no fees, and functionality. Many of those accounts come with mobile banking features, alotted numbers of transfers, access to the banks’ ATMs, and customer support.
If you’re looking to safely store your savings without the risk that often accompanies investments but still get a solid return and easy access to your funds, a high-yield savings account is your top choice.
Certificates of deposit are another low-risk short term savings option which you might want to consider.
CDs come in terms, like 1, 2,3, or 5 years. The only catch with a CD is that your money has to stay there until the account reaches maturity at the end of its term.
To make even more money with your certificates of deposit, I recommend a strategy of CD laddering.
Laddering your CDs allows you to access some of your money and earn a higher profit on interest. With a 5-year CD ladder, you invest in a 1, 2,3,4, and 5 year CD, meaning you’re never more than a year away from getting your hands on your savings.
Although CDs don’t have as high a potential return as other investments, if your main goal is safely stashing your funds, they’re a good option. CDs have a better return than a traditional cash savings account and allow you to dip your toes into strategic investment.
Money Market Account
A money market account gives you the best of both the checking and savings worlds.
Money markets, like CDs and high yield accounts, have better interest than traditional savings accounts, and you can access your funds when you need them. Most banks offer money market accounts, and you can even write some checks from those accounts.
In order to maintain high interest rates, money market accounts come with higher minimum balances than other savings accounts. They also invest in low-risk ventures like government securities and commercial paper.
You can’t get much safer in the investment world than purchasing a treasury bill or note.
If you want to accrue some interest on your savings without risking it all, you might consider a treasury.
Treasuries aren’t taxable on the local or state level, they’re backed by the full faith and credit of the United States government, and they come in the form of bills or notes. A note, for instances, is purchased at a term with a set interest amassing every six months.
A bill, on the other hand, is purchased at a discount, and you receive it at face value once it matures.
Where to Invest Retirement Savings
When it comes to retirement savings, the stakes are different than they are with short-term savings options.
Where you place your retirement savings depends on your goals and how comfortable you are with taking risks.
Types of Retirement Accounts
Most people start here, enrolling in a 401 (k) or 403 (b) account with their employer. If you change jobs, your account can be rolled over to your place of employment or your IRA.
If you’re under age 50, your Roth and IRA contributions are capped at $5500, and $6500 above age 50. A traditional IRA’s growth is tax-free.
Simple IRAs are perfect for small companies with fewer than 100 employees. A simple IRA gives you the opportunity to contribute and be matched by your employer at a certain percentage.
Ideal for self-employed individuals, simplified employer pension is easy to set up and allows you to contribute 25% of your income or $55,000, whichever is less.
I’ve written extensively about Roth IRAs and where to open them. The Roth should be your next line of retirement investing after maxing out your 401k.
Roth IRA funds are pre-taxed and contributions can be accessed without penalty.
Retirement Investment Options
Within those types of accounts, you need to decide how your money is invested. Here are a few tips to keep in mind as you determine how much risk to take with your retirement investment portfolio.
If you’re young and have zero aversion to risk, consider a small-cap stock. They’re risky but the returns could be huge.
If you do your research and insert a few carefully chosen stocks to your portfolio, you could benefit greatly. You might also consider an option like an ETF or mutual fund investment.
The closer you get to retirement, the more you have to risk.
The more money you’re risking, the more caution you might want to apply to your investments. Bonds and blue-chip stocks are great options that are a little safer than small-cap stocks but still highly rewarding.
As you near retirement, take advantage of the increased contribution limit and put as much as you can into your retirement accounts.
With a diverse portfolio, measured risks, and defined goals, you can retire with ease.
More Thoughts on Cash Savings and Retirement Investing
Pinyo from Moolanomy.
Penelope, thank you for your question, it’s a really good one. Also, congratulation on being on top of your finances.
At a high level, I think your financial planner gave you good advice. For someone in your and your husband age group, Roth IRA offers a better tax advantage in the long-term. Lowering the 401k but keep the maximum match is also good advice to help you save some cash for short-term needs.
Now let’s address your questions one at a time.
1. As mentioned above, you’re taking short term hit by paying taxes upfront for your Roth IRA contribution, but I will use Larry Swedroe’s logic here and explains that when you invest in a Traditional IRA or 401k, you can think of it as co-investing with the government where the government owns the portion that you’ll eventually be paying taxes on. For example, if you invest $4,000 before tax dollars, and your tax bracket will be 25% at the time of withdrawal, you are actually investing $1,000 for the government. This is similar to paying $1,000 in taxes today and invest $3,000 in a Roth IRA that you retain 100% ownership of. Since there’s a maximum contribution limit of $5,500 per year, Roth IRA actually allows you to invest more of your after-tax dollars than a Traditional IRA — i.e., $5,500 as opposed to 75% of $5,500.
2. I think Vanguard Lifecycle Funds are excellent choice. If you want to make it work, I think using $6,000 from your savings to fund the two Roth IRAs are acceptable. This still leaves you with almost 4 months of emergency fund. With your income, you can build this back up in no time.
3. As far as what to do to meet your goals of saving for a bigger house in the near future, I am missing one variable, that is the value of your home. If you have sufficient equity in your home, it shouldn’t be a big problem to use your existing equity toward the down payment. So it’s hard to say how much you should save.
At the minimum, I think you should follow your financial planner advice of (1) saving 5% toward your 401k, (2) saving $5,500 each toward Roth IRA, and (3) saving the rest for emergencies and down payment. My suggestion to keep your savings in online savings account so that money is easily accessible.
As far as debt goes, I don’t think it’s the right move to prepay your mortgage or student loans at this time — i.e., in this economy and also because you’re trying to save money for a new house and a car. Beside, the interest rates on your student loans and mortgage are already good.
If I was in your shoes, I would focus on putting 5% in the 401k, maxing out the Roth IRAs, and building up your emergency/down payment funds.
Plonkee from plonkee.com.
Ok, the general rule of thumb for retirement savings is:
- Contribute to your 401(k) or equivalent to get the match
- Contribute to a Roth IRA up to the maximum ($5500 in 2009)
- Contribute to your 401(k) or other pre-tax investments up to the max ($15500 in 2009)
- Use taxable accounts
Doing it this way diversifies your tax risk so that you’re invested a bit through accounts that are taxed when you take the money out (401k) and a bit through accounts that are taxed when you put the money in (Roth). The Roth is the only way of investing so that you’re taxed now and not when you take the money out, plus the limit is lower and phases out as you earn more money, which is another reason why you’re normally encouraged to use it while you can.
It is annoying that you can’t dripfeed your money into the fund that you want. However, looking at it over the long time frame that you have, the chances that you will do significantly better by investing $700 a month for 5 months, compared to savings up $700 a month for 5 months and investing $3500 at once are small.
Looking at the numbers, I’d say that your student loan debt has such low interest rates that it’s not important. It’s lower than inflation, and your mortgage interest rate. Personally, my debts have similar interest rates to yours and I’m ignoring the student loan, and using extra money to invest for retirement, or to pay down the mortgage.
If you save the extra $1500 a month you’ll probably amass something like an additional $55k over the next 3 years. Is that enough to do all the things that you plan on? Or too much? If the mortgage on your condo is $270k, then it sounds like property is expensive where you live, so you might want to put more towards a house upgrade – or since you have a healthy emergency fund, maybe pay off more of your mortgage as you’ll get a better return.
I’m all about balance. In your shoes, I’d probably save around $500 a month towards a new car/kids/moving expenses, put $500 into the mortgage, and $500 into retirement investments. It sounds like a very rough estimate, but it would actually give you about $20k in savings, and a mortgage of only about $240k in 3 years time, plus your retirement income is fairly likely to cover the levels of expenditure you have now (or, as much as you can tell when it’s 30+ years away).
Of course, this is just what I’d maybe do, in your position. I’m not sure how much you money you’ll need to move house, or how much kids cost, and I don’t know what your current retirement investments are projected to give you.
Oh, and congratulations on being very sensible with your money, and best of luck – you have a great problem.
Thanks for contacting us, Penelope. I hope these ideas give you and your husband a few more ideas to consider regarding your short term and long term goals.
You have plenty of options to choose from, so please be sure to decide which actions are best for your needs. You may also consider consulting with a financial planner for more information.
Best of luck!
Readers – do you have any suggestions?