So, you’ve been working hard, making smart financial choices, and now you’re at the point where you’re bringing in more money than you’re spending … good job! Just getting to this point is hard, so take a second and congratulate yourself. Many people’s natural next questions are “exactly how much should I be saving?” and “where should I put the money I’m saving?” This article answers those questions, and a few more, enjoy!
How much should I be saving?
The amount of money you are saving, or your savings rate, is critical to your financial plan. This number helps determine how early you can retire and what type of lifestyle you can live in retirement.
Some personal finance experts recommend a flat savings rate of 15% of your gross income. While that’s a decent rule of thumb, it’s important to note that there are two primary factors that should heavily influence your savings rate:
- When you start saving. The number of years you are able to save for retirement has a huge impact on your savings rate;
- Your desired lifestyle during retirement
The Certified Financial Planner Board recommends a savings rate of 10-12% of your gross income, if you start saving for retirement before you are 32 years old. If you don’t start saving until you are 40, the CFP Board recommendation increases to 20-25% of your gross income.
If you want to retire before the general retirement age range of 65 to 70, or if you have other big goals then you will need to adjust these savings rates accordingly. If you’re looking for help figuring out what your savings rate should be, click below to create your personalized financial plan with Savology.
What type of accounts should I be looking at?
If you’re reading this, we’re going to assume you’re probably past the point where you’re wanting to hide all your savings under your mattress. So, let’s discuss generally what types of accounts exist and how they are used.
For the purposes of this article, we’ve divided the types of accounts into three different buckets, based on how they’re taxed:
These accounts are used for money and investments that you want to be liquid, or easily accessible. As an example, your emergency fund should be put into one of these accounts—likely a savings account—so you can easily access the funds.
The primary purpose of these accounts is for your short-term cash flow, savings, and investment goals. When the funds in these accounts increase in value, whether via interest or capital appreciation, it is taxed in one of two ways:
- Your ordinary income tax rate, depending on your tax bracket. These rates range from 10% to 37% as of May 8th, 2021. Additionally, any investments you’ve sold that were held for less than a year will be taxed at this rate.
- Long-term capital gains rates. This applies to investments like stock you sell that you’ve held in a brokerage account for more than a year. This should result in a lower tax rate than your short-term capital gains tax rate. As of May 8th, 2021 the long-term capital gains rates are 0%, 15%, and 20%, depending on your taxable income and filing status.
Examples of taxable accounts:
- Checking Account
- Savings & Money Market Accounts
- Certificate of Deposit (CD)
- Brokerage Account
- Real estate investment property in an individuals name
Tax-deferred accounts enable you to realize immediate tax deductions up to the full amount of your contribution, but future withdrawals from the account will be taxed at your ordinary income rate.
In other words, your money grows tax-free and then is taxed at ordinary income rates when it’s withdrawn. The most common tax-deferred accounts are 401(k)s and Traditional IRAs.
As an example, if your taxable income this year is $100,000, and you contribute $6,000 to a tax-deferred account, you would only pay tax on your income of $94,000 this year. In 25 years, once you retire, if your taxable income is initially $60,000, but you decide to withdraw $8,000 from the account, your taxable income would be bumped up to $68,000.
Examples of tax-deferred accounts:
- Traditional IRA
- Traditional 403(b)
- Simple and Sep IRA
- Health Savings Account (HSA)
3. Tax-Free or Tax-Exempt
Contributions to tax-free accounts are made with after-tax dollars, so there is no immediate tax benefit. The real benefit is that the investment returns in these accounts grow tax-free, so you do not pay taxes on the money you withdraw.
Examples of tax-free accounts:
- Roth IRA
- Roth 401(k)
- Health Savings Account (HSA)
- Some forms of Cash Value Life Insurance (depending on how it is structured)
So where should I put my savings?
In the author’s opinion, the answer for most people is that they should be putting money in all three of the buckets outlined above. Most people have both short-term goals—like starting a business—and long-term goals, like retiring by a certain age.
The correct split between each account varies greatly depending on your goals. Are you working to build up your emergency fund? Saving for retirement? Looking to invest, but keep those funds liquid? The truth of it is that there isn’t one answer for everyone, nor should there be.
With that being said, I’ve outlined below a few important things to keep in mind as you navigate this important question:
- Write down your short- and long-term financial goals and then create a savings plan to reach those goals.
- Automate the deposits into each account so you don’t have to remember to do it and so you aren’t tempted to impulsively spend that money
- Take full advantage of any employer sponsored plans where they match or make contributions on your behalf. That’s free money, get it!
- Health Savings Accounts (HSAs) are the best of the both worlds because they fall into both the tax-deferred and tax-free buckets, as long as you use the money for qualified medical expenses. Additionally, HSAs can be used for retirement if you don’t end up using them for medical expenses. Learn more about the magic of HSAs here, and make sure you’re taking full advantage of HSAs, whenever possible.
- If you are in a high tax bracket currently and you expect to be in a lower tax bracket when you withdraw funds, it makes sense to contribute to tax-deferred accounts.
- If you are in a lower tax bracket now than you expect to be in the future, then you’ll want to save into a tax-free account and forgo the deduction now for the potential of tax-free growth.
- Tax-free and tax-deferred accounts have different rules for when you can access the money. For example: with 401(k)s and IRAs, in most circumstances, you can’t withdraw funds until you are 59 and ½. With HSAs you can’t withdraw before retirement unless you have a qualifying medical expense. If you don’t abide by the withdrawal qualifications for these accounts, there are tax consequences and related penalties.
- If you are saving up to a start a business, buy real estate, or for other short-term goals, it likely changes the order that you want to be saving in. You would likely prioritize putting money in a taxable account where the money is easily accessible.
Putting your hard-earned savings in the right accounts will have a major impact on your financial future. After reading this article, you are equipped with information on the different types of accounts and their tax ramifications. From here, match your knowledge with your financial goals, open the right accounts, and set up your automatic deposits. You got this!