A primary rule of retiring earlier is to “live below your means” — spend less than you take in. An unavoidable conclusion is that you’ll have money left over. So what do you do with that? Where do you put it?
The first, second, and third thing to know about saving is just do it. Pack away as much of your income as you can.
As long as you don’t do crazy things with your money like buy collectibles or put it all in your brother-in-law’s new business scheme, your savings rate – the amount you save compared to your income – will be far more important in the early years than exactly where you put that savings.
Nevertheless you must eventually put your money somewhere. Under the mattress won’t do, and the default choices pushed on you by your bank may not be suitable either. So here are some thoughts on the different possible destinations for your retirement savings….
In general, cash is not your friend on the path to early retirement. I keep enough in my wallet to pay for an emergency car repair or a taxi ride to the nearest ATM or transportation hub, but that never gets used. I pay for a sub-$5 food or drink purchase once or twice a month, and otherwise I really don’t use the cash in my wallet. I suggest aggressively minimizing your own use of cash. In addition to being a theft target, it’s hard to track, and a temptation to spend. And it’s surely no mechanism for accumulating assets.
Though the era of hand-written paper checks is rapidly disappearing, everybody still needs a checking account. This is your high-volume, low interest-bearing account, for the bulk of your routine financial transactions. It’s the primary mechanism, along with your credit cards, for monitoring and controlling your monthly living expenses. To maximize control and minimize errors, I strongly recommend automating all of your bill paying through your checking or credit card accounts. (I no longer manually pay any routine bills.)
Your checking account is also the place where your income should go before being divided up. However, as essential as a checking account may be, it still is not the place to accumulate assets. Not only will your savings earn very poor rates of return, if any, sitting in a checking account, but they will be too susceptible to being spent on impulse. I wouldn’t generally keep more than a month or two of expenses in a checking account.
Savings and Money Market Accounts
The first place to turn once you’ve accumulated more assets than belong in a checking account, is a linked savings or money market account. The reason is simple: those accounts will pay more interest and, by being linked to your checking, preferably with automatic overdraft protection, they will seamlessly back up your monthly bill paying, if necessary. But savings and money market accounts are generally limited to six withdrawals per month, making them unsuitable for everyday transactions. Checking, savings, and money market deposit accounts are all FDIC insured (up to $250,000), which is the safest your short-term money can be in this age.
Depending on your income, expenses, job security, time until retirement, and sensitivity to risk, I’d keep somewhere between 3 months and 2 years of living expenses in an easily-accessible savings or money market account. This is the classic “emergency fund.” Its purpose is to float you between jobs, in your working years, and insulate you from being forced to sell other assets at a loss, in your retirement years.
Certificates of Deposit (CDs)
CDs are a popular mechanism for earning guaranteed rates of return, somewhat larger than what you could get on a savings account, in exchange for locking up your money at the bank for a set period. Be advised they come with substantial early withdrawal penalties – minimums set by Federal law and maximums at the bank’s discretion — that could even cause you to lose money in some cases. CDs are heavily marketed by banks and are undoubtedly very profitable for them. The compelling features of a CD are its guaranteed return and safety, but that comes at a price.
I don’t use CDs. I just have not found the risk/reward ratio very compelling for my own investing. A CD requires that you relinquish control of your money for a fixed period, which represents inflation and interest rate risk, and yet the reward for doing that is often miniscule, unless very large sums are involved.
When I have large sums of money that I don’t need for a fixed period, I’m more interested in higher-yielding investments such as stocks and bonds. The two scenarios where I can possibly see using CDs would be (1) as an ultra-safe place to park money from the sale of one home that is designated for buying another home within a year or two, and (2) as rungs in a ladder for short-term retirement income, when interest rates are favorable.
Real Estate/Your Home
Real estate is an extremely important savings vehicle for many, with home equity being the largest source of wealth for most savers. Paying down your mortgage is often one of the safest and surest investments you can make – with a guaranteed return equal to the current interest rate on your mortgage.
Buying and operating rental property is a proven route to wealth, for those who are handy and willing to manage tenants. Real estate is a proven investment that keeps up with inflation and can generally be safely financed with borrowed money. Though it wasn’t my path to wealth, and I have no particular expertise to offer, I know of many others who either enhanced or built their wealth (and retirement income) by investing in rental real estate. If you like the concept but want to remain hands off, you can invest in a real estate or REIT mutual fund or ETF, like I do.
Home “improvements” — especially expensive ones using luxury materials installed by a contractor and financed with borrowed money — are almost never “investments” or “savings” in my book. Such home improvement expenses no longer add to the value of your home dollar-for-dollar, if they ever did. (The return on a remodeling investment has eroded from about 87% in 2005 to about 58% in 2012.) On the other hand, modest, self-financed, do-it-yourself projects stand a much better chance of turning out to be profitable investments.
Defined Contribution Plans: 401(k)’s, 403(b)’s, etc.
An employer’s defined contribution plan will be the next stop for most retirement savers. In addition to tax-sheltered growth, these plans have one other enormous savings advantage in most cases: employer matching. Depending on the specific benefits offered by your employer (the matching rate is up to them, within broad limits), this could supercharge your savings by 50% or more annually.
A key issue in employer-provided retirement plans remains the quality of your investment choices, and the default investment your money is placed in, if you don’t make a choice. Expensive, actively-managed mutual funds are still too common in these plans, and shockingly-expensive and complex annuities are all too common in the plans of some of those least able to afford them, such as public schoolteachers and safety workers.
Nevertheless, because payroll deduction can enforce a consistent saving habit, and because employer matching can enhance savings dramatically, you should almost always participate in any employer-sponsored plans for which you are eligible. And you should usually max out your contributions to any such employer-provided plan each year, at least to the extent needed to get all matching funds.
IRAs: Traditional and Roth
The next stop for retirement savings after maxing out employer plans is usually a Traditional or Roth IRA. These are self-administered retirement plans that grow tax-deferred. They differ primarily in the tax treatment at the time you contribute and withdraw, and in required minimum distributions.
There is such a wealth of information available on IRA choices that I’m not going to reiterate it all here. But I will make a couple points. First, there is an overwhelming tendency to favor Roth IRAs these days, and certainly they are a reasonable default choice, offering generally greater flexibility than Traditional IRAs. But be advised that so much of the pro-Roth advice, especially the advice to convert other retirement funds into a Roth, is predicated on the belief that tax rates will go up in retirement.
It’s true, we are living in a changed economic world, where — all other things being equal — taxes are likely to go up, at least on the wealthy. But beware that, for many historically, the tax rate in retirement has gone down, because a retiree’s income is usually substantially reduced. (And should your income not be reduced in retirement, maybe you don’t need to fret so much about taxes.) Lacking a crystal ball for looking into the future, a good plan is to diversify your retirement savings across different types of retirement accounts, rather than assuming a certain scenario for the future.
Second: Be careful about locking up your money in retirement accounts, if you are on track to retire early. If you are a high wage earner who lives frugally and is focused on early retirement (before age 59-1/2), you must be careful not to oversave in your retirement accounts, where you’ll be penalized for early withdrawals. If you retire much younger than is conventional, you’ll be living for many years off your taxable accounts, before ever touching retirement accounts, and so you must divvy up your savings accordingly.
A brokerage account is composed of some type of linked checking, savings, or money market “sweep” account holding cash, plus any market holdings. This is the first step to investing in individual stocks and bonds, something I can’t particularly recommend for most investors. But a brokerage account can also be a platform for buying mutual funds and ETFs — which I do recommend.
However, you don’t need a brokerage account to buy mutual funds and ETFs: Vanguard, for example, as well as many other companies, will let you buy them directly. So, while there is nothing wrong with opening a brokerage account, and it may give you access to a diversity of investment products, it is very likely an unnecessary step for many investors.
Note, your brokerage should pay you some nominal interest on cash holdings, though you’ll probably have to manually move cash to a different type of linked account to get competitive rates. For more on the specific financial services companies that I recommend, see Do You Really Need a Financial Advisor?
Annuities are the only available savings vehicle that can grow tax-deferred, without having to exist inside an IRA or other retirement plan. This makes them potentially appealing as a last-resort destination for long-term savings that you want to grow sheltered from taxes. I say “last resort” because there are so many preferable savings vehicles to consider before taking on an annuity.
Annuities, especially variable annuities, are frightfully complex and often hide very high expenses that will have a greater impact on your savings than the supposed benefits and guarantees that the annuity contract itself provides. Variable annuities will generally only be of interest to the relatively wealthy, under specific savings and taxation scenarios. If you fall into that group you probably know who you are and have the means to analyze the complexities of an annuity contract or hire an advisor to do it for you. For more on variable annuities, and the appropriate scenarios for using them, see Todd Tresidder’s Variable Annuity Pros & Cons.
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So there is an overview of the most common retirement savings vehicles.