October 30, 2018. By John Wolfsberg:
We meet often with individuals and couples at varying stages of their careers. While the range of economic profiles differ significantly from one client to the next, many clients face similar challenges. Often times we hear a similar theme in our conversations – “I think we make a good income and try our best to make smart decisions with our money, but we always seem to be stretched financially! Why is that?” Neither the expression of this feeling nor its frequency in our discussions are surprising, especially for those of us living in the Northeast. We live in an area of the country that has a high cost of living; whether renting or owning, housing is very expensive. Add to this the cost of raising a family (daycare, camp, medical costs, etc.), the various types of loans necessary to pursue personal and family goals (car, mortgage, student loans), and taxes, and the expenses can add up very quickly. It can be frustrating especially when trying to manage a young family, as these parents are often trying to purchase or maintain their first home while simultaneously planning for future retirement and education plans along with the day-to-day. The pressure to get ahead financially can be overwhelming when coupled with the demanding schedule of work and family.
The Three Buckets:
As we have these conversations, we like to try and breakdown our client’s financial well-being into 3 buckets – taxable savings, tax-deferred savings and debt reduction. By shifting focus to managing just these three buckets, financial freedom can feel more achievable.
Taxable Savings – This bucket represents the accounts to which investors can contribute after paying all of their monthly expenses. In short, It’s the emergency savings for the family (the 6 month rule). It’s the account that is the first to get tapped when there is an emergency. What is often overlooked, however, is that this is also the account that should eventually be built up far past a 6 month expense reserve to subsidize income from tax-deferred savings accounts (i.e. a retirement account such as an IRA or employer plan such as a 401k) during retirement. Distributions from tax-deferred accounts will be taxed during retirement, while those from taxable savings will not, so it is important to have the flexibility to toggle between both when the time comes. This account should be built up over time and have a highly liquid portion to it, including a large long-term investment component. I think this is the hardest bucket to fill as it can only be filled once all the other expenses for the month have been paid.
Tax-Deferred Savings – This bucket represents a client’s 401k plan and any other retirement plan they may be involved in. It also may represent their children’s college 529 plans. While contributing to this bucket also impacts cashflow for living expenses, the impact is somewhat muted as contributions are typically made on a pretax basis (not the case for 529 plans). The other consideration here is that often times a company sponsored 401k plan includes a company match which represents “free’ money for its participants. We often advise our clients to contribute an amount to at least max out the matching portion. For example, if your employer offers a 3% match, it would be advantageous to contribute at least 3% to the plan to receive the full benefit of the company match. Because of the pre-tax component, automation, and matching features, many investors find it easier to fund this bucket.
Debt Reduction– This bucket represents the payment and reduction of a client’s outstanding debt obligations, particularly those bearing interest. Whether it is a mortgage, car, or student loan, paying down this debt in a timely manner is crucial to achieving financial freedom.. Another major debt category is credit card debt. This is a particularly concerning area as the interest rates associated with both major credit cards and retail cards tend to be extremely high. We often advise clients to avoid using credit cards if at all possible, and advise that if they must use the cards to pay off the entire balance each month. While the loan (mortgage, car, student, etc.) portion of this bucket is easier to stay on top of (you have a contractual obligation to pay your mortgage each month) the credit card portion is much more difficult as you are often tempted to just make the minimum monthly payment – something credit card companies would love to see you do– or to begin using the card as cash again once the balance is cleared.
As we review these buckets with our clients we try to address their concerns of financial well-being by telling them the goal is to contribute to all three buckets at the same time; however, two out of three will also get your family on the right track if all three represents too much of a challenge at the moment. A client’s financial situation will determine which of the two buckets should get filled first. Working with a financial planner for a QuickStart Consult will also help determine where to allocate funds to get on the right track, right now, without a heavy cost or time commitment.