One of the biggest repercussions of the coronavirus epidemic has been the vast number of layoffs and furloughs that many people have experienced. Due to the loss of jobs or the reduction of hours, many people were forced to find alternative sources of funds to pay for their daily living expenses. Some of these options entailed filing for unemployment, odd jobs, retirement account withdrawals and draw-down of savings. Because of this, people have become more aware of the importance of savings during the last two months. Because of this added attention, our newsletter this month will address the topic of savings and the importance of using different types of saving accounts.
Typically, you would have three different types of savings accounts established:
Emergency Funds: This should be a very liquid savings account that is readily accessible and is only used for emergency situations.
Tax-Deferred Retirement Account: A long-term investment account that features tax benefits to effectively save for future retirement income. This type of account should not be touched until retirement due to its restricted access.
Taxable Investment Account: This investment account should be invested for the long-term and is earmarked for retirement or other long-term goals, but with investment positions that could be sold as a last resort if absolutely necessary for larger emergencies.
We suggested ways to allocate your funds among your different saving accounts in a previous newsletter, which can be read here. In this newsletter, we will largely focus on how to best utilize your different savings accounts. As stated previously, your emergency funds are your most readily available money. These funds are set aside in the event an emergency situation occurs. Your goal for the funds earmarked for an emergency should be a minimum balance, unless that emergency situation occurs. The minimum balance amount varies based upon the individual(s) and their personal situation. If you are married and both spouses earn an income, then a good rule of thumb is to have a minimum of 3 months of your monthly living expenses saved. If you are single, or are married but only one spouse has an income, then a good guideline is to have at least 6 months of living expenses saved. These emergency funds should primarily be invested in either a bank savings account with your other liquid savings or within your taxable investment account’s cash position. Emergency fund accounts are also especially important for those of us who live along the gulf coast, because of our constant risk of hurricanes, we never know which hurricane season may completely alter our lives. Consistently maintaining this type of savings account will not only provide financial benefits, but it will also provide you peace of mind knowing that you have a safety net established should some unforeseen emergency happen.
If your emergency funds are considered your most liquid and readily available funds, then a tax deferred retirement account should be considered your most restrictive savings account. Typically, tax deferred retirement accounts have a number of fees, charges, taxes, and penalties associated with withdrawals if you have to withdraw from them before you are the age of 59 ½. Contributing to a tax-deferred retirement account is important for a number of reasons, but most importantly for the tax advantages of reducing your current income and the deferment of taxes until you withdraw funds from the account. However, your tax-deferred retirement account should not be your only retirement account as withdrawing from your tax-deferred retirement account can prove to be a costly choice.
Because of the restrictions and costs for withdrawals from a tax-deferred account, the third savings account recommendation is a taxable investment account. A taxable investment account can serve multiple purposes, but it should only be started after the contributions to your retirement account meet at least one of the following criteria, which may vary by your personal situation: Receiving the maximum of your employer’s match contribution, contributing at least 10% of your gross income, or you have reached your annual retirement contribution limits. A taxable investment account should be earmarked for retirement and ideally should be added to (not withdrawn from) until retirement. Secondarily, this account would be considered as a last resort source of funds. In the event an extreme emergency occurs and you have completely exhausted your emergency funds it should be easier and cheaper to withdraw from a taxable investment account than a tax-deferred retirement account.
As stated above, it is important to develop financial safety nets for yourself. By creating these different types of accounts, you are not only creating these financial safety nets, but you are also providing yourself with multiple sources of funds, if needed before, and during retirement, providing you a structure to effectively grow your funds for the future. As always, Crescent Sterling hopes you are staying healthy and safe. Please let us know if you have any questions or concerns.
Disclosure: The information presented is general in nature. Because of the technical and individual nature of specific situations, you should consult with your tax preparer for specific tax advice for your situation.