The difference between Roth vs Traditional plans for retirement is primarily about tax rates. Other differences relate to when you can or must withdraw your savings. With one exception, the same withdrawal rules apply to both 401(k)s and Individual Retirement Accounts (IRAs), so I’ll refer to …
This week, I’ll conclude the case study about Mary and her savings. Her last question focused on whether to pay off her student loans. The considerations include: The interest rate on her loans. How many more payments she has. What she can earn if she …
To help set the stage, I created a fictitious person, Mary, whose finances I use for illustration.
- Mary is single with no dependents.
- She lives alone in an apartment she rents.
- She makes $62,000 per year.
- Mary has $25,000 in a savings account at her bank and $10,000 in her Roth 401(k).
- Her annual budget shows:
- Basic living expenses of $40,000
- $5,000 for fun and discretionary items
- $10,000 for social security, Federal and state income taxes
- $4,000 for 401(k) contributions
- $3,000 for non-retirement savings
- Mary has $15,000 in student loans which have a 5% interest rate.
- She owns her seven-year-old car outright. She plans to replace her car with a used vehicle in three years and would like to have $10,000 in cash to pay for it.
- She has no plans to buy a house in the near future.
Her questions are:
- Should I start investing the $25,000 in my savings account?
- Should I have a separate account to save the $10,000 for the car?
- What choices do I have for my first investments for any money I don’t set aside for my car?
- Should I pay off some or all of the principal on my student loans?
I talked about a framework for thinking about her savings and setting aside money for expenses she doesn’t pay monthly and emergency savings here. In this post, I’ll focus on the rest of her savings. I answer her questions about student loans here.
Designated savings is the portion of your investable asset portfolio that you set aside for a specific purchase, such as a car or home. Mary would like to buy a car for $10,000 in three years. She needs to designate a portion of her savings for her car.
As part of her savings framework, Mary
- Will set aside $13,000 for emergency savings.
- Has $12,000 in her savings account after setting aside the $13,000 for emergency savings.
- Included $3,000 a year for non-retirement savings in her budget, some of which she can use for her car.
Mary has decided she will use $5,500 as the start of her designated savings to replace her car. After reading this post, she has decided to pay cash for a car, rather than borrow or lease, She will add half of her $3,000 of non-retirement savings each year to bring the total available balance to $10,000 in three years. If Mary’s car becomes unrepairable sooner, she can use some of the money in her emergency savings, but will want to replenish that account as soon as she can.
Considerations for Investment Choices
When I’m saving money for a large purchase, such as a car or a down payment on a house, I’m willing to invest in something less liquid than a savings account or a money market account. That is, I don’t have to be able to access the money on a moment’s notice.
I do, however, want a similar level of security. It is very important to me that the market value of my investment not go down as I don’t want to risk my principal. Because I tend to have time frames that are less than one year for these types of purchases, I tend to put my designated savings in certificates of deposit.
Certificates of Deposit and Treasury Bills
In Mary’s case, she has three years. She might consider longer-term certificates of deposit (CDs) or short-term government bonds. (Click here to learn more about bonds.) A CD is a savings certificate, usually issued by a commercial bank, with a stated maturity and a fixed interest rate.
A treasury note is a form of a bond issued by the US government with a fixed interest rate and a maturity of one to 10 years. A treasury bill is the same as a treasury note, except the maturity is less than one year. When the government issues notes, bills and bonds (which have maturities of more than 10 years), it is borrowing money from the person or entity that buys them. The table below shows the current interest rates on CDs and treasury bills and notes with different maturities.
When thinking about whether to buy CDs or Treasury bonds, Mary will want to consider not only the differences in returns, but also the differences in risk.
Risks of Owning a Bond
Bonds have two key inherent risks – default risk and market risk.
- Default risk is the chance that the issuer will default on its obligations (i.e., not pay you some or all of your interest or principal). Treasury notes, bills and bond issued by the US are considered some of the safest bonds from a default perspective. I’m not aware that the US government (or Canadian government for that matter) has ever not paid the interest or repaid the principal on any of its debt.
- Market risk emanates from changes in interest rates that cause changes in the market values of bonds. As interest rates go up, the market values of bonds go down. All bonds come with a maturity date that is almost always stated in the name of the bond. If you buy a bond, don’t sell it until it matures and the issuer doesn’t default, you will get the face amount (i.e., the principal) of the bond no matter how interest rates change. Thus, if you hold a bond to maturity, you eliminate the market risk.
In summary, using certificates of deposit or Treasuries held to maturity can increase your investment return relative to a savings account without significantly increasing the risk that you’ll lose the money you’ve saved.
Because she can buy them easily at her bank or brokerage firm and they are currently yielding more the Treasuries with the same maturity, Mary has decided to buy 2.5-year CDs, earning 3.4%, with the $5,500 she has set aside to buy her car.
Long-term Savings – What to Buy
Mary has $6,500 in her savings account that isn’t needed for her emergency savings or her replacement car. She wants to start investing it or use it to pay down some of her student loans. I’ll talk about her student loans next week.
Mary doesn’t want to spend a lot of time doing research, so is not going to invest in individual securities. Instead, she is looking at mutual funds and exchange-traded funds (ETFs). A benefit of these funds over individual securities is that they own positions in a lot of companies so it is easier for Mary to diversifyher portfolio than if she bought positions in individual companies.
Mutual Fund and ETF Considerations
Briefly, here are some of the features to consider in selecting a mutual fund or an ETF. I note that you may not have answers to a lot of these questions, but they should help you get started in your thinking.
- The types of positions it holds and whether they are consistent with your investment objectives. Is the fund concentrated in a few industries or is the fund intended to produce the same returns as the overall market (such as the S&P 500 or Dow Jones Industrial Average)? Does it invest in larger or smaller companies? Does the fund focus on growth or dividend-yielding positions? Is it an index fund or actively-traded?
- The expense load. All mutual fund and ETF managers take a portion of the money in their funds to cover their expenses. The managers make their money from these fees. Funds are required to report their expenses, as these reduce your overall return on investment. There are two types of expense load – front-end loads and annual expenses. If you buy a fund with a front-end load, it will reduce your investment by the percentage corresponding to the front-end load when you buy it. Almost all funds have annual expenses which reduce the value of your holdings every year. Although funds with lower expense loads generally have better performance than those with higher loads, there may be some funds that outperform even after consideration of a higher expense load.
- Historical performance. Although historical performance is never a predictor of future performance, a fund that has a good track record might be preferred to one that has a poor track record or is new. As you review returns, look not only at average returns but also volatility (such as the standard deviation). A fund with higher volatility should have a higher return.
Mutual Funds and ETFs – How to Buy
You can buy mutual funds directly from the fund management company. You can also buy mutual funds and ETFs through a brokerage company. If you buy them through a brokerage company, you will pay a small transaction fee but it is often easier to buy and sell the funds, if needed. Holding these assets in a brokerage account also lets you see more of your investments in one place.
Mary decides to invest in an S&P 500 index fund (a form of exchanged-traded fund that is intended to track S&P 500 returns fairly closely). Since 1950, the total return on the S&P 500 corresponds to 8.9% compounded annually. It is important to understand that the returns are very volatile from month-to-month and even year-to-year, so she might not earn as much as 8.9% return over any specific time period.
Retirement Savings – What Type of Account?
As Mary thinks about her long-term savings, she not only wants to decide how to invest it, but also in what type of account to put it – a tax-sheltered retirement savings account or a taxable account she can access at any time. In addition, she needs to think about how much she needs in total to retire and how much she will need to set aside each year.
Retirement Account Contribution Limits
In the US for 2018, she is allowed to contribute $18,500 ($24,500 after age 50) to a 401(k) plus $5,500 ($6,500 after age 50) to an Individual Retirement Account.
In Canada, the 2018 maximum contribution to group and individual Registered Retirement Savings Plans (RRSPs) combined is the lesser of 18% of earned income or $26,230. The 2018 maximum contribution to group and individual Tax-Free Savings Accounts (TFSAs) is $5,500. If you didn’t make contributions up to the limit last year, you can carry over the unused portion to increase your maximum contribution for this year.
In Canada, there are no penalties for early withdrawal from a RRSP or TFSA as long as the withdrawal is not made in the year you make the contribution, so it is easy to take advantage of the tax savings. If you make the withdrawal from an RRSP, you need to pay taxes on the withdrawal. In the US, there is a 10% penalty for withdrawing money from a 401(k) or IRA before the year in which you turn 59.5. As such, the choice of putting your money in a 401(k) or IRA needs to consider the likelihood that you’ll want to spend your long-term savings before then.
Returns: Taxable Account vs. Roth IRA/TFSA
Mary has decided she won’t need the money for a long time. She will decide how much to put in her retirement account and taxable accounts after she looks at her student loans. Mary’s savings is considered after-tax money. As such, she can put it in a Roth IRA or TFSA. She will not pay taxes on the money when she withdraws it. If she didn’t put the money in a Roth IRA or TFSA, she would have to pay income taxes on the investment returns. If she puts it in a Traditional IRA or RRSP, the amount of her contribution will reduce her taxable income but she will pay taxes on the money when she withdraws it. This graph compares how Mary’s money will growover the next 30 years if she invests it in a Roth IRA or TFSA as compared to a taxable account.
As you can see, $4,000 grows to just over $30,000 over 30 years in a taxable account and just over $50,000 in a Roth account assuming a constant 8.9% return and a 20% tax rate.
The key takeaways from this case study are:
- You may need to save for large purchases over several years. The amount you need to set aside today as designated savings for those purchases depends on how much they will cost, when you need to buy them and how much of your future budget you can add to those savings.
- Certificates of deposit are very low-risk investment instruments that can be used for designated savings.
- Treasuries with maturity dates that line up with your target purchase date can also be used for designated savings. By holding bonds to maturity, you eliminate the market risk.
- Mutual funds and ETFs require less research and more diversification than owning individual companies (unless you own positions in a very large number of companies). These instruments are an easy way to get started with investing.
Your Next Steps
This post talks about Mary’s situation. Here are some questions you can be asking yourself and things you can do to apply these concepts to your situation.
- Identify the large purchases you want to make. These purchases can include a car, an extravagant vacation or a house, among other things. For each purchase, estimate when you will want to spend the money and how much they will cost.
- Determine how much of your savings you can set aside for these large purchases. Look at your budget to make sure you can set aside enough money to cover the rest of the cost. If you can’t, you’ll need to either make changes to your aspirations or your budget. In my budgeting series starting in a few weeks, I’ll dedicate an entire post to what to do when your expenses are more than your income.
- Decide whether to start a relationship with a brokerage firm. Last week, I provided a list of questions to help you get started if you do.
- Look into options for your designated savings.
- What are the returns offered by your bank or, if you have one, brokerage firm, on certificates of deposit with terms corresponding to when you need your designated savings?
- How do Treasury returns compare to certificates of deposit?
- Decide how much of your long-term savings you want to put into retirement accounts and how much will be left for other savings. I put as much as I could into retirement accounts, but always made sure I had enough other savings for large purchases that I hadn’t identified in enough detail to include in designated savings. If you want to retire before the year you turn 59.5, you’ll also want to keep enough long-term savings out of your retirement accounts to cover all of your expenses until that year.
- Decide whether you want to start investing your long-term savings in mutual or exchange traded funds or in individual stocks. If mutual or exchange traded funds, take a look at the list of questions above.
Some bonds have features that allow the issuer to re-pay the principal before the maturity date. For this discussion, we will focus on bonds that do not give the issuer that option. These bonds are referred to as “non-callable.” Bonds that can be re-paid before the maturity date are referred to as callable bonds.
For those of you interested in investing in individual equities, a guest blogger, Riley of Young and The Invested (www.youngandtheinvested.com), will write about how to get started with looking at individual companies right after the first of the year.
Portfolio diversification is an important concept in investing. I’ll have a few posts on this topic in the coming months.
If you are interested in more information on selecting mutual funds, I found a nice article at https://www.kiplinger.com/article/investing/T041-C007-S001-my-9-rules-for-picking-mutual-funds.html
This volatility is often referred to as the risk of a financial instrument and is another important concept in investing. Look for insights into the trade-off between risk and reward coming soon.
I’ll cover retirement savings more in a future post.
Income taxes on investments are somewhat complicated. For the illustrations here, I’ll assume that Mary’s combined Federal and state tax rate applicable to investment returns is 20% and that all returns are taxable in the year she earns them. There are some types of assets for which that isn’t the case, but identifying them is beyond the scope of this post.
For illustration, this graph shows a constant 8.9% return. Over long periods of time, the S&P 500 has returned very roughly 8.9% per year on average. The returns vary widely from year-to-year, but for making long-term comparisons a constant annual return is informative even though it isn’t accurate.
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