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Tax-deferred or taxable savings
Question: I’m in my early 20s, a recent college graduate making $55,000 a year with no debt. A house and kids are probably 7-10 years away at soonest. I’m currently saving 7% in my employer’s Roth 401(k) (plus a 4% match, though I might have to move when my girlfriend graduates, which would be before I’m vested) and making my full Roth IRA contribution (about 10% of my current salary) every year. Also, my parents & grandparents were great savers, so I’m lucky enough to start out with savings.
My uncle (the financial guru of the family) strongly encourages a “pay yourself first” strategy…setting aside a little every month for savings as though it were a bill. I like the idea (since saving doesn’t come naturally to me), and I’m planning on starting small (say, $50/month) and working my way up.
My question is, would I be better off adding that to my savings in taxable accounts (for a house, kids, and eventually my kids’ college) or increasing my 401(k) contribution? I like having flexibility with my investments, and I feel like my current ~17% retirement savings is probably enough, but it’s hard to argue with that kind of tax break. Thanks!
James, Oak Ridge, TN
Answer: Your Uncle is a wise man. I really like the idea of adding to your taxable savings. This isn’t a brief against saving in tax-sheltered vehicles, such as a Roth or 401(k). It’s important to fund the retirement savings plans.
But savings also should be geared toward funding career and lifestyle transitions over a lifetime. Retirement is only one of those shifts, although it’s a big one. This perspective came home to me in a series of conversations I had with Marc Freedman, head of the San Francisco-based nonprofit Civic Ventures. The organization is dedicated toward encouraging folks to launch second and third careers with an eye toward giving back to the community. “The new goal is to have sufficient assets to liberate yourself to work,” says Freedman. “You save not to have freedom from work, but the freedom to do the kind of work you want.”
In practical terms, this means following your plan of setting up an automatic savings program that regularly puts money into a variety of taxable accounts.
Some of the money could go every month into a savings account, certificates of deposit, Treasury bills, and the like. You could load up on tax-deferred I-bonds, the inflation-protected savings bond. Some money could regularly be invested in a broad-based stock index fund, such as the Wilshire 5000, the Russell 3,000, or the Standard & Poor’s 500. The mix of relatively safe and riskier savings starts out small, of course, but it accumulates over time.
Of course, you’ll pay taxes on interest, dividends, and realized capital gains along the way. And you do get a tax break with retirement savings. But the advantage of saving in taxable accounts is that it’s a simple strategy that gives you the flexibility to tap the savings at any time without penalty.
I’d listen to your Uncle.
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