There’s a simpler way to understand your money. Zoom way out. Way way out. Here’s all that matters: Have enough for the expected and the unexpected, both now and in the future. That’s it. The whole banana.
The Expected, Now
How much does it take to sustain your life each year?
This is The Expected, Now.
The Unexpected, Now
Have three to six months of essential expenses (expenses required for you to stay alive) in an account that is earning interest for you and is liquid so you have access at any time, i.e. Money Market accounts and High Yield Savings accounts.
MJ calls this your “sexy” account — you’re much sexier when you’re not financially stressed.
This is The Unexpected, Now.
The Expected, Future
How much will it take to sustain your future life? Have a baby? Hire a personal chef? Stop working? Remodel?
Retirement rule of thumb: Multiply the annual amount needed to sustain your life by 25, less annual retirement contributions, less Social Security (SS) if eligible. Assuming this amount is invested, you can hypothetically withdraw 4% per year without decreasing the principal and sustain your desired lifestyle. Tip! Use the online calculator at ssa.gov to estimate your monthly SS benefit in retirement.
This is The Expected, Future.
The Unexpected, Future
Your “sexy” account will stay with you ‘til the end. Like a garden, you’ll take from it and replenish it. Update it as your financial numbers change.
This is The Unexpected, Future.
So how do you use real accounts to the best of your ability? Everything comes down to taxes. Read that again. Everything. Comes. Down. To. Taxes. If taxes weren’t a thing, we’d all have one account type, put money in it forever, take money out whenever we want, and we’d be done.
If you invest $100,000 and let it grow untouched for 10 years at a rate of 6%, it will be worth anywhere from $125,718 to $179,085 depending on what type of account it’s in. This is because of taxes. Think of all accounts as having a purpose. They incentivize that purpose and sometimes penalize straying from the purpose. So, it’s most important to understand your goals and liquidity (how readily you need access to the money) needs before you decide on an account. Here is a very simple way to think of it using a couple different spectrums:
The more liquidity you need, the less favorable the tax treatment. Conversely, the less liquidity (more willingness for your money to be untouchable for a while), the more favorable the tax treatment, usually.
The less specific the account, the less favorable the tax treatment. If an account has a specific purpose like education or retirement, it’s usually taxed more favorably. Over time, those taxes make a tremendous impact.
A High Yield Savings Account is an account that can be accessed at almost any time and doesn’t have a specific purpose. You can use the money for whatever you want including ski passes and beer. Each year, the growth on your money is taxed at your ordinary income tax rate. For most folks this will fall around 22% (unless you’re a billionaire in the Roaring Fork Valley, then it might be more like 36%).
On the other end of the spectrum is an education account, known as a 529. It has a very specific purpose and as such is taxed more favorably. If 529 money is withdrawn for specific educational purposes, it is not taxed at all and the growth on the account is not taxed each year. If the money is used for ski passes and beer, it is taxed at ordinary income rates plus a 10% penalty. Ouch!
The goal is to keep your money growing for you at all times, whether it’s allocated for the present or future. Keeping your money growing means putting it into the right accounts that favor it for your particular goals. Identify your goals and watch them flourish!
Megan Janssen is the founder of Money Juice (www.money-juice.com) and a financial advisor with Forum Financial Management, LP. The ideas and language written here are those of the author and do not necessarily reflect the views or opinions of Forum.