If your career is accelerating and your income is growing, you probably have a lot of questions about what to do with your money. Maybe you even have mentors telling you to save as much as you can as early as you can. A quick Google search quickly results in a ton of ideas and opinions about what you should focus on. But this season of life is so busy – between career, family, and community, it can be hard to find the time to cut through the noise, get the insight you need, and make wise decisions that can help set your financial life up for long term success.
That’s why we created this guide! Below you’ll find six essential concepts that, if understood and put into practice, will help you put yourself on really solid financial footing. While this isn’t an exhaustive list of what to do and it certainly isn’t meant to be prescriptive for anyone, as everyone’s financial situation and goals are different, this should help put you on the right path.
1. How to Prioritize What to Do With Excess Cash
Watch this video to hear Eric Loftus, Financial Advisor at Wealth Dimensions, explain how to determine what to tackle first with your excess dollars.
When you have competing options for your hard-earned dollars, like paying off loans, saving for retirement and lifestyle spending, it can be difficult to manage and know you’re on the right path. This can prove especially tough for those in the earlier stages of building wealth. There are a few principles that will help you navigate how to prioritize where your excess cash should go.
First, let’s talk about debt. Not all debt is bad debt. For instance, a mortgage on your home helps you build equity and, assuming you have a reasonable rate, it’s often best to simply pay it off as scheduled. Now, if you have high interest debt, like credit card debt, it’s a good idea to pay that off as quickly as possible. Other types of debt, like student debt, can be more complex and it is important to craft a plan, taking advantage of any programs or relief available.
When it comes to saving money, the very first thing you need to do is set aside an emergency fund. Our recommendation is usually somewhere around 3-6 months of expenses in a savings account that you can get to easily when you need it. Once your emergency fund is established, then you can start building your investment portfolio. Unless you have an additional need for liquidity, we typically recommend clients begin to save long-term dollars for retirement – but even in that category, you have a lot of different options.
If you have an employer match available in your retirement plan at work (like a 401k, 403b, or Simple IRA), then that’s generally where we advise clients to start. Depending on your financial situation, the next place to save dollars is likely some combination of a Roth IRA, which in 2023 you can max out $6,500 per account (one for you and one for your spouse, if you’re married), contributing to a brokerage account if you need more liquidity, maxing out your contributions to your 401(k) ($22,500 in 2023), saving for your children’s education or even putting some dollars into an Health Savings Account or similar account-type, if available to you. Keep reading to understand the unique tax benefits of each of these types of accounts.
The right combination of savings vehicles really depends on your unique financial and life goals. The important thing is that you make sure that every dollar has a job – whether it’s to save for a home, retirement, a vacation, or children’s education, and then choosing the appropriate account type and investment strategy to help you accomplish that goal.
2. Roth, 401(k), Taxable Accounts: Choosing Between Savings Buckets
Watch the video above to hear from Eric Loftus, Financial Advisor at Wealth Dimensions, as he breaks down the tax treatment of different account types.
One of the best ways to gain wealth and financial independence is to build a diversified portfolio from both an investment and tax perspective. While there are many different account types and holdings, there are three primary tax “buckets” you should be aware of: 1) taxable accounts, 2) tax-deferred accounts, and 3) tax-free accounts. By understanding these three tax buckets, you can make informed decisions about your savings and investment strategies, save money on taxes, and help secure your financial future.
1. Taxable Accounts
The first tax “bucket” is the taxable bucket. Taxable accounts are often referred to as brokerage accounts, money-market accounts, or even joint accounts. These are typically basic investment accounts that don’t have any preferential tax treatments, meaning that any money made from the investments in the account is subject to taxes. For the most part, dividends paid from those investments will be recorded as income, while gains from selling assets, such as stocks or real estate are subject to taxes but oftentimes are at the lower capital gains rate. This makes them somewhat inefficient from a tax standpoint, but they also typically have no restrictions on when you can withdraw funds and how much you can withdraw. Basically, you’re trading access to the funds for tax efficiency.
2. Tax-Deferred Accounts
The second bucket is the tax-deferred bucket. This includes accounts like traditional 401ks and IRAs. The contributions you make to these accounts are not taxed in the year you make them but they are taxed when you withdraw the money. This can be a great way to save on taxes in the short term but you will pay taxes on the money when you take it out. This bucket is ideal for those who believe they will be in a lower tax bracket in retirement than they are now.
3. Tax-Free Accounts
The third bucket is the tax-free bucket, and yes, there is a tax-free bucket. This includes accounts like Roth 401ks and Roth IRAs. Contributions to these accounts are made with after-tax dollars, but the money grows tax-free and is not taxed when you withdraw it as long as you meet IRS guidelines. This bucket is ideal for those who believe they will be in a higher tax bracket in retirement than they are now.
So you may be asking yourself, which bucket is right for me? It really depends on your financial goals and circumstances. Ultimately, the goal of saving is to provide flexibility in the future as it relates to retirement and who you would like to impact with your money. If you have these three buckets well established, you can largely control the taxes you pay in retirement by optimizing your distribution strategy and taking advantage of advanced planning techniques like Roth conversions, estate and gifting strategies, and many more. Understanding these tax buckets is essential for effective financial planning. There are contribution limits tied to the pre-tax and Roth buckets each year so it is important to craft a plan for current and future saving strategies.
3. Where Should You Invest Your Dollars?
Watch this video from Tom Schiller to learn more about how funds in accounts are invested.
So, you’re ready to save and invest in your future. You might have opened up a taxable brokerage account, a traditional IRA or 401k, and you have a Roth IRA. Well, now what? What do you invest in and where?
There are two strategies that you need to think about to help in determining how you invest the dollars in each of those accounts: asset allocation and asset location. The situation that I just described is fairly common amongst the younger generation that is now making enough money to start investing. Asset allocation and asset location are important to think through as this can have a sizable impact on your net worth in the long run.
Asset Allocation
Asset allocation involves dividing your investments among different assets, such as stocks, bonds, and cash. The asset allocation decision is a personal one, and will change over time as your life changes, depending upon how long you have to invest and your ability to tolerate risk. If you are young and have several years before retirement, you can take on a slightly more aggressive portfolio compared to an individual that is closing in on retirement and should reduce risk. For most young professionals, you’ll deploy a portfolio that has mostly stocks. Therefore, an 80/20 portfolio as an example. This would mean that 80% of your portfolio will be in stocks while 20% of your portfolio is in fixed income. As you near retirement, the portfolio should reduce risk by lowering the stock percentage and increasing the fixed income. Therefore, a portfolio near retirement could be 60% in stocks and 40% in fixed income. Whatever asset allocation you go with, you should apply it to your overall portfolio. It’s extremely important to stay disciplined to your desired allocation and don’t try to time the market. And lastly, rebalance the portfolio when asset classes stray from their tolerance bands.
Asset Location
Asset location refers to where you strategically keep the money you’re investing, between tax advantaged, tax-free, and taxable accounts in order to maximize after tax returns. Assets that have a greater potential for growth should be located in your tax-free accounts, such as your Roth IRA. Therefore, an example would be investing your Roth account with a heavier percentage of growth stocks, as these have a potential for higher returns compared to other asset classes. Your tax deferred account, such as your traditional IRA or 401k, is a great account to keep income-producing investments, such as bonds or even dividend-paying stocks. Bonds will continually produce interest, which would be taxed if held in your taxable account, however, you can defer that tax payment by keeping in the IRA or 401k. Lastly, in your taxable brokerage account, which is an account where you pay taxes on any interest, dividends, or capital gains that are realized in that current year, a tax-related goal with this account is to keep assets where we can manage the tax burden in this account. We can pick and choose when we realize gains and losses. If we sell a stock at a gain and pay taxes based on short-term or long-term rates, we can also offset those gains against any realized losses through tax loss harvesting.
Asset allocation and asset location are two great strategies that can help increase your net worth if applied to your portfolio.
4. Keep Your Lifestyle from Sabotaging Your Hard Work
Sean Paddock explains how behavioral finances and lifestyle creep are some of the biggest risks to a successful financial future.
“Lifestyle creep” occurs when an individual’s standard of living improves in expenses that were previously considered wants become needs. The rise in discretionary income can happen either through an increase in income or decrease in costs. A common goal that many of us share is working hard to improve our standard of living for ourselves and our families. We have desires and goals that drive us to develop the skills and experiences needed to move up in our careers and therefore earn more money. Maybe you’re working toward buying a first home, a second home, that car you’ve always wanted, or your kid’s education. The list is endless. While those desires and goals vary from person to person, increased income or reduced costs or a combination of the two naturally lead to more money in your pocket.
You’ve worked hard, you’ve sacrificed and your mindset may have subconsciously changed. Non-essential items that were previously viewed as a “want” may now be viewed as a “need.” There are many examples of non-essential spending like eating out more frequently and more expensively, replacing a car sooner than you need to or purchasing even more expensive clothing or jewelry. To be sure, none of these examples are bad, per se. In other words, where you choose to spend your dollars is your decision. However, the potential downside is that lifestyle creep left unidentified or unchecked can pose significant risk to one’s long-term financial goals and security.
We want to help identify your life and money goals. At Wealth Dimensions Group, we’re not here to judge your spending or savings habits. Our goal is to help frame what’s most important to you, ascertain where you are toward reaching those goals, and offer observations and potential solutions that best position you for the life you envision.
5. Getting Started with Estate Planning
Eric Loftus shares why having a simple estate plan is important, even in the early days of your financial life.
As a young family, you may not have given much thought to estate planning. Many young couples think it is only for the elderly or super wealthy. Plus, it is never fun to contemplate an unforeseen tragedy happening to you or your family. However, it is important to make sure you’re prepared if it does. Having a solid estate plan in place can provide you with a peace of mind and ensure you that your loved ones are taken care of if something unexpected were to happen.
Estate planning is the process of preparing for the transfer of your assets and properties to your heirs or beneficiaries. This process involves many decisions, including determining who will inherit your assets, how your assets will be distributed, and who will care for your children.
Creating a Will
The first step in estate planning for young families is creating a will. A will is a legal document that outlines how you want your assets to be distributed after you pass away. It is essential to have a will, even if you have a small estate. Without one, your assets will be distributed according to your state’s laws, which may not align with your wishes. If you have young children, it is crucial to appoint a guardian in your will. A guardian is responsible for taking care of your children if both parents pass away. This should be someone you trust to raise your children, and who is willing and able to take on that responsibility.
Buying Life Insurance
Life insurance is another important component of estate planning for young families. Life insurance can provide financial support for your loved ones in the event of your passing and can help ensure that they’re able to maintain their lifestyle, cover any outstanding debts, and provide for goals like education. When it comes to estate planning, it’s important to review your financial situation and ensure your assets are properly titled and accounted for. Beneficiary designations are used to distribute assets outside of your will, such as retirement accounts, life insurance policies, and bank accounts. You may also want to consider setting up a trust or other legal structures to bypass probate and ensure that your assets are distributed according to your wishes.
Talking to Your Loved Ones
Finally, it’s important to have open and honest conversations with your loved ones about your wishes and plans for the future. You’ll be naming guardians, executors, trustees, and powers of attorneys in the legal documents, and you want to confirm that everyone knows their role, is on the same page and that your wishes are carried out in the event of your passing.
While we are not attorneys at Wealth Dimensions, we would be happy to introduce trusted attorneys to simplify the process and ensure your estate plan and financial plan work in conjunction with each other.
6. When Should You Hire an Advisor?
Hear Tom Schiller share how to decide when you’re ready to hire a financial advisor.
“I wish I would’ve done this sooner.” That’s a statement I hear all the time from younger clients to clients that are nearing retirement and everyone in between. There are a number of reasons why people don’t engage with a financial advisor. Some may think that they don’t have enough assets, some may think that waiting until retirement, or a few years out is the best time, others don’t engage just because they’re not sure where to get started.
So when is the right time? The truth is that the sooner you go through the financial planning process, the better. If you wait until just a few years from retirement you may not like the outcome and you may not have enough time to change it at that point. Getting started early can be extremely valuable because we can help develop plans, change habits, and employ different strategies at different stages of your life. Ideas and strategies that we bring to you can be even more valuable than portfolio management.
Most people don’t feel like they have enough assets to make it worthwhile and for some firms that may be true. Certain advisory firms have a requirement that you have a minimal level of investments or net worth for them to even talk to you. Oftentimes, their fee structure depends on selling you a product or putting you into a portfolio that provides a commission to them. A minimum level of investment assets is needed to make it worthwhile for them. This type of compensation structure creates an inherent conflict of interest.
To avoid this, seek out a firm that is fee-only. This means that you are the only one paying them for their services. Therefore, you can feel confident that they aren’t selling you a product, but rather recommending strategies that fit your individual situation. I hope these tips help you and encourage you to get the conversation started as early as possible. If you have any questions, give us a call today at Wealth Dimensions.
For informational purposes only. Not intended as investment advice or a recommendation of any particular security or strategy. Past performance is not indicative of future results. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of writing and are subject to change without notice. For more information about Wealth Dimensions, including our Form ADV Part 2A Brochure, please visit https://adviserinfo.sec.gov or contact us at 513-554-6000. Please be advised that this material is not intended as legal or tax advice. Accordingly, any tax information provided in this material is not intended and cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.