How to Save Money

Derek Notman |

We are all aware about the value of saving, and as children, we may often hear our parents talk about the importance of it.  But have you stopped to consider what saving is really about?  Why did our parents keep telling us to put money away when we started working?  We know we need to save, but how do we do it?

 

Well, let’s chat about it and explore what saving is all about, why it is beneficial to you, and some common ways to set money aside for the future.

 

SAVING MONEY

Most of us work hard at our jobs – whether we work for a company or have our own business.  We also usually work long hours, requiring sacrifice and stress.  It makes sense to take our hard-earned money and invest it for our future needs to make the most of our earnings.

 

What about prioritizing your money?  Spending money is easy, and it gives us instant gratification – something we have all become accustomed to with the advent of technology.  saving, however, requires patience & discipline and prioritizing our financial futures over our short-term desires.

 

saving allows you to set money aside whilst carrying on with life.   Having that money work for you rewards your hard work in the future.

 

If you are new to saving, think of it as a tool for building your wealth.  Don’t be fooled into thinking it’s only for the wealthy – anyone can get started with saving and there are various ways that make it easy to begin even with small amounts and add to a portfolio as time goes on.  Saving is not gambling and it’s not a get rich quick scheme.  Investing takes discipline, patience, and time.

 

WHY IS SAVING IMPORTANT?

In a nutshell, saving is a way to ensure your present and future long-term financial security.  Money generated from your savings & investments can provide financial security as well income.  Investments like stocks, bonds and EFT’s can provide income by way of dividends and capital appreciation.  This is an amount paid to shareholders for holding the investment.  As many investments pay monthly, quarterly or annual distributions, one can enjoy a passive income that ultimately could replace your salary.  If you want to retire or become financially independent, investing is a great way to do it.

 

 

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HOW TO START SAVING?

There are a number of ways to start saving, so don’t get too hung up on which account to open up just yet.  Opening a bank savings account is a common place people start but there are other options.  It is usually best discussing the best option with your financial advisor as your financial situation, goals, needs, etc. will be different from everyone else.

 

If you are new to the savings & investment game, then one of the first decisions to be made is determining which type of account to open and fund.  A qualified financial advisor is good person to walk you through the steps and offer the best advice to assist you in determining which type of savings or investment account to open and fund.

 

Most twenty and thirty-somethings are weary of investing in the stock market since they grew up during the last financial crisis of 2008 & 2009.  However, I cannot stress enough how much opportunity there is to kick start a lifetime of wealth-building if you start now.  The best thing is – you don’t even need a lot of money!  Why? Because you have time on your side as you’re young.  The power of compounding is truly remarkable.

 

WHAT OPTIONS ARE THERE TO INVEST IN?

As a Certified Financial Planner ® I have helped people open up a large variety of savings, investment & retirement accounts, here are some of the more common one’s people use.

 

INDIVIDUAL RETIREMENT ACCOUNTS (IRAS)

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Individual retirement accounts, often called IRAs, are extremely popular among investors. An IRA must be owned by one individual, and there are specific guidelines provided by the Internal Revenue Service (IRS) that must be followed when establishing an IRA.

 

In 2019, you will be able to save up to $6,000 in your IRA, up from $5,500 in 2018. If you are 50 and over and looking to make up for lost time, catch-up contribution limits will remain the same for 2019. For IRAs, you can put in an additional $1,000.  You can split your contributions between both types of IRA accounts Traditional & Roth), but you cannot exceed the maximum contribution limit.

 

Contributions must be made by the tax filing deadline in April each year.

 

 

The two most common IRA account options that you can select are:

 

TRADITIONAL IRA

With the Traditional IRA, contributions are usually tax deductible (see below) and future withdrawals are taxed as ordinary income.

 

You must have earned income (salary, wages, commissions, self-employment income, alimony, or combat pay) and be younger than 70½ years of age to fund a Traditional IRA.

 

Not all Traditional IRA contributions are tax deductible.

 

If you (and your spouse) are not covered by an employer sponsored retirement plan (such as a 401k), Traditional IRA contributions are always tax deductible.

 

If you (or your spouse) participate in a qualified, employer sponsored retirement plan, contributions are tax deductible only if your income remains below the IRS threshold.

 

In most cases you cannot withdraw money from your Traditional IRA until age 59½. If initiated before then, withdrawals could be subject to a 10% penalty in addition to the tax liability. When you reach age 70½, you must begin taking required minimum distributions (RMD’s) from each Traditional IRA that you own. When the money is withdrawn, the entire withdrawal is taxed as ordinary income. The tax rate depends on your taxable income at the time of withdrawal.

 

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ROTH IRA

Roth IRA accounts are one of my favorites!  They are funded with after-tax dollars. There are no tax breaks for contributions made to a Roth account.

 

However, all earnings inside of a Roth account grow completely tax-free, and qualified withdrawals are completely tax-free.

 

Like the Traditional IRA, you must have earned income to fund a Roth IRA. However, there are no age restrictions when making contributions.

 

While Traditional IRA contributions are limited by the availability of employer sponsored retirement plans, Roth IRA contributions are limited by your modified adjusted gross income (MAGI).

 

Roth IRA contributions are not allowed if your MAGI (Modified adjusted gross income) exceeds the IRS threshold, which is $193,000 for married couples filing jointly in 2019.  Roth IRA contributions never depend on your participation in a qualified, employer sponsored retirement plan.  Like the Traditional IRA, Roth IRAs are subject to the same 10% penalty for withdrawals made before age 59½ years old. However, there is an exception to this rule. All your initial contributions can be withdrawn from a Roth IRA at any time after having the account for at least 5 years.

 

For example, let’s assume that you contribute $5,000 this year to a Roth IRA and the account balance grows to $8,000 over the next five years. You can withdraw any portion of the initial $5,000 contribution, at any time, without penalty, after the 5 year period has passed. But you cannot withdraw any portion of the $3,000 earnings growth. A withdrawal of any earnings before the age of 59½ will be subject to the 10% penalty.

 

There is another important rule that you must understand. The Roth IRA requires that your first contribution be made at least five years before you withdraw any earnings, regardless of your age when the account is opened. For example, if you open a Roth IRA and make your first contribution at age 58, you must wait until age 63 to withdraw any earnings from the account. If you violate this rule, the IRS deems the withdrawal a “nonqualified distribution,” where all earnings are subject to taxation and the 10% penalty.

 

As an added benefit, Roth IRAs are not subject to required minimum distributions at age 70½.

 

WHICH IRA SHOULD YOU CHOOSE?

You can contribute to either IRA account type each year, and you can split your annual contribution between both accounts.

 

Under the IRS rules, the Traditional IRA provides additional tax savings for individuals in a higher tax bracket, while the Roth IRA provides the largest benefit for individuals in a low tax bracket.

 

Which type of account to have will be driven by your specific financial situation and what your goals are for the future.  It would be a good idea to work with a professional to figure out which IRA (‘s) would make the most sense for your situation.

 

EMPLOYER SPONSORED RETIREMENT PLANS

Many employers offer retirement accounts to their employees, such as the 401(k) and 403(b). These plans offer tax benefits that are like the IRAs, making them a great investment choice if you are looking to invest more than the IRA limit. For 2019, The maximum employee contribution is $19,000, or $25,000 for those age 50+. Employer contributions do not count toward this limit.

 

One downside is that employers often impose a waiting period before an employee becomes eligible to participate in the plan. These waiting periods range from a few months to over a year. These restrictions are put in place to incentivize employees to stay with the firm.

 

On the upside, employers often include a matching contribution for employees who contribute to the retirement plan. For example, your company might offer a 3% match on your 401(k) contributions. If you contribute 3% of your pay check, the employer contributes an additional 3% on your behalf. That means you can double your retirement contribution using “free” money from your employer.

 

Employers that offer to match retirement contributions often impose a vesting schedule, which means that you must work at the company for a certain period before the matching contributions are legally yours. In most situations, if you leave the company before the vesting period is up, you will lose some or all your employer’s contributions. You are always entitled to your own contributions by law. You should check with your employer about the specific vesting schedule in your plan.

 

Much like the IRA, many employers offer a choice between Traditional and Roth accounts.

 

TRADITIONAL 401(K) AND 403(B)

The most common employer sponsored plans include the 401(k) and 403(b) plans. Both plans operate similarly, where an employee can contribute a portion of earned income into the plan. Your employer chooses the available investment options in the plan (frequently mutual funds and ETF’s), and you decide how to invest your contributions.

 

When compared to the Traditional IRA, these retirement plans have a major advantage. The funding limits are much higher ($19,000 vs $6,000 in 2019) and there are no income limitations preventing participation. Regardless of your income, you can participate if your employer sponsors a plan.

 

Traditional employer sponsored plans have the same tax implications as the Traditional IRA. Contributions are generally made through payroll deferrals (you choose how much to contribute as a percentage of your overall income). Contributions reduce your taxable income for the year and all investment earnings grow tax-deferred.

 

Future withdrawals are fully taxed as ordinary income. You may begin withdrawing money at age 59½, and early withdrawals are subject to the same 10% penalty described in the IRA section. There are required minimum distributions once you reach age 70½.

 

ROTH 401(K) AND 403(B)

Roth employer sponsored plans operate similarly to the Roth IRA. Contributions are not tax deductible, but all earnings grow completely tax-free, and qualified withdrawals are completely tax-free.

 

Compared to the Roth IRA, the benefits include a much higher funding limit ($19,000 vs $6,00) and no income limitations preventing participation. The major disadvantage is that Roth 401(k) and 403(b) accounts are subject to required minimum distributions once you reach age 70½.  But, you can roll these into IRA’s once you retire or leave your employer so you have more control over the money and for the Roth there would no longer be an RMD required if it was in an IRA.

 

IMPORTANT TO NOTE

Much like the decision between Traditional and Roth IRA, you must decide how to split your contributions between these different accounts. The maximum you can defer between both Traditional and Roth is $19,000 ($25,000 for those age 50+) in 2019.

 

The most important consideration is your employer’s matching program. Make sure to contribute to whichever account will receive a match, then decide how to handle the remaining contributions after that using my guide.

 

(Note – the same considerations apply when choosing between Roth and Traditional, whether you are funding an IRA or an employer sponsored plan)

 

TAXABLE BROKERAGE ACCOUNTS

A taxable brokerage account is an investment account funded with after-tax dollars. These accounts operate like a regular savings account but allow you to own and trade financial assets including stocks, bonds, ETF’s, etc.

 

A brokerage account can be opened individually, or jointly with another individual, or even owned by a trust, corporation, charity, etc. These accounts are free of the restrictions and rules that govern IRAs and employer sponsored plans. Anyone of legal age (usually 18) can open and fund a brokerage account, and there no contribution limits and no restrictions on when you can make withdrawals.

 

Unlike IRAs or employer sponsored plans, these accounts don’t offer the same tax benefits. Any interest or dividends that you earn in a taxable account are subject to taxation in the year received. Additionally, there are tax consequences when you trade an investment. When you sell an investment for more than the purchase price, you realize a capital gain, and when you sell at a loss, you realize a capital loss.

 

The tax treatment depends on the holding period. If you sell an investment after holding it for 365 days or less, you have a short-term capital gain (or loss). If you sell the investment after holding it for 366 days or longer, that is considered a long-term gain (or loss).

 

Short-term capital gains are treated as ordinary income, while long-term capital gains are taxed a preferential tax rate. For this reason, it could be better to hold investments for longer than one year. If you sell any investments at a loss, you can use the capital loss to reduce any capital gains, offsetting some of the taxes.

 

Also keep in mind that you can own a variety of investments in a brokerage account that generate federally, and sometimes state, tax-free dividends.  You can take these in cash or have them reinvested, but either way you receive tax free.

 

 

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HOW TO CHOOSE A SAVINGS & INVESTMENT ACCOUNT

As you have read, I’ve covered several different types of accounts in this blog. However, if you need an introduction to help you decide between the accounts, consider these tips:

 

  1. PURPOSE OF THE ACCOUNT

Are you saving for a down payment on a car or house or are you saving for college education or retirement?  Answer this question first as it will drive which type of account to open.

 

2) ALWAYS TAKE THE EMPLOYER MATCH

Your first consideration is your employer’s matching program. If you are eligible to participate in an employer sponsored plan, and your employer offers to match your contributions, make sure to contribute enough to receive the maximum possible match. That is free money, and you can’t beat free!

 

3) CONSIDER THE IRA

After contributing enough to receive your employer’s match, consider opening an IRA if you are eligible.

 

IRAs allow you to establish the account at a provider of your choosing, which means you have complete control over the investments held in the account. With employer sponsored plans, you are limited by the investment options provided by your employer.

 

4) BACK TO THE EMPLOYER SPONSORED PLAN

If you are ineligible to contribute to an IRA, or if you have funded the maximum amount allowed by the IRS, your employer sponsored plan may be the only remaining option.

 

You can contribute up to the IRS defined limit each year, splitting your contributions between Traditional and Roth (depending on your tax preferences and plan availability).

 

5) TAXABLE BROKERAGE ACCOUNT

Once you have exhausted any available tax-sheltered accounts, you can continue investing through a brokerage account.

 

6)  MULTIPLE ACCOUNTS

Most likely you will end up having a variety of savings, investment, and retirement accounts.  This is OK and quite normal, just make sure you know which account is earmarked for what goal and review them on a regular basis.

 

Your Choice of Car and Engine

An easier way to think about all is this is to think of the different accounts types as a Car.  There are lots of different cars you can buy.  The engine could be thought of as the investment inside the account.  You can put almost any type of investment (engine) you choose into the account (car) of your choosing.

 

I am aware this can all seem a bit daunting, but it doesn’t have to be.  If you want to invest for the future and have the cash flow to do so then you have already cleared the biggest hurdle.  Now you just need to figure out which investment option (s) are best for you and take action.

 

If you are feeling overwhelmed that is OK, most people feel this way at some point.  If you do, then consider working with a professional that can educate you in straightforward terms.  This will help you get comfortable and make the best-informed decision for your money.

 

Thank you for reading!

 

Cheers,

 

Derek Notman