Saving for the future and planning for retirement can be extremely daunting. You might feel frozen and unable to do everything you want to improve your situation. However, taking advantage of simple financial strategies today (e.g., automating your savings, cutting current expenses and saving raises) could significantly improve your future.
If you’re looking for more than just basic strategies, there are more complex tax, investment and savings strategies out there. Or you can simply look at common financial planning solutions in new ways to save for retirement. Here are four unique ways to approach basic retirement saving strategies.
Roth Savings
Roth savings and tax diversification are two of the most underutilized retirement strategies out there. According to a survey by Transamerica, roughly 52% of plan sponsors offer a Roth 401(k) option. A different survey found about 6 in 10 employees who were familiar with a Roth 401(k) and had one through work used it.
Tax-deferred 401(k) and traditional IRA savings provide a tax deduction today, postponing taxation until that money is withdrawn in retirement. Roth accounts don’t offer tax deductions on your contributions, but you don’t have to pay taxes on any gains or withdrawals (assuming you meet certain requirements).
If your tax rates stay the same, you accumulate the same amount of after-tax money whether you go the traditional or Roth route. Think about what your future tax bracket might be. Will it be higher or lower than where you sit today? An answer of “higher” might sway you toward a Roth since you won’t be taxed on withdrawals.
What’s so great about Roth savings? Well, you hear a lot about investment diversification, but this is about tax diversification . Having after-tax, tax-deferred and Roth savings diversifies the tax treatment of your savings and ultimately reduces the potential impact tax system changes will have in the future. If tax rates rise or fall, being diversified can help offset the impact.
If you’re looking at ways to save more money for retirement each year in a tax-advantaged savings account, Roth accounts let you do this. Let’s say you want to set aside the maximum salary deferral in a 401(k) in 2019 of $19,000.
You could put this into a Roth or traditional deductible salary deferral account. Now let’s assume your effective tax rate will always be 25%. When you contribute $19,000 into a tax-deferred account, 25% of it will always be the government’s money. After taxes, you’ll have $14,250.
If you contribute the $19,000 to a Roth account, you pay taxes on it today, but you can still put $19,000 into the 401(k) at a Roth contribution, which means it is really $19,000 of your money in a tax-advantaged account. However, if you put $19,000 in to max out your 401(k) with a traditional deductible salary-deferral contribution, you will eventually pay taxes on that amount when it is distributed. Essentially, a portion of that is the government’s money. If your tax rate is 25 percent, that means $4,750 of that $19,000 contribution is earmarked for future taxes. So in essence, the Roth savings allows you to put more of your money away in a tax-advantaged account.
The same aspect of maximizing tax-advantaged money applies when comparing traditional IRAs and Roth IRAs. For those looking to maximize their tax-advantaged retirement savings, Roth accounts can provide a nice option.
Permanent Life Insurance
Many people hear the advice “buy term and invest the rest.” This essentially means you can get term life insurance and grow your wealth faster by investing in the markets rather than in life insurance. If you need life insurance coverage while working to protect your family in case your income is lost due to a premature death, term insurance can be the most effective solution.
The “buy term and invest the rest” strategy has good intentions, but limited follow-through –many people tend to forego the “invest” part of that equation and just spend the rest.
Permanent life insurance is a more expensive option, but it offers some compelling benefits, most notably in taxes, to use for retirement savings.
By purchasing permanent insurance with ongoing premiums, you’re automating a form of savings through your premiums. Because each premium essentially allows you to build more wealth in your policy tax free and can pay out death benefits income tax free, you grow your wealth over time. Permanent life insurance can offer tax-free access to the cash balance of the policy as an effective way to supplement your retirement income with non-taxable sources.
Additionally, life insurance could be viewed as a bond or CD-like asset substitute. People invest in bonds and CDs to bring safety to their investments as they have less volatility than the markets but offer less gain potential.
If you look at life insurance as a bond substitute, compare the internal growth rates or rollup as compared to bonds and CD rates today. You’ll notice many life insurance policies can out-perform what CDs and bonds pay today. While life insurance shouldn’t be confused with a CD and bond replacement as they’re very different, it can give you a comparison for a way to save for retirement with a lower risk product than the stock market.
Buy Instead of Rent
I’ve written for years about why housing is a bad investment, but one you should do anyway. Two factors support my argument. First, housing is a bad “investment” in the US because it doesn’t provide any real rate of return as it keeps pace with inflation. If you just want to grow wealth, you’d be better off investing in the markets for a long period of time.
The second part of my argument is that you should still invest in housing. Here’s why: Even though renting can be cheaper in areas, people who buy homes accumulate more wealth over time.
A report titled Homeownership and Wealth among Low- and Moderate-Income Households, showed low and moderate-income homeowners generated a higher net worth than their counterparts who rented during the same time period. While the study didn’t argue or conclude that homeownership is always the best avenue, it did show that people with responsible mortgages increased their net worth on average by $20,000 over three years compared to only $15,000 for those who rented.
Despite many academic and conceptual arguments that renting should increase wealth faster than owning, research by Harvard University’s Joint Center for Housing Studies shows the opposite. Even after controlling for sociological, economic, and other differences, people who buy homes tend to increase their wealth faster than those who rent.
When you do buy a home, treat it as a long-term decision. If you churn through houses, closing costs and moving costs can erode your potential for wealth gain. In other cases, you might want to consider pre-paying a mortgage if you have a high interest rate. Today, with interest rates nearing historic lows, you might benefit from refinancing to lower your ongoing interest payments.
While you might find it cheaper to rent, people who buy a home tend to create more wealth. Why? The answer might lie in the same automation argument laid out with permanent life insurance.
By purchasing a home and taking on a mortgage, you create a form of automated savings. Each time you pay off some of the principal of the loan, you’re paying down debt and freeing up home equity. Assuming your home appreciates with inflation, your home value increases while the debt on the home decreases. By automating these two features through home ownership and mortgage repayment, you might just be automating your wealth creation.
Health Savings Accounts (HSAs)
HSAs are often used in a less than optimal fashion. To fund an HSA you need to be in a qualifying High Deductible Health Plan and meet other requirements. As an HSA owner you can deduct your contribution, invest the money and use it tax-free in retirement or later in life for qualified health care expenses.
An HSA is one of the best tax and investment vehicles in the IRS tax code for long-term investing. However, most people don’t use them for the long term. A HealthSavings Administrators survey found that 47% of advisors position HSAs as a short-term savings account. This helps support research and findings by the Employee Benefit Research Institute, which found that very few Americans, roughly 5%, invest their HSA in anything other than cash.
The same report found that nearly 66% of HSA owners withdraw funds. HSAs can be rolled over each year, though. More Americans need to think about HSAs as tax-advantaged savings vehicles for retirement. Fund the HSA, invest in low-cost funds and let it grow for the future. Then you can use the funds in your retirement to offset health care expenditures in a tax efficient manner and allow all the growth to come out income tax free.
Retirement savings can be challenging to navigate with a slew of strategies to choose. While all of these strategies can be beneficial, they need to be incorporated into an overall plan. One strategy can impact another and the benefits of each depend on a person’s unique situation and goals. Since many of these strategies are complex and involve tax planning too, it’s important you work with a trusted financial advisor and tax professional.
