When you want to get started with financial planning the basics are the place to start. This article looks at the 3 Basic Buckets To Put Your Money. There are additional resource links at the end of this article.
There are different places that you can put your money. None are right for every situation. Each has its own distinct advantages and disadvantages. This is a brief summary of each.
Taxable – These are accounts that have no tax advantage. You pay tax on the money that you deposit. You pay tax on any returns. You are taxed coming and going. So why would you put money in this type of account? Liquidity! This is the type of account that we want to keep our emergency money. We want to grow this account over time so that we have 3 to 6 months of living expenses in this account. Examples include checking, savings, and money market accounts. While individual stocks and mutual funds could be considered in this group I would not keep our emergency funds in these. You could include CD’s since if you needed to the institution that holds the CD’s will usually allow loans using the CD as collateral. Another reason to use these may also be used when you have exhausted your ability to contribute to the other types of accounts. They have no contribution limits and in some cases that can be attractive.
Tax deductible – These are accounts that allow deposits to be places into the account on a tax deductible basis. The money that is put in is not taxed. The money and any earnings that are credited are not taxed, if certain conditions are met. We are not required to pay the tax until we make withdrawals.
A farmer plants seed in the ground. He does not pay tax on the value of the seed. The seed grows and he does not pay tax on the value of the plants as they mature. At harvest time, the farmer harvests the plants. This is when the tax is paid. The tax is based on the value of the harvest and it is not paid until that time. Which has a higher value the seed or the harvest? Under most circumstances, it will be the harvest.
There are several examples that fall into this category:
1. Traditional IRA
4. Simple IRA
The biggest advantage to this category is the employer match. This is free money that is hard to turn down. To receive this match, the employee usually has to make contributions of their own. There are penalties for early withdrawals. Some plans allow hardship withdrawals or loans. This is the most common bucket and should certainly be part of your plan if you have an employer that provides matching. You should at least contribute to the point that the matching stops.
Tax deferred – These are accounts that tax the deposits that are made. However, there is no tax as the account grows and no tax on withdrawals. There may be some penalties for early withdrawal depending on the type if account. Let’s go back to our farmer:
Prior to planting the seed a value is established for the seed and a tax is paid accordingly. The seed is planted and it is allowed to grow. There is no tax levied while the plants are growing. The plants are harvested. There is no tax paid at harvest time. This means that we paid a tax on a smaller amount today so that we could avoid paying a tax on a larger amount tomorrow. Some examples of this type of account are:
1. Roth IRAs
2. Roth 401Ks
3. Tax Deferred Annuities
4. Life Insurance distributions prior to death
Like the other examples we have given each have their own advantage and disadvantage. Prior to investing in any of these accounts you should consult a tax professional to determine which is best for your personal situation.