The Importance of a Diversified Funding Strategy to Achieve Financial Freedom
We all know how important it is to save for retirement. Most of us have a decent understanding of the vehicles that will fund retirement (401(k)s, IRAs, etc.) You’ve likely even heard us talk about how important it is to maximize each vehicle, as part of a diversified savings plan.
The advantages of tax-deferred retirement plans are very appealing, making it easy for them to be the first choice of a destination for your money to accumulate. But because of restrictions and limits associated with these accounts, it’s important to fund other vehicles in conjunction as part of your overall wealth accumulation strategy.
A truly diversified financial plan offers flexibility that can truly allow you to 1) optimize your tax savings today, 2) ensure you’re able to reach your own personal retirement goals, when you want to and 3) manage an efficient tax rate in retirement.
The Type of Vehicle You Fund is Just as Important as How Much You Save
“When and how you plan to retire is a very personal thing,” says Brittany Frazier, CPA at Cain Watters & Associates. “Do you want to retire early at 50? Keep working until you’re 65? Go until 72? This is a personal choice that every investor must make based on their unique situation.”
Creating and executing a diversified savings plan targeted to your overall goals is one of the most important steps to accumulating wealth. Brittany asserts that the type of vehicle you fund is equally as important as the amount you fund. Without strategic funding of different types of vehicles, you could find yourself in a situation we call “pension poor.”
According to Brittany, “A person is pension poor when they’re not able to access the funds they need when they need it, due to age restrictions or tax penalties”. A person that is pension poor will also likely have a high tax rate in retirement, because the bulk of the money they are withdrawing from their accounts each year is from a bucket that is fully taxable in retirement.
No matter your personal retirement plans, the roadmap to avoiding a pension-poor retirement starts with prioritizing the different savings vehicles and the benefits of each. Tax-deferred plans like a 401(k) and defined benefit plan offer current year tax savings which roll into tax-deferred compounding returns.
While tax free accounts like a Roth IRA use after-tax dollars, gains are tax free. Each of these options are an essential piece of the puzzle, however retirement accounts cannot be accessed before age 59 ½ without penalty. Investors should also consider the benefits of taxable accounts as part of their financial life cycle and cash flow plan.
Small business owners will want to work with their advisor to fund their retirement in the following order:
– Max out your 401(k)
– Max out your Roth IRA or traditional IRAs
– Fund an HSA, if applicable
– Fund a personal taxable account
– Consider a cash balance defined benefit plan or permanent life insurance policy (after the above buckets are maximized)
The Importance of Taxable Accounts
If you wish to prepare for a flexible retirement, funding a personal non-retirement investment account becomes more important. Your 401(k) and Roth IRA accounts can offer financial freedom by 65 years of age, but funding taxable accounts offers the opportunity to cross that bridge much earlier, oftentimes even by 55.
The funds in this vehicle are invested the same way as any other retirement account–in a diversified asset allocation based on one’s risk tolerance. A major benefit of this bucket is that the funds are accessible at any time, both now and in retirement.
Utilized for large one-time expenses or emergencies, there are no restrictions on the use of these dollars or penalty for withdrawal before a certain age. Although these dollars will not compound as quickly due to taxes on dividends and interest, the flexibility makes them attractive.
Take Shawna, for example. Shawna wants to retire at 55. She’s done a great job funding all the traditional retirement savings vehicles and, as a dollar amount, has plenty saved for her retirement lifestyle needs.
However, Shawna hasn’t accumulated enough non-retirement savings to fund her living expenses until she reaches 59 and a half. She has plenty to retire on when you look at the amount she has saved in the retirement accounts, but she’s disadvantaged because she can’t start withdrawing from these accounts without taking the 10% early withdrawal penalty.
She does not have liquidity to access without a penalty, so she is “stuck” with a penalty or having to work to fund her living expenses for 4 and a half years longer than she would have otherwise.
Leveraging Cash Reserves
The optimal amount of cash to have on hand varies by where you are in your financial life cycle. Current business owners should have 3-6 months of business expenses saved as cash reserves. For personal accounts, we recommend anywhere from 3-12 months of living expenses.
While the reasons for having cash pre-retirement are obvious, this becomes less obvious as you are near and in retirement.
For retired clients, Brittany typically recommends ensuring you have 18-24 months of cash on hand. In retirement, you rely on your invested assets to live on for the remainder of your life. If you do not have sufficient cash reserves and the market becomes volatile when you need to take a distribution from your invested assets, you could be stuck liquidating at a loss.
Leveraging cash during this time offers flexibility by allowing the invested assets time to recover.
“A diversified savings plan that includes liquid cash assets is crucial to reaching your retirement goals,” said Brittany. “It is something CWA advisors spend a lot of time on with our clients.”
Talk to a Professional Tax and Financial Advisor
Brittany suggests consulting a professional who will take the time to expand upon each bullet below, giving you a thorough explanation of each benefit and what it means to your savings plan.
Diversified Savings Plan:
- Provides flexibility in retirement
- Helps to mitigate changes in tax law
- Helps with required minimum distributions and optimal distribution planning
Non-Retirement Personal Savings–Taxable Accounts & Cash Reserves:
- Allows you to access cash rather than retirement accounts during market volatility
- Provides liquidity for unexpected expenses
- Gives you funds you can have access to without penalty if and when you need it