The Best Ways To Save In A Recession
Ashlea Ebeling Forbes Staff
I write about how to build, manage and enjoy your family's wealth.
So you survived the latest round of layoffs, but your employer froze your salary and suspended its match to your 401(k). Time to ramp up your savings. "I'm telling people now is the time to save even more," says Marc Soss, a tax and estate planning lawyer in Sarasota, Fla. "You're going to need it for tomorrow."
Nervous Americans have figured that out. When 1,000 adults were polled in February for the AARP, 28% said that despite the recession, they were saving more than a year ago. (Many more reported they'd cut back on spending. But for families with reduced incomes or big debt to pay off, that doesn't necessarily translate into more dollars in savings accounts.)
Another notable finding: While almost as many adults said they were saving for retirement as for an emergency, 37% reported they were putting less in dedicated, tax favored retirement accounts. Maybe that's not surprising, given widespread job insecurity and the restrictions that limit your ability to get at the money in retirement accounts before age 59 and a half, without paying a 10% penalty.
In Pictures: 10 Smart Ways To Save
If you are pouring all you can into a 401(k) but don't have a substantial emergency fund (think at least six months expenses) then it makes sense to divert some of those dollars into a taxable account or into a Roth IRA. A Roth can serve as a second-tier emergency fund, since it can be tapped without penalty in an emergency.
The key is this: To secure both tax savings and financial flexibility you must spread your savings across different types of accounts, just as you spread your savings among different types of investments--stocks, bonds, real estate and so on.
Of course Congress hasn't made choosing among accounts simple. There are more than a dozen different tax advantaged ways to save for retirement alone, plus special accounts for college and health care expenses. All these accounts have their own rules on contributions and withdrawals, their own advantages and their own traps. Internal Revenue Service Publication 590, simply covering individual retirement accounts, runs to 114 pages. (If you download it from www.irs.gov, make sure to get the latest edition; since 1986, Congress has changed the laws on IRAs and 401(k)s 73 times, according to tax publisher CCH.)
But despite such complications now is not the time to give up on retirement savings--or savings discipline. Timothy Wyman, a planner with the Center for Financial Planning in Southfield, Mich., says that if clients do cut back on 401(k) contributions to build up an emergency fund, he advises them to build the fund with automatic transfers--say $500 moved from checking to a separate savings account each month--so as to replicate the systematic savings of the 401(k). "It's not a save-to-spend account," he says. "Even though you can get at the money, having a different account at a different institution gives it that arm's length that you're less likely to touch it," he adds.
Building an emergency fund makes sense, planners say. What doesn't make sense, says Justine Tenney, a CPA and financial planner with Weiser LLP in Lake Success, N.Y., is what she's heard some clients say recently: They're limiting contributions to tax-deferred retirement accounts for fear of market losses. "You shouldn't stop deferring. Just put it in a safer investment until you're comfortable with where the market is going,'' counsels Tenney.
There's no reason (other than fear of missing a stock market rally) that you can't park your IRA in a federally insured bank CD or invest your 401(k) in Treasury bonds or, if you're worried about the government pumping up the money supply, Treasury inflation-protected securities (TIPs). This might turn out, fortuitously, to be a tax savvy move.
Here's why: All funds you take out of a pretax 401(k) or IRA are taxed as ordinary income, at a current top rate of 35%. That's the same way interest income is taxed. But long-term capital gains from stock and funds held in regular accounts, as well as stock dividends, are taxed at a maximum 15%. Plus, you can harvest capital losses from your taxable portfolio now to offset future gains.
So when all is said and done, you may be better off holding fixed-income investments, such as Treasury bonds, in your pre-tax retirement accounts and stocks in other accounts--otherwise you'll be turning income that might be taxed at a maximum of 15% into income taxed at a maximum of 35%. (President Obama wants to take the top rates to 20% for capital gains and dividends and 39.6% for interest income in 2011, so the point would still be valid.)
Does worrying about where you hold your investments, as well as what you invest in, sound like extra work? It is, but it's worth the effort. While you can't control the markets, you can boost the long-term after-tax return on your investments by making savvy decisions about which assets you hold in which accounts.
For more tips on how to do this, see "10 Smart Ways to Save." No, you can't control the markets.
Ashlea Ebeling
I'm an associate editor on the Money team at Forbes based in Fairfield County, Connecticut, leading Forbes' retirement coverage. I manage contributors who cover retireme...