Savings Waterfalls
What are they and why they are so powerful. Bonus: 4 Sample Savings Waterfalls
Dave Ramsey has famously said that if you don’t give your dollars a place to go, they will find their own place. The main ideas behind this saying is: be intentional with your money.
Save as much as you can
Design a savings plan that achieves your goals
Stick to the plan
Before we begin please refer to the may caveats at the end of the article.
Here is a picture of my oldest son Jay at Granite Falls in the Rocky Mountain National Park. Granite Falls is a series of smalls pools where water falls from the top pool down the the next pool and then onto the next. A savings plan is much like a waterfall in that the top priority (pool) gets filled and the excess water or money falls into the next priority or pools.
A Savings Waterfall is a great way to illustrate what a savings plan looks like. The objective of a savings waterfall is two-fold; first, to establish a progressive savings plan so that you know exactly where your savings money will go (kind of like a checklist) and second, to encourage you to save more.
Below is an example of a Savings Waterfall for an employee over 50 who has signed up for OTRS (Oklahoma Teachers Retirement).
OTRS Contribution:
If you signed up for OTRS, 7% of your compensation is deducted from your paycheck before your see anything. Obviously this is the first bucket and its a percentage rather than a dollar amount like most of the other buckets.
ICE Fund:
Commonly known as an emergency fund, an ICE (In Case of Emergency) fund serves as a cash reserve to absorb the unforeseen financial bumps of life. Appliance replacement, insurance deductible, airfare for an emergency, etc. Any large(r) expense that could potentially destroy your monthly budget should be covered by this fund. The only exception to the ICE fund bucket is carefully using your credit card to absorb these large(r) expenses. This is a slippery slope so accompany this strategy with a hard rule; always pay off your credit cards when they are due.
HSA:
The Health Savings Account (HSA) is the one account to rule them all… at least tax wise. Its known as the triple tax advantaged account because your money goes in without being taxed, it grows without being taxed and if used to medical expenses, it comes out without being taxed. For all the tax reasons, I prefer to stack HSAs as high as I can on the Savings Waterfall. If you are worried about having a large HSA account and not having a lot of health care expenses, worry no more. Not only are HSA approved health expenses very abundant (search HSA approved expenses on Amazon), you always withdrawal the money for non-healthcare purchases and just pay the income tax as if the HSA was just another IRA and avoid the early withdrawal penalty (20%) if withdrawn after age 65.
HSAs are exempt from payroll taxes (6.2% soc sec + 1.45% Medicare), which is not the case with retirement accounts, as well as state + federal.
High Interest Debt:
Not many people want to hold onto debt their whole life. Some debt isn’t bad and some debt is bad. My line between not bad and bad debt is around the 10% interest rate. Any debt above 10% is worth prioritizing and dedicating important dollars towards its reduction. Another way to think about it is an interest rate on debt is similar to a guaranteed rate of return. And its hard to earn a guaranteed 10% in the stock market.
Roth IRA:
Roth IRAs are my second favorite account of all time and in some cases when HSAs aren’t available, Roth IRAs are my absolute favorite type of account. The idea that you can pay taxes on the acorns and not the trees is awesome. Plus you get to control the rate at which your money is taxed. We know the tax rates today but we have no idea what they will be tomorrow.
Another great thing about Roth IRAs is that the working spouse can contribute $6,000 a year and the non-working spouse can also contribute $6,000 a year. Plus, after 50 years old, each person can contribute an additional $1,000 to their account.
Warning, there is an income limit to Roth IRA contributions but don’t worry, there is a way around this limit. Its called a Backdoor Roth IRA. I’ll write more about this in another article.
Finally, after 5 years you can take out the contributions without taxes or penalties. This is a tricky provision of the Roth IRA so make sure you review all the rules and exceptions regarding Roth IRA withdrawals.
457(b) and 403(b):
I grouped these two accounts together because they are very similar. The main reason I like the 457(b) over the 403(b) is that if you ever leave your employer (separation of service) you can withdrawal your money from the 457(b) without the early withdrawal penalty (withdrawals before 65) that most retirement account have. I’ll go into more depth on this single but powerful difference in another article.
For those who have enough money to save, the annual limit is $20,500 per year or $27,000 per year for those over 50 years old. Then you could stack another $20,500 - $27,000 into the 403(b). That’s $41,000 - $54,000 pre-tax savings per year = massive tax savings.
Others:
From here, customization and preference drive the next dollars. Here are a few options for those who find themselves with more money that needs ‘a job’.
529 Education Savings
Oklahoma has a decent 529 plan and you can read more about here.
529s are similar to HSAs in that you get a pre-tax benefit (state income tax only), it grows tax free and when used on educational expenses, it comes out tax free. Each state has different contribution limits but for Oklahoma the tax benefit limit is $10,000 if filing single and $20,000 if filing a joint return.
Brokerage Account
As long as capital gains tax rates remain lower than ordinary income tax rates, a brokerage account is a great account to improve withdrawal flexibility in the future. A brokerage account is simply an investment account that allows you to buy and sell publicly traded securities (stocks and bonds). Because there is no major tax advantage to this account, it has very few restrictions and rule. Simple is good. Despite investing after-tax dollars, saving into a brokerage account and investing in the stock market is a really good way to grow one’s wealth.
Real Estate Investing
Real estate is a great investment for some people. If you are one of those people, building up a real estate fund is a great first step. This is simply stacking cash in a savings account to be used for a down payment on an investment property.
Lets run this through a case study to show the power of careful savings.
The greyed out item (OTRS, HSA, 457, 403) are all deferred compensation contributions meaning they are pre-tax. Pre-tax contributions lower your taxable income and therefore your tax bill.
* 457s have a special catch-up provision that allows for double the normal contribution amount if an employee has worked for the same employer for 15 years. This is a massive deal.
** 403s have an extra catch-up amount ($3,000 a year or $15,000 over 5 years) for those employees within 5 years of retirement.
Developing a savings plan is essential for optimizing your retirement preparation. A savings waterfall offers a great visualization of your savings plan and helps you see the path to your dream retirement. The key is to rearrange the buckets to best suit your situation.
Lets end with another Dave Ramsey quote that encourages early and consistent savings,
“Live like no one else, so someday you can live like no one else.”
This is a great time to review not only your savings plan and look for improvements but also review your spending history and look for ways to spend less and save more.
Sample Waterfalls:
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Here are the caveats:
Two-income households change everything. A two-income household saving waterfall will likely be much more complicated. These samples are based on a simple, single-income household.
Spending goals like cars, vacations, house down payments, etc., aren’t included in any of these samples. A savings waterfall, at least the ones I design for clients, are focused on retirement and more specifically retirement and investment accounts. Spending goals are included in the more comprehensive cash flow planning portion of financial planning.
Each person’s income, budgets, obligations and goals are so different from the next person’s so please know that these samples are for educational purpose and are not designed to be applicable for everyone.
For the sake of completeness, I assumed that the saver has enough money to fill all available ‘buckets’. Those with less available savings should prioritize their savings goals and pick the best savings waterfall to fit their situation.
Dave Ramsey gives good general advice but no one should take his advice as personal financial advice.