Savings Buckets vs. Investments

I don’t know if you’ve seen the papers, but 2008 was, financially, a pretty crummy year.

And the worst part of it was having to watch the TV newscasters interview ordinary Americans about their financial woes. Well, that and the 25% drop in our 401(k) accounts.

On one newscast, the designated ordinary-American-with-financial-woes made the following statement: “If a Roth IRA is such a good idea, how come mine is worth so much less than what I put in?” The interviewee, to his discredit, failed to note the distinction between his investment—which dropped in value—and the type of savings bucket in which it was housed, in this case a (totally innocent) Roth IRA.

So let’s get this important distinction straight. As you save for your retirement, there’s really two decisions you have to make: Into what type of savings bucket should I contribute my savings? And what investments should I buy with the contents of that bucket? If the ordinary-American-with-financial-woes had understood that distinction, he still would have lost money, but at least he wouldn’t have embarrassed himself on national TV.

There are a lot of different ways to characterize savings buckets. The taxonomy of savings buckets can be as complex as that of the invertebrates. One way to characterize savings buckets is by their tax attributes. From that perspective, there are basically five types of savings buckets (with lots of sub-categories and variations). They are:
• Traditional tax-favored retirement account (such as a traditional Individual Retirement Account or 401(k) account)
• Roth tax-favored retirement account (such as a Roth IRA)
• Taxable investment account (such as a bank savings account or ordinary brokerage account)
• Annuity (such as a deferred variable annuity or an immediate annuity)
• Non-qualified deferred compensation account (available only to highly paid executives)

For most people, the first two are the most important. Why? Because most of us find it hard to save, and if we are limited in our saving, it usually makes sense to put our scarce dollars into the savings bucket offering the greatest tax advantages. And that would be the first two. Of course every savings bucket has its own set of rules to consider—contribution limitations, investment restrictions, distribution requirements, and tax characteristics—which I will save for another posting. For now, I just wanted to note the distinction between the receptacle, and the investments with which you fill it. Just in case you’re the next ordinary-American-with-financial-woes on the nightly news. (I certainly hope not.)