Jack Wang

GUEST COLUMN: Save for the Future by Using the Right Vehicles

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This is an article in an occasional series on personal finance. Each article will address a different aspect of personal finances and provide some tips for you. However, always consult your own financial adviser or tax professional for your specific situation.

Start saving for retirement early.

That’s one of the pieces of financial advice given to new college graduates, and likely one of the things we all agree on in hindsight. After all, no one has ever said “boy I wish I saved less money.”

My friend Eric* is starting his new life. A recent college graduate from a local university, he’s just started a job for a large consumer products company. And he’s already heard that advice from both his parents as well as his employer. If Eric starts contributing to a workplace retirement plan, theoretically there could be 40 or more years of contributions and compound interest. To make this process easy, his company, along with many others, offer 401k plans that automatically enroll new employees.

While starting early on retirement savings is generally good advice, there are many more things to consider. Let’s unpack this advice a bit.

The challenge is always how to balance life and competing financial goals. After all, Eric has an entire life to live. He just moved closer to the city so he doesn’t need a car today, but will in the future to replace the one his parents gave him during high school. Eventually, he does want to buy a house in the general area. Though no plans yet, he can envision himself getting married and having a kid or two. And in between all of those life goals, he’ll want a nice vacation at some point. All in all, a common situation with reasonable goals.

Traditional financial advice would say that for every goal, save in an appropriate vehicle, considering time frame and risk tolerance. Typically, that would mean something like a savings account for a vacation or even down payment on a house. And a 529 plan for college savings. And we could easily calculate how much is needed per month to hit those goals, as long as you have a reasonably good idea of how much money he’ll need for each.

In reality, very few people are able to save for all of those goals. Why? Because life. Because student loans and other debt. For many, the only savings — aside from a small amount in a savings account — would be in the company 401k. According to the IRS, a 401k is “a defined contribution plan where an employee can make contributions from his or her paycheck either before or after-tax, depending on the options offered in the plan.”

My friend Eric is no different from most. He likes his outdoor adventures on weekends. And hanging with his roommate and friends for a beer and dinner a few nights a week.

Yet, 401ks are hardly the vehicle to save for the various goals. It is meant for retirement savings, and withdrawals for other purposes would incur income taxes and in many instances, an additional 10 percent tax penalty. And other savings vehicles, such as 529 plans have similar limitations if the funds are not used for the account’s intended purpose.

What should Eric do instead? He definitely wants to save for retirement with the long time for compounding, but also save in a way where he can access the funds for the other purposes with minimal cost and taxes. He does have his entire life ahead of him.

The key is to be smarter in how he saves, not just how much he saves. Considering his life, there are other ways to save for retirement while being able to access the funds for other purposes should he need it. Eric may want to consider two vehicles that offer the ability to save for retirement yet provide access to the funds: Roth IRAs and properly structured permanent life insurance.

The important aspect to Roth IRAs is the ability to access the principal, not the earnings, at any time and for any reason tax free and penalty free. Thus, if Eric needs the money for a down payment, he could take it from the Roth IRA. If not, the funds stay in the IRA and can continue to grow for retirement.

Further, if he chooses to save in this manner and needs the funds for college or buying a house, he can withdraw the earnings without penalty. He may still have to pay income taxes on the earnings, but college expenses and first time home buyer are two of the allowed penalty exceptions available to IRAs, but not available to 401ks.

Alternatively, if Eric uses properly structured life insurance, he can get the same benefits as a Roth IRA, but very few of the limitations. He can access the funds for any reason, at any time, without taxes or penalties. And he has the ability to put the money back in, where the Roth IRA would be limited to the annual contribution amount. And permanent life insurance offers benefits to Eric without having to die first that are not available in any other vehicle.

These strategies are the equivalent to buying a multi-purpose tool rather than having separate individual tools such as a hammer, screwdriver or wrench. While there is no such thing as a perfect tool, both Roth IRAs and properly structured life insurance can serve as other tools, in addition to the 401k, to help Eric build a solid financial foundation.

*Name changed to protect this client’s identity.