The Savings Cascade
The next best place to put your money
What should I do with my money?
If you’ve ever had surplus money lingering in your checking/savings account or unspent surplus income piling up, this question might feel familiar to you. If so, you’re in good company. You probably won’t be shocked to hear this is the question I get most often. I’ve fielded this question from clients, colleagues, family members, and friends; nearly anyone. Wondering where to save and invest money is a very common concern.
To answer this question, a good financial planner should begin by saying “it depends”. There are many factors that impact this decision. Your values, your goals, your timelines along with the balances you already own in these accounts. But what should you do if you’re not sure about your future goals, or simply need the next best place to put your hard-earned money?
The Savings Cascade
Enter the savings cascade. While I like to use the term “savings cascade”, this idea has been around for a long time. Commonly called the “savings waterfall”, my savings cascade helps prioritize where your money should go. Simply, it is a catch-all way to answer the question, “what should I do with my money?” absent individual or special circumstances.
Take a moment to envision a cascade. That is, imagine a series of small waterfalls, each falling down into the next. Beginning with the stream at the top (your cash flow), the savings cascade prioritizes different types of savings and investment options for your money. Once the highest priority is full, the money then cascades down to the next step and so on. Each small waterfall continues to fill the step or pool below before overflowing down the list of investments. This is generally how the concept works. Should one pool become too low, the cascade halts until the deficiency is full and once again continues overflowing down the line.
The steps
Listed below are are the steps of the savings cascade. Step 1 is actually three steps grouped together in quick succession. They could also be considered in tandem. Feel free to measure them to match your needs but if unsure, follow them in order.
1a. Emergency Fund
This step is critical to everyone.
Common advice tells us to store between 3-6 months of expenses in savings, money market, or similar type of highly liquid account. Depending on your unique scenario, 3 months may be enough, but you might feel safer with 6 months or even longer. Make sure this money is stored in a highly liquid account with a competitively high interest rate. The idea is that this money is readily usable at any moment while attempting to keep up with inflation. High yield savings and money market accounts are ideal places to keep your emergency fund. Read here to learn more about how the emergency fund can work for you.
1b. 401k/TSP/403b employer match
This is free money! While this is the second step in your cascade, make sure to max out any company 401k/TSP/403b or similar match offered by your employer. If you cannot quickly fill your emergency fund before maxing out your company match, you should think critically about the tradeoff of building your emergency fund over a longer time frame vs leaving free money on the table from your employer. After all, if you don’t use it, you lose it.
1c. High Interest Debt/All Debt
If you previously read my emergency fund vs credit card debt article, you learned about the trade off between paying down debt and establishing an emergency fund. Here is where the wiggle room happens. As I mentioned before, you might want to blend these first three steps together. But, for most people, this is where your debt payoff focus should begin.
For this step, you can choose to attack all your debt at once or focus only on high interest liabilities (6% interest rates and higher). If you are careful with money, focusing on higher interest debt will maximize your net worth. If you have trouble with debt in the past, it might be a good idea to hammer down all your debt regardless of the interest rate. When in doubt, here is more information about types of debt. Also, if you’re considering paying down your mortgage, here is why your money could best be used elsewhere.
2. HSA - Health Savings Account
After savings, employer match, and debt, a Health Savings Account is next. If you have a high deductible health care plan, an HSA can be an incredibly flexible, lucrative, and beneficial plan to take advantage of.
An HSA is the only “triple-tax-advantaged” plan there is. That is, money can go in tax-free, can grow tax-free, and can be withdrawn tax-free so long as the funds are used for qualified medical expenses. Further, unlike a Flexible Spending Account, your HSA dollars can roll over indefinitely year after year.
Finally, after age 65, you can withdraw funds from your HSA for general spending. You will pay taxes but avoid a 10% penalty. This effectively turns your HSA into a bonus traditional IRA.
3. IRA - Individual Retirement Account
This is where I typically get a lot of questions. Once you have maxed out your company match, why does an IRA come before maxing out the rest of your 401k/TSP/403b?
The answer is flexibility. While your employer has hopefully (and graciously) provided you with a retirement plan option, you are usually limited to the investment choices provided by the plan provider. Usually this arrangement is fine and is certainly better than having no employer sponsored plan at all. But while the chosen provider may indeed serve your needs, an IRA can be invested with ANY investment company you choose (yes, even the same one your employer uses). Also, while most employer plans offer a limited series of mutual funds to choose from, your IRA can be used to invest in unlimited types of funds, ETFs, REITS, bonds, precious metals, and even real estate.
Additionally, if you prefer to invest in after-tax Roth accounts, a Roth IRA is currently a better option than a Roth 401k or Roth TSP. The most important difference between a Roth IRA and Roth 401k is treatment of contributions. Contributions to Roth 401k/TSP plans must remain invested until 59.5 and can suffer a 10% penalty (along with earnings) if withdrawn before. On the other hand, contributions to a Roth IRA can be withdrawn at ANY time free of taxes and penalties; only earnings are subject to a penalty before age 59.5. For this reason, Roth IRAs can act as a dual retirement vehicle/bonus emergency fund. While I expect legislation to fix this discrepancy at some point, this remains the case in 2024.
4. Max 401k/TSP/403b
The only drawback to IRAs when compared to your employer retirement accounts is contribution limits. In 2024, annual contributions to an IRA are limited to $7,000 ($8,000 if over age 50) whereas annual contributions to common retirement accounts are limited to $23,000 ($30,500 if over age 50).
Even though IRAs offer more flexibility and control, employer provided retirement accounts still offer a wonderful tax-advantaged vehicle for retirement savings. After the steps listed above, you should make every effort to max out this opportunity.
5. Section 529/Bonus Roth IRA account
If you have children and want to save for college, a section 529 plan is a great place to do so. A 529 account behaves very similar to a Roth retirement account; money is invested after-tax, grows tax-free, and withdrawals are also tax-free so long as they are used for certain college expenses.
What if you don’t have children? If you are expecting to have children in the future, you can open a 529 in your name, begin investing, and then transfer the beneficiary designation to a child in the future. 529 beneficiary designations are fully transferrable between family members.
If you don’t have children and don’t expect to have any in the future, a 529 can also be beneficial if you have maxed out your Roth IRA options. Beginning in 2024, a 529 plan can be rolled into a Roth IRA! The account must have the same beneficiary for 15 years and there is currently a $35,000 lifetime limit, so there is some planning to be done before using this approach.
6. Brokerage Account
If you have maxed out your employer match, HSA, IRA, employer retirement plan, and 529, chances are you are set up very nicely for your goals. However, if you still have income left over, you should consider a brokerage account.
A brokerage account is a general account allowing you to purchase stocks, funds, bonds, ETFs, and other types of securities. They are ubiquitous and very easy to establish. Robinhood, Schwab, and Vanguard are common brokers, but there are nearly limitless options. Make sure to read disclosures and mind the fees.
There is no tax advantage to this type of account; you will be taxed on dividends and interest received along with any capital gains as you trade in and out of positions. However, buying and holding index ETFs in brokerage accounts is an efficient way to capture stock market returns while keeping your overall costs low. Read more here on the advantages of passive investing.
Most importantly, your brokerage account is highly liquid. This makes it a wonderful “catch-all” account to keep money that is easily accessible while achieving stock market levels of returns. This money is ready for anything; college expenses, down payments, retirement savings, income generation, and so on.
7. Low interest debt (optional)
Finally, if you have maximized the accounts above, you may choose to focus on paying off low interest debt.
Why is this step optional? If you have low interest debt such as a mortgage, student loans, vehicle loans, and so on, you can have a greater effect on your overall wealth and net worth by choosing to invest money in equities instead of paying down these type of accounts. That said, any good financial planner will not fight you if you wish to pay off debt.
To be fair, the most enticing reason to focus on this step is cash flow. If you are near retirement and paying off these debts will help you achieve a “retirement cash flow goal”, by all means go for it. In fact, cash flow needs can even push this step higher up your cascade.
The retirement pool.
There you have it, your savings cascade. As always I encourage you to reach out to your financial professional to discuss your needs. In the meantime, following these steps will start you on a solid path to future financial success, no matter your particular goals or situation. Do things right and you will have a deep, calm pool at the end of your cascade to enjoy.
