The Overview:
The barbell savings plan is one that is cash heavy, and retirement account heavy, but ignores funding all goals that happen in the middle section of your life
- Once your emergency reserve is funded, and you are saving enough for a successful retirement you need to consider funding investments for medium term goals
- A medium term account can allow you to save for goals that occur before retirement in a more effective manner than a typical savings account plan can, and give you considerable flexibility in your financial plan
- Medium term accounts will typically be titled "Individual Accounts, Joint Tenant Accounts, TOD Accounts, etc." They are taxed very differently than retirement accounts (401k's, 403b's, IRA's, etc.)
The Barbell Problem
As stated in my overview, a "barbell problem" exists when you have ample retirement account funding, and an excess of cash accruing that is not needed for any near term goals. This is a great problem to have! Having excess cash is typically a symptom of being conservative with your spending, and managing your finances in a prudent way. However, if you are not careful you will begin to expose yourself to the opportunity cost of lost growth potential that all cash accounts create.
Example 1
Jane Doe is a 35 year old that works as an attorney at the local power company. She has been maxing out her 401k plan annually, and is on track to replace her earnings when she retires at age 60. She also has an emergency reserve of $30,000 which is equal to three months of her monthly expenses set aside in a liquid FDIC insured account. In addition to her emergency reserve account, she has over $80,000 in a bank savings account that she adds $1,000/month to currently earning 0.10%.
Jane plans to retire in 30 years and anticipates that she will continue adding to this account each month until she retires. As a result, the cash part of her plan will look like this.
Current Plan:
The Alternative Approach
Jane Doe decides to open a medium term account and allocate her $80,000 and save her $1,000/month towards this portfolio. She picks a moderate risk portfolio that she expects will average 5% per year.
** This portfolio is hypothetical in nature. Please speak to a financial professional to develop an investment plan suitable for your goals and risk tolerance.
Example 2
Compound interest is the difference between the cash you contribute to an investment and the actual future value of the investment. In this case, by contributing just $12,000 per year with the annual contribution being increased by 0% per year (cumulative contributions of $380,000) you are able to accumulate $872,270 over 25 years. Compound interest makes up $492,270 of your future balance.
Conclusion
In Example 1, Jane has accumulated $385,956 with $5,956 of interest earned over her 25 years. In Example 2, she has accumulated $872,270 with $492,270 of interest. That is a difference of $486,314.
This is an oversimplified comparison, but it illustrates an important concept. The power that compound interest can have on an investment plan over time should not be ignored. If you are fortunate enough to have extra cash in your plan, I strongly encourage you to think about incorporating an investment plan for your medium term goals into your overall savings strategy.
Additional Considerations
1. Taxation
One unique consideration you need to think about when saving in a medium term account is taxation. Investments that are held in medium term accounts are typically subject to short term, and long term capital gains tax which will be assessed annually via a 1099.
This is very different than your qualified retirement accounts which grow tax deferred (401k's, 403b's, IRA's, etc.).
While paying taxes on your investments may damper your excitement about medium term accounts, it is important to remember the following benefits:
- No early withdrawal penalties
- No contribution limits
- Capital gains tax rates are typically less than ordinary income tax rates
There are a wide menu of options available to limit your tax liability in a medium term account. It is important that you work with your financial professional to pick investments that are tax sensitive when picking investments for this type of strategy. The same options you own inside a qualified account (401k's, 403b's, IRA's, etc.) may not be as tax efficient as other options.
Read more here from the IRS on capital gains tax: https://www.irs.gov/taxtapoics/tc409
2. Investment Risk
Technology has made it easier that ever to open a medium term investment account. Many of the companies that encourage people to invest with them are unfortunately recommending their customer to take unnecessary investment risk to get rich quick. Option trading, individual stock purchases, and margin investing may be offered to you. Unless you are a seasoned professional, I recommend you stay away from these concepts. You can lose a lot of money very quickly, and in some cases cause irreparable damage to your finances.
When you are funding your medium term accounts, you should consider implementing a diversified approach that takes into account your goals, risk tolerance, and time horizon. A trusted financial professional can help you identify investments that are in your best interest.
Thanks as always for reading. If you found this information helpful, please feel free to share.
To schedule a complimentary meeting to discuss whether a medium term account is right for you, please select the link below.
https://calendly.com/sloan-walters
Thank you,
Sloan Walters, Co-Founder