Investing in a 401(k) is often very easy. But what happens when you want to save money outside a 401(k)? What do you do? Where do you start?
In financial planning, it’s common to start here. Goal setting.
Specific goals help in developing a savings and investment strategy. Generally, specific financial goals include the following:
While this doesn’t constitute a complete list of financial planning goals, these three objectives rise to the top of many financial planning to do lists. Usually the goals have an easily identifiable timeline and cost. For these reasons, developing a savings strategy is easy.
Unfortunately, everything related to financial planning isn’t so easy. In fact, one of the more difficult financial planning goals to fund is the “middle bucket” goal, or investing money outside a 401(k) plan. This isn’t money for retirement, nor is it money that should be earmarked for an emergency fund.
The middle bucket is the bucket of money that falls somewhere in between. Maybe it’s money to buy a new house or a new car. Maybe it’s money to help fund college expenses above those covered by a 529 plan. Or maybe the middle bucket is money that is earmarked as a supplement to other income in retirement.
The problem with the middle bucket is that we aren’t always exactly sure what the middle bucket is for. So with no exact time horizon, no exact need, and no consistent funding, how and where do we invest this middle bucket money?
Option 1 – Set Goals and Specifically Identify Accounts
The financial planning purist would suggest tackling this problem head on. The first step would be to specifically identify goals and individually fund each goal. It is easy to argue that this is the best way to tackle the middle bucket. In practice, the middle bucket may quickly turn from bucket into buckets.
For example, it may make sense to identify a goal of buying a new house (or vacation house). One might say I want to have $50,000 saved in 10 years for a down payment on a new house.
A second goal could be to fund 25% of a projected college expense in addition to the 529 plan.
A third goal could be to save $500,000 in non-IRA savings by the time you are 60 years old to supplement retirement.
As you can see, these goals are identifiable, timely, and specific. These specific goals will allow you to identify how much and how often you need to save in order to reach the goal.
Specific goals also allow you to prioritize. Prioritizing goals is important during those times when cash flow does not allow you to sufficiently fund each one.
Having individual goals may also allow for each goal to be invested differently. For example, the risk profile for a goal with a 5-10 year time horizon may be substantially different from the risk profile for a goal that is 20 years into the future.
Option 2 – Create One Bucket – Fund and Spend it Accordingly
Saving in the middle bucket may be as simple as creating one investment bucket. In this strategy, the focus shifts from funding individual goals to funding one bucket and filling it as fast as you can.
It may make sense for an investor to establish a non-IRA investment bucket with an indefinite time horizon that is allocated exclusively for their desired risk tolerance. If you are a safe investor, the entire bucket will be invested with low risk. If you are a risky investor, the entire bucket will be invested more aggressively.
Regardless of risk tolerance, the bucket may then be funded to the maximum amount as allowable by the individual cash flow.
As the bucket grows, it can be used to fund college, a new home, a second home, retirement, or any other goal. This strategy often works for those who know they need to be saving but aren’t quite sure exactly what they are saving for.
One downside to this strategy is making the decision on when and how to use the money. Is it for college or is it for retirement? What about the vacation or second home? Pulling money out of one bucket may be easy or hard, depending on your tendency to be a spender or a saver.
How to Invest the Middle Bucket Money
In theory, all investment decisions should be made with consideration to personal risk tolerance, risk capacity, investment time horizon, and other personal factors.
In practice, it’s often appropriate that long term investments are allocated more aggressively and shorter term investments are allocated more conservatively.
With bucket planning or goal planning, it’s often accepted that as the goal date gets closer, the investments become more conservative. The exact transition from higher risk to lower risk is subject to many factors beyond the scope of this blog post.
Typically, saving in the middle bucket is something investors implement after they have accumulated an emergency fund and retirement dollars. With excess cash flow above and beyond these needs, it is common to establish an investment account to receive these funds.
Often, automated (or forced) savings via a monthly investment are employed. Like contributions to your 401(k) or other retirement plan, this method of saving makes things easier and allows you to invest using “dollar cost averaging”. Dollar cost averaging* is a strategy that suggests buying a fixed dollar amount on a regular basis, regardless of share price. Although ease and automation often help lead to increased wealth accumulation,
So do you have a “middle bucket?” If so, what are you saving for?
*A plan of regular investing does not assure a profit or protect against loss in a declining market. You should consider your financial ability to continue your purchases over an extended period of time.