The story of COVID-19 in this country is like the tale of two countries. There is little doubt that the virus has laid bare the inequities in our society. For millions, the virus has resulted in sickness and loss of jobs, and for hundreds of thousands even death. But it is also true that for millions of others who have been fortunate enough to keep their employment and stay safe, there has been a very significant upsurge in savings. And, if you are an expat, given the relative strength of the dollar this year, this effect may be amplified. It is undetermined if this pandemic will cause a paradigm shift on how we spend and save, but for the moment, many have a lot of extra cash in the bank.
The question then is what do we do with this unexpected excess, which I call the COVID Dividend?
Pay Down Debt
As announced by the Federal Reserve, and reported on National Public Radio in February this year, U.S. credit card debt hit an all-time high of $1 trillion dollars. In addition to credit card debt, we also need to consider other personal debt, including student debt, which comes in at close to $1.5 trillion dollars!
I have had some people ask me if it would be better to use the extra funds to fund their Roth IRA or contribute to their 401(k) plan at work instead of making additional payments on the credit cards. We need to acknowledge that credit card debt has extremely high interest rates and fully realize that it is unlikely that over time our investments will pay average rates of return that are higher than those charged by the credit cards. Under normal circumstances, prioritizing savings when you have a lot of debt is like taking one step forward and then two steps back. Let us look at a simple example.
Assume you have $5,000 in credit card debt with an interest rate of 16%. Let us also assume that you make a generous 10% on your $5,000 investment portfolio. Finally, let us also assume that you have $1,000 dollars extra and you want to know whether it is best to add to your account or pay down the credit card balance. As you can see below, adding the extra funds to savings may make you feel like you are richer, probably because your investment account went up and you earned a very respectable 10%! But that is an unfortunate illusion. On a net worth basis, you are actually poorer by year end for not paying down the debt.
As you can see your net worth went up an impressive 7.5% by choosing to pay down the debt instead of investing the excess.
Credit card debt can be a serious threat to your financial health. If at all possible do not carry any credit card balance at all by paying the cards off each month. If you have a credit card balance, and have cash to pay them down, pay off the highest interest rate debt first.
There is an exception to the recommendation to pay down debt before adding to an investment account and it is this: if you would miss the opportunity to get a match on an employer retirement plan. A dollar for dollar match is the equivalent of a 100% return and that, my friend, is hard to beat. Once you have been fully matched, then go back and start paying down those credit cards.
After credit cards, I suggest student debt be prioritized. It is not so much that their interest rates are high. This debt is particularly risky from the standpoint that it is also particularly sticky. At least with most personal debt a declaration of bankruptcy can wipe the slate clean and give you clean start. But with student debt, you cannot get rid of it in bankruptcy. Further, your wages can be garnished, Social Security payments diminished, your professional license denied and, in a few states, even be denied a driver’s license. Life will throw you a curve ball at some point (one of the few statements I can guarantee in my line of work) and if you are bonked on the head and have difficulty getting back on your feet, you don’t want to have student debt hanging over you. Your very ability to work in your chosen profession can be put in jeopardy. To me that is too high a risk and thus I suggest that you prioritize this debt as well.
The Federal Reserve’s 2019 Report on the Economic Wellbeing of U.S. Households shows a slight improvement over the 2018 report as to the ability of a family to pay an unexpected expense of only $400. While we have seen significant improvement since 2013 when 50% of U.S. families would find an expense of this level difficult, the present percentage of 37% is still quite high…. And think about it, it’s only $400! I am confident that both you and I know, by personal experience, that almost any sickness, car repair, child in need of financial help, you name it, is going to cost more than $400. Imagine if the amount were higher, what percentage of U.S. households would be OK? In fact, Bankrate did a survey in this regard and found that the average unexpected expense was closer to $3,500. Now that feels more real.
You will find that most financial planners will recommend that you keep between three and six months of your monthly expenses in cash as an “contingency or emergency fund”. The purpose of this money is to provide you and your family with the ability to absorb an unexpected expense. And if you are working, these funds can help cushion a period of unemployment. The last thing you want to face is the loss of a job and then a need to sell assets in a fire sale or falling market or pile on a bunch of debt. That would be most inconvenient.
Discussing this matter with one of my colleagues, he pointed out that another strategy may be to establish a “mini-emergency fund” as a priority, even before paying down debt. The reasoning is this: if you do not have any cash set aside for emergencies, in the case of an unforeseen need for liquidity, you will go back to relying on credit cards. If that is a real possibility you may want to consider funding a mini-emergency fund first. How much will depend on your circumstances.
Finally, and maybe even more important, there has been some research that has shown that liquid assets, such as cash, correlate well to happiness and a sense of wellbeing. Could it be that you can buy happiness after all?
Add to Investments
U.S. society has for many years had very low savings rates. For years our rates have hovered in the 7% to 8% range. During the pandemic our savings rate has increase significantly to the point that in April of this year it was close to 33%! Wow! But as the pandemic has progressed, we have been coming off that high mark. Hopefully, we will in fact see a paradigm shift in our habits and save more as a society going forward.
So, what if you have extra cash, where should you save it? Not all investment accounts are made to provide the same advantages, so there is an order you should consider. This is also a good place to point out that, as with all these recommendations, your unique situation needs to be looked at by a professional.
As mentioned above, don’t leave money on the table by missing out on an employer match. If you are attracted to the idea of a 100% return on investment, this is your chance. Layup!!
Next, if you have one, fund your Health Savings Account (HSA). These deposits result in 1) a tax deduction, 2) tax free growth and 3) tax-free access if used for qualified expenses. This is a “three-fer” from a tax perspective. More points in our favor.
Once you have bagged the match, and contributed to the HSA if available, you need to decide which of the other tax deferral accounts you should contribute to. Many people would benefit by funding a Roth IRA first. That would take care of another $6,000 per person ($7,000 if over 50) per year. The tax advantages of Roth IRAs are significant. While they do not allow for a current tax deduction, they do grow tax free, funds can be accessed also tax free and the account is not subject to required minimums distributions (RMDs). Also unknown to many is that funds in the Roth can actually be used penalty-free under certain circumstances to fund life events other than retirement: help save for a down payment for first time home buyers, help with medical expenses, help pay for medical insurance premiums, among others. Flexibility is valuable in and of itself.
Once you have fully contributed to a Roth IRA, go back and increase your 401(k) contributions up the $19,500 (plus an additional $6,500 if over 50) allowed for 2020. Each dollar contributed will lower your income tax burden since these contributions lower taxable income.
If you are in a very high tax bracket you might benefit more by reversing the order of 401(k)-Roth- 401(k) to a full contribution to a 401(k) first and then do a so-called backdoor Roth. For high earners there are also other 401(k) strategies and retirement plans that may allow for greater contributions to tax deferred accounts.
Also, in this category we can find contributions to tax advantaged college savings plans set up by states, commonly referred to as 529 plans. Here one can contribute large sums, up to $75,000 per donor ($150,000 with gift splitting). While there is no federal tax deduction, some states will permit a state tax deduction, funds will grow tax free, and can also be used tax free for qualified purposes.
Last but not least is the traditional brokerage account. These accounts can be effective tax deferral machines as well since gains are only taxed when realized and then taxed at favorable rates. In essence you can invest into these accounts and not pay any income tax on the growth in the accounts, maybe ever, if you never sell. And when you pass away and leave these investments to heirs, they will receive them with a step-up in basis, further reducing any tax impact. Compare that tax treatment to a 401(k), Traditional IRA or similar account where you are required to take funds out at some point and then pay tax at your highest marginal rate. In fact, one of the biggest mistakes I see people make is to emphasize 401(k)s and similar accounts, but not diversify into other investment vehicles, limiting tax planning opportunities and flexibility in retirement.
Give to Charity
If you are charitably inclined, you may want to discuss with your tax advisor about the possibility of taking an itemized deduction if you make a greater charitable contribution than normal. This strategy may come into play if you are on the cusp of itemizing, but simply do not have enough deductible expenses. For 2020 you can contribute up to $300 if single or $300 if married filing jointly and take a deduction. However, if like many of us you give more to charitable organizations, those additional transfers above the limits just mentioned result in no tax benefit unless you itemize.
To put in in terms of dollars and cents, you might be in a situation where you normally tithe $1,200. If you do not itemize you can deduct only $300 and get not tax benefit from the additional $900 donated.
However, if you have the COVID dividend you might be in a situation where giving a bit more to the charity which might unlock a full charitable deduction. This year individuals can in fact deduct up to 100% of their adjusted gross income (up from the normal 60% of AGI) for gifts to so called public charities. In fact, you might want to “bunch” the 2020 and prospective 2021 deduction this year if you have extra cash so that you can get a full tax benefit in 2020. In 2021 you would then take a standard deduction, which you might would have had to do anyway.
To summarize, some of us have been fortunate enough during this pandemic to be able to continue to work. At the same time, we are spending quite a bit less and saving more, resulting in excess funds that I have been referring to as the COVID Dividend. I have reviewed a few strategies that can be employed to better your financial standing, namely, to pay down debt, invest more strategically and look to tax planning for opportunities for increased tax deductions. But truth be told, these strategies should be considered in good and bad times. Like always, what works for planning in the U.S. may not be appropriate abroad, so consult with your advisors to make sure your unique situation is appropriately addressed.
Maybe something good can come from this pandemic after all.