How To Avoid Your Own Fiscal Cliff

Let’s face it.  Americans have not been particularly good at saving. We’ve gotten better over the years but, as my 11-year old son would put it, generally we are “a fail.”  Last week’s discussions on the fiscal cliff and resulting tax deal had me thinking about our own personal budgets and ability to save. Sadly, like our own government, we can sometimes fall into our own trap of spending beyond our means and not adequately preparing for our future.

So here are a few tips to help you avoid heading for a fiscal cliff of your own and creating a secure financial parachute to bring you safely to your destination:

1.    Have Emergency Savings – It’s financial planning 101.  Every household should have enough savings to cover three to six months of expenses, period.  And as painful as it might be to have these funds sit in an account that barely earns one percent due to exceptionally low interest rates, it’s important to keep them liquid and readily accessible, such as in a traditional savings or money market account.  That means that even a one-year CD is less than ideal because it locks you in and limits access without a penalty.

 2.    Protect Yourself – No matter your income or level of savings, financial disaster could be right around the corner if your assets are not protected adequately.  This means purchasing the correct amount of personal insurance, including life, disability, property and casualty, umbrella, and in some cases, long-term care.  Remember that these policies need regular review; insurance that you bought at age 30 may not be adequate at age 50.

3.    Eliminate bad debt – If you have significant bad debt, such as unmanageable credit card payments, make 2013 the year you start getting it under control.  Take steps to pay off as much as you can or obtain lower interests rates by consolidating loans.  Another option could be to use a lower interest home equity loan to pay of credit card debts at higher rates but remember that this is merely shifting debt to make it more affordable, not eliminating it.  Also keep in mind that student loans or mortgage payments are not traditionally considered “bad debt.” But like credit card payments, if they too are out of control, paying them off may need to take precedence over other spending.

 4.   Fund Retirement – To this day, I am still amazed at how many people who have the means still do not save enough for retirement.  This is not only important when you actually do retire; contributions to a 401(k), individual IRA or other retirement plans are an above-the-line deduction and thus help to reduce your tax liability – an important benefit particularly for those in the highest tax bracket, whose marginal rates just shot up to 39.6%.

Investments within retirement accounts are also not subject to capital gains taxes, which jumped to 20% for long-term capital gains and qualified dividends as a result of last week’s deal.  So, if you own tax inefficient investments that throw off a lot of income, such as high-dividend paying stocks or municipal bonds, it may make sense to place them here, rather than your taxable accounts.  Last week’s deal also included other retirement savings incentives (for example, the ability to convert 401(k) plans into Roth IRAs), so it’s a good idea to talk to your advisor or accountant to see there are any new strategies you should be considering.

5.  Know Your Priorities – If you have enough the cover the first four buckets, consider yourself very, very, very fortunate.  After that, it really just comes down to your personal preferences.  If college and education is your next priority, then you should start saving there and have your advisor talk to you about plans to grow your money in funds specifically for that.  If it’s charitable endeavors, re-decorating your house or a dream vacation, go for it.  Only you and your family can determine what these are.  When it really comes down to it, this is really icing on the cake (yes, even saving for college is a privilege in the scheme of things).

Of course, there are complex strategies and hard decisions we all need to make.  But whether you are Congress trying to solve America’s debt, or an individual trying to get by, in the end being financially responsible should not feel like a sacrifice but a choice.

And to me and my 11-year old son, that’s not “a fail.”

Jennifer S. Faherty, CFP®, CDFA™ is the founder of Redbird Partners, LLC.  She helps people find holistic solutions in their career and finances.