How to set up your cash waterfall

4 min read
Tools
Sep 13, 2020

Building wealth means setting up your own cash waterfall

To build wealth, you first need to save. And once you have savings, you want to put those hard-earned dollars to work rather than leave them to languish in a bank account. Your goal, at least in general, is for your money to return as much as is prudent given the level of risk you’re comfortable with.

What’s prudent depends on your goals, and how to invest for particular goals is a topic of another post. In this post though, I want to talk about how setting up a cash waterfall to cascade your savings across different types of accounts can drive extra return over the long run.

How you save matters

This works because the government provides incentives to save for some specific goals like retirement, college, health, and charitable giving. You can access those incentives by investing your savings in tax-advantaged accounts like 401ks and IRAs for retirement or 529s for college savings. The “tax advantage” in these accounts comes from not having to pay capital gains, dividend income, or interest income taxes on returns generated in these accounts.

Getting the most out of your tax-advantaged accounts adds return.

To give you a sense of just how powerful these accounts can be, let’s look at one in a little more detail. IRAs currently allow you to save a maximum of $6,000 per year in them. Let’s say you were diligent and saved the maximum amount in your IRA each year for 30 years. Let’s also pretend that you invested the same amount in a normal taxable brokerage account alongside it for the same 30 years and never touched either of them for that time. 

If both accounts grew at an annual rate of 7% over that time, you would end up with $588k in those accounts. But if you wanted to withdraw your invested dollars, you would only end up with $506k in your taxable brokerage account assuming you only paid capital gains. That’s an extra $82k in your pockets. Or put another way you would miss out on an extra 16% total or 1% annually if you don’t fully utilize this account. 

And that’s assuming that you don’t qualify for a savings deduction on your current taxes as well.

How to set up your cash waterfall

There are a number of these types of tax-advantaged accounts you, your spouse, and your kids can take advantage of to get closer to the mathematically optimal investing solution. This is exactly where technology can help. With a cash waterfall set up to put your dollars into tax-advantaged accounts first, every year, year-after-year, you can rest easy knowing you’re stretching your investing dollars farther.

To give you a sense of just how powerful this can be, consider a married couple with two kids who make $250k each year, spend $130k in expenses, and want to put their kids through a four year private college. By maxing out their 401ks, IRAs, and 529 plans each year they’ll end up with about a $4.2m nest egg in 30 years after all taxes are accounted for(1). That nest egg would wither to only $3.4m without fully utilizing those tax-advantaged accounts. That’s a 23% difference or a whopping $800k extra. 

What could you do with an extra $800k?

We’ve designed our cash waterfall to put you on this more mathematically optimal savings path. After you set up your accounts, you’re all set to reap those extra rewards.

What about your other goals?

While that might be mathematically optimal, we understand that competing priorities come into the equation as well. Maybe you’re saving for a house, a vacation property, or a business.

That’s no problem either. We’ve designed our cash waterfall system to be flexible to accommodate any goal-based accounts you want to set up. That way you can prioritize that Tahoe cabin or beach house in the Hamptons over college savings should you want. Don’t worry, we won’t tell the kids.

Bringing it all together, automating saves time and gets you to your goals faster. Investing your money starts the virtuous cycle of compounding returns, and those returns go farther in the right accounts. Building your cash waterfall helps you supercharge that process by automating the decisions you know you should make, but don’t have the time to consistently manage.

(1) For simplicity’s sake, we assume that 401k and IRA assets are withdrawn immediately at the 30 year mark but at their current effective tax rate. In reality, these assets would continue to grow over time during retirement drawdown, making their contribution even more powerful.

Taylor Matthews

Co-Founder and CEO @ Farther

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