What are savings and saving plans?

The excess money an individual holds from their income after incurring all necessary expenses is called savings. Savings may be kept in cash or at a bank. Savings kept in a bank have no risk and provide minimal returns. Therefore, individuals could consider investing their savings through a savings plan to maximize returns.

A savings plan refers to financial products that are meant to encourage disciplined savings in individuals. These savings are meant to provide steady returns helping individuals achieve their financial goals. The biggest benefit of a savings plan is that it allows individuals to build financial security to manage any unexpected future events.

Investment vs Saving

Saving refers to money that is available for use at any time. It can be used for regular purchases or in case of emergencies. It is important to have a savings goal and a timeline to save effectively. For example, an individual wants to take a vacation a year from now and the vacation is likely to cost $2,600. There is a saving goal of $2,600 and a fixed period of one year.

On the other hand, investing may refer to the careful allocation of funds to achieve long-term goals. These long-term goals could be a child’s college fund or retirement fund. Since these goals require large funds, investing early on is crucial. These investments therefore could be age-based. However, the risk of investments is higher than the risk of savings. By investing in multiple places and maintaining good investment portfolios, the market risk can be managed effectively.

401 (k) Plan

401 (k) is a savings plan meant for retirement. This savings plan is offered by several American employers. The employee signing up for this plan may have to deduct a small contribution to this account periodically from the paycheck. The employer may choose to match this contribution to get a tax benefit. The 401 (k) account is of two types: Traditional and Roth. In the case of a traditional 401 (k) plan, the contribution made to this account can be deducted from tax. However, taxes are payable during the withdrawal of funds from this account. The withdrawal is generally upon retirement. In the case of the Roth 401 (k) plan, the income tax is paid regularly by the account holder. This means that the after-tax amount is used to contribute to the Roth 401 (k) account. However, the withdrawals under this plan are tax-free. The employees with 401 (k) accounts can choose how the fund must be invested. Generally, the money is invested in mutual funds as the risk of loss is low.

Thrift Savings Plan (TSP)

A TSP account is also a retirement plan similar to the 401 (k) plan. TSP savings plan is specifically for federal employees of the U.S. This plan allows federal employees to have the same saving benefits as private employees. Similar to 401 (k), a traditional TSP account can be opened to receive the immediate tax benefit and a Roth TSP account can be opened to receive the future tax benefit. If a federal employee moves to the private sector, the employee has the option to convert the TSP account to a 401 (k) account and vice-versa. Unlike 401 (k), a TSP account owner has the option to choose one out of six investments. The six investment options are G, F, C, S, I, & L. G stands for investment in government securities. F stands for investment in the fixed-income index. C stands for investment in the common-stock index. S stands for investment in the small-capitalization stock index. I stand for investment in the international stock index. L stands for investment in a life-cycle fund.

529 Plan

The name ‘529’ comes from the federal tax code. The 529 plan is one of the most recognized education savings plans in the U.S. Initially, it was meant to cover only post-secondary education expenses however in 2017 the plan was expanded to cover K-12 tuition costs too. In 2019, the plan also included offering account beneficiaries a student loan of $10,000 for apprenticeship program expenses.

The 529 plan is of two types: Savings plans and Prepaid tuition plans. The savings plan is the most commonly used education savings in the U.S. The funds invested under this plan are generally invested in mutual funds. The savings plan under the 529 plan grows tax-deferred. The funds withdrawn from the plan are also tax-free provided that the fund is used for education purposes only. The funds can be withdrawn for both college expenses and K-12 expenses. Funds that are withdrawn for expenses other than education are subject to taxes along with a 10% penalty.

On the other hand, prepaid tuition plans are only offered in certain states and certain institutions. Under this plan, the account holder pays in advance the college tuition at the present cost. This plan may be beneficial as tuition costs increase every year. This prepaid plan is only allowed for college education expenses and not K-12 education expenses.

College savings month is celebrated in September every year. During this month, the 529 savings plan is promoted. Events are held to teach parents the benefits of education saving plans. The direct-sold 529 plans have a lower cost compared to advisor-sold 529 plans. However, investors may pick advisor-sold plans for certain benefits.

Context and Applications

The aspiring students can pursue further specialization in this field into the following streams:

• Bachelors in Business Administration (Finance)
• Masters in Business Administration (Finance)
• Masters in Business Administration (Investment Management)
• Masters in Business Administration (Risk Management)

Practice Problems

Question 1: Which month of the year is celebrated as the national college savings month?

1. 1. September
   2. October
   3. November
   4. December

Answer: Option a

Explanation: Every September the 529 saving plan is promoted to parents and students on behalf of the national college savings month.

Question 2: How many investment options are provided under the thrift savings plan?

1. 1. Four
   2. Five
   3. Six
   4. Seven

Answer: Option c

Explanation: The account holder of a thrift saving plan can choose from six different investment options.

Question 3: Which plan under the 529 plan covers both K-12 and college expenses?

1. 1. Roth 401 (k)
   2. Savings plan
   3. Prepaid tuition plans
   4. Thrift savings plan

Answer: Option b

Explanation: Savings plan is the only plan under the 529 plan that covers both K-12 and college expenses.

Question 4: What is the penalty percentage in case the 529 savings fund is used for purposes other than education?

1. 1. 5%
   2. 10%
   3. 12%
   4. 15%

Answer: b

Explanation: A 10% penalty is applied for misuse of the college fund under the 529 account. Apart from the penalty, the account holder must also pay taxes for the withdrawal of funds.

Question 5: Which plan under the 401 (k) uses after-tax income for contributions?

1. 1. Traditional 401 (k)
   2. Roth 401 (k)
   3. TSP
   4. 529

Answer: Option b

Explanation: Under Roth 401 (k), income tax is paid, and after-tax income is used for contributions periodically. However, fund withdrawals under Roth 401 (k) are tax-free.

Common Mistakes

It is incorrect to assume that education saving plans such as 529 are standard throughout the country. While the 529 plan is governed by the federal tax code, the regulations of the account vary from one state to another. These regulations may change regarding the contribution limits or participating institutions, etc.

Additionally, if an individual of state A opens a 529 account in state B, then he/she may not get tax benefits. This is because the plan is then considered an out-of-state investment. Therefore, regulations on savings plans within every state can largely affect the investment.

Related Concepts

While studying the healthcare plans, it is important to read the following topics to get a better knowledge:

• Bank deposits
• Insurance policies
• Capital market investments