[This post is part of my Back to Basics Post Series where I break down some of the most fundamental aspects of retirement planning. If you find this post helpful, check out the rest here, Back to Basics Post Series index.]
It’s easy to feel overwhelmed and do nothing with respect to saving and planning for the future. When I first graduated from grad school and started receiving a steady income, I felt like I had a TON of extra money. I had just finished EIGHT years of college. Eight years where every last dollar I had went towards tuition, books, rent, or food (maybe some beer too). Now that I was done with school, I didn’t know what to do with my extra money. I decided to aggressively pay down my school debt, but I put off contributing to an IRA and fully capturing my employer’s matching 401k contributions. It wasn’t the worst mistake I’ve ever made and I’ve since come a long way in terms of my financial education. Hopefully this post can prevent someone else from making a similar mistake, I know it would have been helpful to have a road map like this when I first graduated.
Basic Saving Strategy
Here it is, in 6 steps:
- Establish and fund an “Emergency Fund.”
- Contribute to your 401k as much as is necessary to capture the full company match. If you do not have a 401k or do not have a company match, skip this step.
- Contribute to an IRA up to the maximum allowed. If you’ve already contributed to a 401k, maybe you do this while also doing #4.
- Establish and fund savings for other goals, like buying a house, funding your child’s college tuition, etc.
- Go back and contribute more to your 401k, up to the IRS max, if available.
- Establish and fund a non-tax advantaged brokerage account.
Here, I made a flow chart for you. I think it’s a little clearer, click the image to enlarge it.
But what about my debt?
If you have debt, you should work paying it down into the plan above. Care should be taken to determine if paying down the debt is worth it. Things like high interest credit cards and other high rate debt (rates > 8%) should be paid immediately, right after or during #1. Debt with rates between 3% & 8% can go either way, depending what you might be able to do with those dollars otherwise (like get an employer match on a 401k). And debt with rates < 3% are fine, I wouldn’t recommend you pay them down any faster than you need to. There are too many better uses for your dollars at that rate.
Establishing an emergency fund
Those first leftover dollars need to go into establishing an emergency fund. An emergency fund is one of the most important aspects of a healthy financial life. A flat tire, a broken window, a cavity because you don’t floss, whatever. An emergency fund makes unexpected expenses no big deal.
It should be almost completely liquid. I recommend keeping it in a savings account, money market account, CD ladder, etc.. Always keep half of it über liquid in a savings account, make sure that you can get to the rest in a week or two if an emergency comes up. You don’t want to put it anywhere too risky.
The amount you save will vary based on your situation/preference but six months worth of expenses is widely recommended as the minimum. I think a lot of it depends on how employable you feel you are, the local economy, etc. I know some people who keep more than 12 months of expenses in their emergency funds. They do this because they are a single income family with children. Remember, six months of expenses, minimum.
Personally, we keep $10,000, which is slightly more than six months worth of expenses if we really buckle down, in a savings account. We then have another $10,000 in a brokerage account invested in super conservative assets.
Until you have fully funded your emergency fund, do not do anything else. All your leftover monthly money goes into the fund until it’s full.
Contributing to your 401k to receive full match
OK, so now you’ve got an emergency fund, nice work. Now you should use some of those extra dollars to contribute to your employer sponsored 401k plan if you have access to one. Contribute as much as necessary to get the full match from your employer. This one should be self explanatory (if it isn’t go read my post All About 401k Plans and pay attention to the bits about employer matches). Free money, really. Go do it.
Contribute to IRA & save for goals
So now you have an emergency fund, you’ve contributed to your 401k and you still have some leftover money. Great! Now you should split your leftover money in half and do two things: fund an IRA and put some money in a savings account for other goals (new house, vacation, children’s college, etc.)
Note, if you have not contributed to a 401k yet, fund your IRA before saving for goals. Make sure that the IRA gets funded all the way up to the annual limit. In 2013 the annual contribution limit for an IRA is $5,500. See the post All About IRAs for more information.
Go back and fully fund your 401k
Take advantage of the tax savings available to you in the 401k. Contribute as much as possible.
Establish and fund a non-tax advantaged brokerage account
If you still have money left at this point, you are definitely on the right track and it’s time to start contributing to your regular brokerage account. You might also be interested in knowing how close to early retirement you probably are (link coming soon).
Approach the plan incrementally
Looking at these 6 steps initially makes it seem like you need thousands and thousands of dollars of left over money. Remember that you are going to contribute to these accounts on a monthly basis, with smaller chunks of money. For example, with $750 left over at the end of the month, assuming you already have a emergency fund, you can:
- get your full 4% employer match in your 401k, $171 (assuming you make the median US income)
- fully fund at IRA, $458
- save $50 for your child’s college education
- save $35 for your next big vacation
- save $36 for a new car (or get a bike, and save yourself loads of money)
Implementing the plan
I have found that Capital 360 (used to be ING Direct) is a fantastic bank that really works well for my saving strategy. I am able to partition our savings account into as many sub-accounts as I want, which I can then name, and set up all sorts of fun automatic transfers.
For example, we have “Main Savings” which is an account that serves to temporarily hold money that is destined for somewhere else. Then we have “IRA Funds” that holds the money each month that gets automatically contributed to our IRAs. I use a separate fund for this because it gets it out of the Main Savings account where it won’t accidentally be spent or invested elsewhere. Then we have the “Emergency Fund” account that is the 100% liquid portion of our emergency fund. Then we have “Will Spending” and “Jane Spending.” These are the accounts that hold each of our personal spending funds that we can spend however we want. We’ve found it works very well in terms of budgeting and marital harmony. For example, I can grab a Fontano’s sub for lunch at work without worrying about how it effects our budget or making Jane feel like I got a “treat” that she didn’t. (We’ve found that most of my money goes to bikes and most of Jane’s goes to running gear.) I’ll expand on this idea in another post, it’s been a very useful tool for us.