I focus so much on financial triage, that sometimes I forget to share the basics of saving and investing. Today I want to show you exactly how you should save money for the short-term, mid-term, and the long-term.
So here is the Step by Step instructions on how to save for the future
(Danny) Step one, we can have lots of fun
(Donnie) Step two, there’s so much we can do
(Jordan) Step three, it’s just you for me
(Joe) Step four, I can give you more
(Jon) Step five, don’t you know that the time has arrived
What? Not a New Kids on the Block fan? Fine. Here’s the legitimate instructions. You’re so demanding.
Step 1: Setup your retirement account, ideally through your employer
You can’t, under any circumstances, wait to save for retirement. You must immediately defer a portion of your current income into your retirement savings. For many people, this means a 401(k), 403(b), or 401(a) which you would access through your employer. Waiting to save for the future is inexcusable for several reasons. First, you probably won’t have three streams of retirement income like your parents and grandparents do/did. You’re more likely to have one or two. Additionally, if you aren’t saving into your company sponsored retirement plan, then you are probably missing out on the employer match (free money from your employer).
Differ at least enough money into this account to maximize the match from your employer, but truth be told, you should save at least 10% of your pre-tax income to this account. Can’t do 10% right now? Then make sure you save your next raise directly into the plan
. Saving your raises through the years will decrease your dependency on your income, and it will help you accumulate the proper amount of assets. And don’t forget, the contributions you make to this account will decrease your taxable income. That’s a good thing.
If you currently aren’t saving at least 10% of your gross (pre-tax) income, there are two ways to fix this. You can either GO FOR IT now, by changing your retirement contributions to 10%. Or you can creep your contribution up over time. In my opinion, you should sit down with your budget, and see if you can eliminate 10% of your gross income from your current expenses. And yes, you should definitely still contribute to your retirement plan when you are in debt.
You need to save for the long-term, even when you’re trying to get out of debt.
If for some reason your employer doesn’t have a company sponsored retirement plan, then setup an IRA or Roth IRA on your own. The limits on IRAs and Roth IRAs are much lower than a company sponsored retirement plan. In 2014, people under the age of 50 are limited to $5,500/year in contributions, whereas 401(k) contributions can equal $17,500/year.
Step 2: Save at least 10% of your take-home pay into a savings account (Emergency Fund)
Life happens. Whether this means your dog gets sick, your job is eliminated, or you need new tires on your car, at some point in the near future you are going to need money above and beyond your monthly income. I recommend having around $1,000 or so in this savings account while you are battling with consumer debt (e.g. credit cards). This 10% allocation toward savings should be used for debt reduction, when you have consumer debt. Once it’s paid-off, you can shift focus back to saving.
You need to accumulate three months worth of expenses in this account. If your monthly expenses are $3,500, then you need $10,500 in your emergency fund. I know what you might be thinking. “That’s a lot of money to have earning zero point nothing percent in interest.” No, it’s not. This money is designed to have your back under any circumstance. You can’t risk tying it up in illiquid investments or risk having it decrease in value by investing it in anything other than a savings account or money market account. If $10,500 seems like a lot of money to you, your goal is to change this. This emergency fund will decrease the financial stress in your life, and it will allow you to take additional risks with your mid-term bucket of money (which we’ll discuss in a moment).
Before we move on, here are a couple of other rules for your emergency fund. This is not down payment money for a house. This is not new car money. This is for unexpected expenses. In fact, I’d prefer people use this account for almost any unexpected, involuntary expense. Brakes go out on your car? Use this money. Unexpected medical bill? Use this money. Stop trying to handle unusual expenses with your income. When you try to absorb an unusual expense without tapping into your savings, you end up throwing your timing off. Before you know it, your bills will be due before you get your next paycheck, and you will wonder what happened. Use your emergency fund, and then replenish it with your 10% monthly contribution to this savings. DON’T EVER BREAK THE HABIT OF THIS SAVINGS.
Step 3: Create wealth by investing with the mid-term bucket
I know that I’ve previously told you that I don’t like dangling the carrot of you possibly becoming a millionaire, but if it’s going to happen, it’s because of Step 3. Once you’ve committed to saving for your retirement (by differing money into your company sponsored retirement plan), and once you’ve secured your present financial life (by saving three months worth of expenses), then this can get really fun. If you thought spending and acquiring new things were fun, just wait until you get addicted to growth and accumulation.
When you’ve “got more money than you know what to do with”, then you need to be throwing this money into this mid-term bucket. This mid-term bucket is technically called non-qualified money. This means it doesn’t have any special tax advantage. The money doesn’t grow tax deferred, but you don’t have to wait until you are 59 1/2 to access the funds in this bucket (as long as you don’t put money from this bucket into an annuity). Making regular contributions to this bucket certainly could warrant the need for a financial advisor. Since you’ve already filled up your emergency fund, you are cranking at least 10% (if not more) of your income into this mid-term bucket. The investments in this bucket need to fall in line with your risk tolerance, time horizon, and other financial considerations
. This is why I would like you to employ a financial advisor, at this step in the process.
You’re probably wondering what types of investments should go into this bucket. Well, lots of things could go into this bucket. Stocks, bonds, mutual funds, ETFs, real estate, or any other investment that doesn’t lockup your money until you are 59 1/2 years old. You do need to be aware that some investments in this bucket can create current tax problems for you. Again, talk to a financial advisor or tax accountant about this.
And this is where things get really fun. This bucket can be used for anything. It can be used for a down payment on a home. college, a wedding, vacation, a business, staying home with the kids for a predetermined amount of time, or anything else that tickles your fancy. If you want to enjoy life and not worry about money, then bust your hump to fill your emergency fund so that you can start putting money into this mid-term bucket.
Additionally, your goal is to crank up contributions to both the mid-term and long-term buckets. Saving your raises helps with this, as does proper budgeting and an overall spirit of financial wellness. And by the way, feel free to take this post to your financial advisor and ask them how to best utilize this strategy to build wealth. Don’t, under any circumstances, let them convince you that Step 2 can be skipped in any way, shape, or form.