In most lines of work, you read about “best practices”. Well, let’s take a moment to apply best practices to your finances. You may be just beginning your financial journey, fresh out of college. You may have children or grandchildren that are starting their first real job. Perhaps, you just want to get serious about your finances. This savings guide is designed to help organize cash flows, so that money is being used in the most efficient manner possible.
Below is a series of steps to direct these free cash flows. The goal here is to completely fill up the “buckets” at each step before moving onto the next one. For instance, you will want to completely establish your emergency fund before you begin contributing for the match on your 401(k).
Obviously, you need to eat and you need somewhere to live. So, please feed yourself first. However, this also includes making the minimum payments on all of your debt obligations – credit cards, car loans, student loans, a mortgage. Defaulting on debt can make your life extremely difficult for years. Always pay the minimums on your debts.
Note that this is different from paying off your debt, more on that later. For step 1, we’re just paying the bare minimums to avoid default.
An emergency fund is necessary for those unforeseen events that can strike without warning. We typically recommend that you set aside three to six months of expenses in a cash account to act as a rainy-day fund. We live in uncertain times. Corporate loyalty is generally non-existent. Injury and illness can strike even the healthiest of us without much warning. Of course, there’s always the threat of a busted transmission or a leaky roof to offer a swift punch to the gut.
Think of your emergency fund as self-created insurance for all of life’s little pitfalls.
For less reliable forms of employment or for those who have medical concerns that may temporarily put them out of work, aim for an amount closer to six months of expenses. For those who have high-demand or secure employment situations and have lived health-incident-free lives, you can probably get by with three months of expenses set aside.
This money is not general savings that you should be tapping into often. Establish this account separate from your regular savings account.
The matching contributions from your employer into a 401(k) plan (or other form of retirement plan through work) is often considered “free money”. Your employer is giving you extra money simply for doing what you should be doing anyway: Saving for retirement. It truly is free money, take advantage of that.
If your employer matches the first 3% of your contribution, by contributing 3% of your paycheck, you are in effect, receiving an instantaneous 100% return on that money (ignoring vesting considerations). Even less generous matching schedules such as one quarter of the first 4% you contribute, still result in one-day returns above any investment opportunity or the cost of any debt.
Do not contribute beyond the maximum required to receive full matching contributions right now, though.
It does no good to save or invest when a credit card charging 21% interest is sitting with a balance. In general, I recommend paying off all debts with an interest rate greater than 5% before dedicating funds toward other investments. That threshold will vary slightly person to person, but the point is identifying which debt is handicapping your finances and which debt is actually a valuable tool.
Start with the debt with the highest interest rate and begin dedicating all your available funds toward paying that off. Continue only making the minimum payments on debts with a lower interest rate. Then, move on to the next highest interest rate debt and continue until all of your moderate-to-high interest debt has been paid off.
Now we can finally begin taking deliberate steps to save for retirement. Your first move should usually be to max fund an IRA or Roth IRA. For 2017, the shared limit for an IRA and Roth IRA is $5,500 ($6,500 if you’re over age 50). Which type of account you choose to contribute to will be based on your income and tax situation.
The reason I suggest funding these accounts before your retirement plan through work is due to fees and investment restrictions. Unless you are a government employee with access to the Thrift Savings Plan, it is very unlikely that you have access to a retirement plan with lower fees and restrictions than you can accomplish on your own in an IRA.
Separate from these accounts, if you are enrolled in a high-deductible health insurance plan, you are also eligible to contribute to a Health Savings Accounts (HSA). HSAs benefit from the most favorable tax treatment if used for qualified expenses.
Retirement is expensive. You are going to need to save a lot over a very long period if you intend to retire when you want to. However, we know that the earlier we begin saving, the better off we will be in the future. Aim to be saving 15% of your gross income (pre-tax) into retirement accounts. After maxing out contributions to IRA and HSA accounts, begin increasing your contributions to your employer’s retirement plan. If you are able to stash away 15% of your gross pay, then aim to max out your contributions. The annual limit you can defer to a 401(k) plan for 2017 is $18,000 per year ($24,000 for those over age 50). Fill up this limit as much as possible as early as you can.
If you’ve made it through steps 1 through 6, then you’re doing great. Now we can begin saving for the fun things – houses, weddings, vacations. Keeping savings for large purchases like this in cash is typically unwise. Inflation will erode the purchasing power of this money if your goals are several years or more away. For goals that you intend to act on in the next 2-5 years, consider low risk investments such as fixed income. For goals that may be more than 5 years off, consider investing in equities to take advantage of long term growth.
If you have children, you may want to begin thinking about how to save for their eventual college education expenses. Funding your personal retirement comes first. If worse comes to worst your children can borrow money for school. You cannot borrow money for retirement.
You’ve paid off your debts, you’ve maxed out all of the retirement accounts available to you, your kids are set up for college, and you even took a few nice vacations this year. Great job.
What do you want out of money going forward? Early retirement? A step-up in lifestyle? Either of these options may be possible, but both carry significant risks, even for the most well-off financial situations. I would heavily caution against advancing from here without some form of professional, financial advice.
Notably, I have not addressed discretionary spending anywhere in this piece. It is obviously unrealistic to expect anyone for completely forgo entertainment and leisure spending until we’ve made it to step 8. While you absolutely should be conscious of, and aim to minimize, discretionary expenses in all lifecycles, there are certain points where you can begin loosening your belt a little.
For the first four steps, it is extremely important to keep discretionary expenses to an absolute minimum. After Step 4, your spending can open up a little bit. Once you are saving at least 15% of your income in retirement accounts (Step 6), you can indulge a little more.
You’re here because you want to employ healthy financial strategies. Don’t shoot yourself in the foot by taking $10,000 vacations or eating out six days a week if you can’t make it through this list. You might be there one day, but you aren’t going to get there unless you take deliberate, smart steps with your money. If you haven’t already, make a budget.
This savings guide is not meant to be an authoritative ordering that will apply to all scenarios, for all people. This is simply intended to be a general priority list that may be appropriate for most circumstances. Please consult a financial planner before adjusting a saving plan that you already have in place.
If you need some help getting started, please don’t hesitate to reach out to our firm and get started with a savings plan.
Once you determine that it might be time to work with a financial advisor, it’s important to find the right advisor for you and your family. We’ve put together a guide of questions that are essential to ask an advisor before you hire them.
Don’t make a mistake by working with the wrong financial advisor. Ask the right questions the first time to determine if a financial advisor is right for you.