After discussing the importance of investing to meet retirement expectations and the value of investing early and often to utilize compound interest, most people want to know how much to invest and what to do with their money. As my co-worker who occasionally asks me financial questions has quickly learned, it always depends. It really depends on your own unique situation, goals, and personal openness to risk. The most important financial step for someone to make is to define their short and long-term financial goals to give them motivation on why they are taking their specific course and what they need to do to get there. Who am I, or anyone else, to judge if your goal is to travel the world on the back of a dolphin (sign me up), buy an entire animal shelter and play with dogs all day (not sure my wife realizes this is a semi-realistic goal of mine), or save for a down-payment on a house. Each person has their own unique goals and paths to get there, but the important aspect is documenting those goals and creating a plan in order to meet those goals within your own personal framework.
So with each person having a unique financial plan, this blog post should be finished, right? Fortunately for you, I still have not reached my jokes quota for the day, and there are still some basic tenets recommended for every financial plan. So what are some of the main goals to consider in your life?
First, you should not be carrying a credit card balance paying 15% or more interest. It is great if you want to build credit, but pay it off every month. We’ve previously discussed the harm compound interest can do especially when buying items that do not increase in value (like clothes). Credit card debt and short term loans (the biggest legal robbery possible) should be one of your first priorities to address.
Next, the most basic step is to build an emergency fund. This fund should be 3-6 months of your expenses to cover any unexpected happenings. Only 60% of Americans can cover unexpected expenses1 which is terrifying. These expenses could entail car trouble, medical expenses, house repairs, a loss of your job, or paying for that elopement to Vegas. In any case, you need extra money saved in order to meet these, potentially unexpected, needs. I feel like one of the last hurdles of becoming a full-fledged adult is being able to pay for your own car repair or job search and not having to rely on your family for money. I would recommend prioritizing a savings of 3 months’ salary and slowly increasing the savings to 6 months. Extra importance for all the single people (I know the hits just keep on coming) who rely solely on their own income to save up to 6 months.
Where to put your money? A place easily accessible (example: checking/savings accounts)
So you held off on buying that brand new Audi for a few months and have been able to save an emergency fund. Congrats, you are better off than 60% of the American population…way to go. The next step is retirement savings. The goal should be 15-20% (or higher depending on how late you start), but that percentage can be built up to overtime. If your employer offers a retirement match of say 4%, and you are not using it, then you might as well be lighting money on fire. That is part of your compensation and should be the minimum amount you contribute. Then after getting a raise, put half of it in your retirement until you reach the goal. It will be easier to manage since those raises are money in addition to the life you were already use to living. If you do not have an employee plan, then an IRA can be created in many different areas. This behaves just like a 401k but with lower contribution limits allowed per year. The beauty of both of these is you put in money pre-tax, lowering your current tax bill, and only pay taxes on your withdraws in retirement (at possibly a lower rate). The one caveat is this should be money that is never touched until retirement or else a severe penalty, along with taxes, will be delivered putting you back to lighting money on fire.
Where to put your money? Employee 401k plan or Roth IRA with a basic investment until you learn what you are doing (example: target year fund, index fund, etc.)
After you have an emergency fund and retirement taken care of, you can now focus on your own unique goals. It could be paying off debt, saving for a car, saving for a down payment, saving for a kid’s college, saving (do you see a pattern yet?) for a Europe vacation, saving for that future hovercraft, whatever, it depends on you. I will just highlight some different tools available for your goals. You want to try to avoid using a screwdriver to cut wood or Marvin Gaye to get you through an intense workout, so find the right tool for your need.
Health Savings Account (HSA) – Need a High Deductible Medical Plan ($1300 deductible for a single person) but you don’t pay taxes (Suck it Uncle Sam!) on the amount as long as it is used for medical expenses. The total amount carries over from year-year.
Flexible Spending Account (FSA) – Similar to HSA focusing on medical expenses without paying taxes, but you do not need a high deductible plan although you can only carry over $500 year-year.
529 Account – A state-specific savings account you don’t pay taxes on as long as it used for college expenses. Great for saving for a kid but also can be used for yourself in Graduate School.
Roth IRA – For retirement but you pay taxes now instead of during withdraw (opposite of 401k/IRA). Protects against your tax bracket in retirement being higher then current (government raising rates).
Money Market/Online Bank Savings – Great for saving for something like a down-payment, new car, or vacation where you can make much larger interest (currently ~1%) compared to regular bank savings.
Investment Account – You pay taxes on money going in, and on capital gains (different tax rate) but allows you to buy and sell stocks/funds without worrying about keeping the money in until retirement.
These are just a few of many tools available to assist in meeting different goals. Each one can have a role to play based on what you are trying to accomplish with your money and your current situation. Unfortunately, there is no magic financial fairy that looks over everyone’s money (or I haven’t found one), so hopefully everyone is thinking about where they want to be and how they can get there. It is important to plan for the life you want and take action to make it happen. I am excited to hear if there are any other useful tools people utilize that I did not highlight and how it can be used. Any feedback is welcomed.