How do I get better at saving?
You work hard for your money, right? And once you earn it, there are four places your money can go. You can spend it, save it, give it away or invest it.
Savings are critical to long-term financial health – so here are some ideas that will enable you to think differently about the value of savings in your life.
First, put your money into context. Why should you save? A base of savings provides security (should things go wrong with your income), flexibility (you have the ability to choose what to do with your money, versus living paycheck to paycheck) and over time it becomes normal to have a cushion of money that you can grow through investments.
A different view to consider is this - every dollar you spend is part of the bigger picture of the economy. It’s your spending, and the spending of people just like you that generates most of the value in the economy. Companies know this, and they make a huge effort to get your attention and pull in your dollars. So unless you have a specific strategy or plan (including a minimum savings number that you want to keep in your account), it’s all too easy for your ‘savings’ to become a new television, or a closet full of clothes you rarely wear!
The way many people manage their money is to have separate savings and checking accounts. Checking accounts are for your day-to-day spending, the money you need for your life to run: your food, clothes, transportation, rent or mortgage and maybe some entertainment.
Savings accounts can be used to hold what money is left over after you pay all your bills. Or better yet, create a transfer every month of a set amount into your savings account. Savings accounts are a great place to build up the money you don’t touch. Set a goal – say to have 3 – 6 months worth of living expenses in your savings account. Banks promote savings accounts as a safe place to save, and they are safe, but when interest rates are low, this money won’t grow much. So once you exceed your savings goal, transfer the excess funds into an investment account where you have your money work harder for you.
A good rule of thumb for savings is the 20 / 50 / 30 rule. Every month transfer 20% of your income into a savings or investment account. 50% of your income stays in your checking account and goes towards necessities – housing, bills, education, transport, food etc. The last 30% also stays in your checking account and is for discretionary spending – clothing, entertainment, travel, charitable donations or gifts. When you get a raise, make sure your transfer reflects the new amount.
This idea of turning savings on it’s head, and making it a planned effort, as opposed to an afterthought, is a great way of driving savings.
Remember, your money is powerful. If you deposit your money in a bank, they can put your money to work and lend it so someone else. If they use it to give someone a cash advance on their credit card, your bank can earn 15% interest – or 15 cents on the dollar, from your savings. When interest rates are low, your bank pays you less than 1% - or a fraction of a penny! Your bank is making a lot of money off of your savings, so why shouldn’t you too? THIS is why it’s so important to learn about investing.
Getting smart about saving is a fundamental pillar in long-term financial success. You can change your financial future if you start to think beyond the bank and getting your money to work for you. And when you plan your savings, you’ll be able to protect yourself from emergencies, save for short-term goals and buy yourself options in the future.
How much should I be saving?
What a great question!
The super investor Warren Buffet has a great quote: “Do not save what is left after spending, but spend what is left after saving”.
The idea that you should plan your savings is a terrific one. If you target your savings and are disciplined with your spending, it can help you save considerable amounts of money. And in the long run, continuous, regular contributions to savings, which can be grown over time, are proven to be the most effective way of growing your wealth.
So, how much should you be saving? First of all, you shouldn’t force yourself into a box that makes your life difficult. You don’t want to put so much money away that your quality of life suffers. So the amount you target for savings should be reasonable.
Your savings target should also be relative to what you earn. If you aren’t making much money, it will be difficult for you to save any money. Also, if you have a lot of debt, especially high interest debt, it is a very good idea to pay off your high interest debt first before you put money away.
But if you are ready to save, you should set a target for your savings. An interesting approach is to segment you paycheck into three separate chunks, with each going to a specific category of spending. A popular version of this is the 50/20/30 rule of thumb. With this approach, you allot 50% of your take home pay for essentials (rent, food, transportation), 30% is allotted to discretionary spending (entertainment, clothing etc) and 20% is allotted to financial priorities.
This formula is popular because the 20% allocation to finances is flexible. If an individual has high interest debt, the financial allocation will go to pay off debt (and pay your highest interest debt first!). If you have no debt, then the allocation can go into retirement contributions, investments or into savings.
But for many people, this 20% allotment will be difficult to match. For those just starting out, 20% would be a considerable percentage of their income.
For people who are in their early years of earning and have little disposable income, a slightly different version of the 50/20/30 rule may be more appropriate. Instead of 20% for finances, a more reasonable starting point may be 10%. If you have a heavy burden of debt, all of your 10% should go to paying down debt.
For every year that passes, you should add one percentage point to the amount of money you put towards financial issues. So after 10 years, you will reach that 20% target. By the time you get there, you will probably have paid off your debt, have saved a good chunk of money and will be putting all of that 20% into an investment account. Cha ching!
Here is one last strategy that can help you get to your savings goals. It is a simple savings plan that targets your monthly non-essential spending. The money you spend on entertainment, eating out or taxi rides is the most variable spending you have. It also tends to be the most abused form of spending you have. So by setting limits on this spending you can target a set amount of savings at the end of each month.
A simple way to do this is to go to the bank at the beginning of the month and take out the all the cash you’ll need for discretionary spending for the entire month. And that’s it. You can’t use your credit card or go back to the bank. What you get in cash is what you can spend on non-essential items.
The idea is that if you see your month’s worth of money in front of you, you will be forced to make rational decisions about how you spend it. And as that money in your wallet disappears, you’ll be forced to make critical spending decisions about how you spend that money. If your money is dwindling, you’ll skip that taxi ride to work and take a bus instead, or you’ll bring lunch to work, or delay buying that new pair of shoes…
It’s a simple way of budgeting without actually making a budget. You literally see how much you have to spend and make decisions based on what is left in your wallet. Then at the end of the month, if all goes well, you’ll have a nice pile of money left that you can move over to savings!
So do your best to target a portion of your paycheck for savings. Make sure it is reasonable. Take care of your debt first if you can. And when you have money at the end of the month, move it into a savings account or your investment account.
We understand that saving is not easy to do. Most American’s don’t even have one month of income saved in their bank accounts. So if you are struggling to save, you are not alone. But try to make saving a goal. If you do, you should be able to consistently put money away for the future.
How do I make the most of a retirement fund?
If you’re trying to save for retirement, anything that can help you build up your savings is a bonus. In fact, any way that can help you keep more of your money and grow it should be a part of your financial plan.
But often it’s not. Why? Because they are branded “retirement” plans. And that sometimes translates to “there’s no urgency for me to address this today”.
Which is just not true – because the sooner you start, the better off the “future you” will be.
The key benefit to retirement plans is the fact that they are tax advantaged. This means that money that you ‘put away for later’ – will not be treated the same as money in your bank account or regular retail investments.
And this can help you build up your retirement savings.
There are 2 types of tax advantages:
- Tax deferred: These plans use pre-tax money. They use money that is either taken out of your salary before tax is applied, or they give you a tax deduction for income that has already has been taxed. The funds and all of the gains you make on them are only taxed when you withdraw money. (Usually when you’ve retired and your tax rate is lower)
- Tax-free: In these plans, people use income that has already been taxed. The benefit to these accounts is that the money can grow in the accounts tax-free and can be withdrawn tax-free in retirement.
In the US – 401Ks and traditional IRAs operate the first way- tax deferred.
Roth IRAs and 529 plans (college savings plans) work the second way- tax-free.
Also, note that 401Ks have the huge benefit that your employer can match some of your contributions. This is literally free money and should be taken advantage of when available.
Because there is no tax liability while the funds are in these accounts, there can be a temptation to trade more frequently or to take more risks. In a regular trading account, there is a high tax burden if you hold a stock for less than a year. There are no such penalties in these tax-advantaged accounts. But that shouldn’t give you reason to avoid a ‘buy and hold’ strategy. A buy and hold policy is the best long-term strategy for any investment account.
So, how can you access these programs? 401Ks come with your job, so the terms of the program vary from company to company. Check with your employer to see what is available to you so you can maximize your company match. IRAs and 529 plans are self-directed plans, meaning you have to set them up and manage them yourself. Most brokerage firms offer these accounts.
Also be thinking of next steps. For example, did you know that even if you have a 401K, or several, on the go – you can also contribute to IRAs?
It’s important to note that setting up your retirement accounts is only step 1. Going to all the trouble of setting it up, and then keeping cash in there, is a waste of time. Learn as much as you can about investing so that you can manage your own accounts. If you want to start somewhere on your own, look at lower risk, low cost Exchange Traded Funds (ETFs). You can find ETFs that are linked to a US index like the S&P 500, so your gains will mirror those of the overall market. It’s a great first step to building a portfolio within your tax-advantaged account.
If you don’t want to manage these accounts yourself, you can look for professional advice instead. Make sure the advice you get is based on your risk profile, investment goals, and life stage. Fee only financial advisors can get you set up with a balanced portfolio that you can manage on your own.
Finally, remember that retirement accounts are for retirement only. There are penalties for taking your money out before retirement. If you do, you will not only have to pay tax on your gains, but you will also be charged a 10% penalty. So when you open these accounts, make sure you will absolutely not need the funds before you retire.
It’s an interesting quirk of humanity – people prioritize their short-term wants over their long-term needs. Think of your future self, and make sure that you have explored all the options available to you to build your future finances through the tax-advantaged programs available to you.
What are short and long term contingency funds?
It’s easy to think of your savings as a single number – a goal to work towards.
But savings is more sophisticated than that. There are important differences between different types of savings. So to be strategic about how you save, think of your savings living in three buckets
- Emergency savings
- Short-term goals
- Long-term savings
In the first bucket you have emergency money. Call it a contingency fund if “emergency” is too alarming. But it’s important to have money accessible. The rule of thumb is to have savings equal to 6 months of expenses should you lose your income. The key thought here is that if you live month to month and suddenly lose your income, you may have few options other than going into debt.
And if you’re already in debt, like 75% of Americans, it’s still important to save and have a contingency fund so that in times of emergency you don’t go deeper into debt.
So where should you put your contingency fund? You never know when you’ll need the money, and keeping it in a savings account allows you to access your money instantly. Don’t lock it up in places like retirement accounts where access is limited or penalized.
In the second bucket you have money for short-term goals. This is money for things that you should not go into debt for. Taking a trip, upgrading your computer or holiday gifts should all be part of your short-term savings bucket. These are higher cost items that you should pay for by setting aside savings. Many savings accounts allow you to assign money to individual goals. It’s a great way to stay on track when you see your vacation savings, for example, growing towards your goal.
For short-term savings, you won’t need constant access this money. So you can lock this savings away for specific amount of time. If you’re saving for a trip, for example, you should be comfortable with locking this savings away for a few months at a time. By temporarily giving up access to your money, banks will give you better returns. Products like Certificates of Deposit (CD) or Government Bonds offer you protection of your principal and higher rates of return than savings accounts. And don’t worry. If you do need to access this money, you still can. There will just be a fee for doing so.
The final bucket is for long-term savings. These are the funds that you need in order to build the future you want. Consider these your ‘investment funds.’ It is money you don’t need access to in the short term. If you have a 401K or IRA – that’s a great start.
If you don’t have a retirement account, make sure you get one. They allow you to grow your money either tax-free or tax-deferred. Check with your employer if they have a 401K and if they do, take advantage of it. They often come with matching funds from your company. Take advantage of this “free money”. If you don’t have access to a 401K, look to IRAs. They are another tax-advantaged way to grow your money.
But often your long-term plans may include things that will come before retirement. You may want to start a business, or buy a vacation property. Or maybe unexpected expenses will come up (braces really cost that much???). These are all things you cannot fund from a retirement account without getting hit with huge early withdrawal penalties.
This is why it’s important to also have a separate investment account that is not a retirement account. You can open one through a brokerage or investment advisor, where part of your third bucket can be put to work in a way that can buy you options in the future.
By categorizing your savings into these three buckets, it will help you manage your savings, and reduce the temptation to dip into emergency or investment funds for your day-to-day needs or you short-term wants.