The Savings Hierarchy
How to start saving and investing for the future.
We live in a financially illiterate world. I went through high school and college knowing very little about personal finance and investing. It wasn’t until I started working in the finance industry that I began to learn and understand the basics of investing and finances. If you don’t learn about finances early on, it could be a lifelong struggle. Being good with finances starts with mindset, first and foremost, then creating goals, and finally establishing good saving and spending habits to achieve those goals. Finances tend to overwhelm us and give anxiety. You don’t have to have the mind of Warren Buffett to invest or have thousands of dollars to start. The most difficult part of any journey is taking the first step. Here’s a step-by-step guide of how you can start your journey.
Emergency Fund
The most important, foundational step of your financial journey is having an adequate emergency fund. At the very minimum, you should have a ‘rainy day’ fund of $1000. Ideally though, you should have enough money to cover 3-6 months of living expenses. Why is this important? Because life is full of uncertainty. Your water heater stops working. Your car breaks down. You lose your job. You need to bail your kid out of jail. Your dog has heartworms. You get it. We live in a chaotic world; emergencies happen. The bottom line is that you want the money to be there when you need it. Otherwise, you may have to sell out of long-term investments at a loss, or worse, withdraw from your retirement accounts and be subject to exorbitant taxes and penalties. For instance, if you take an early withdrawal from an IRA, you could be hit with taxes and a 10% early withdrawal penalty on top of that. You want to avoid this at all costs. Having to sell and withdraw short of your goal could greatly hinder your progress toward that goal.
Retirement
Retirement is looking more and more like a pipe dream these days. According to data from the Natixis Global Retirement Index, 59% of Americans said they will have to keep working longer, and 36% believe they will never have enough to retire. Everyone has their own setbacks and circumstances that may preclude them from their retirement goal. I typically see two reasons for not having enough to retire. First, they don’t have a plan in place. Second, they don’t have a realistic idea of how big of a nest egg you really need to retire comfortably. A good rule of thumb is that you should be saving 15% of pretax income toward retirement from age 25 to 67. According to Fidelity Investments, you should aim to save at least 1x your salary by 30, 3x by 40, 6x by 50, 8x by 60, and 10x by 67. The normal retirement age is 67 when most people are eligible for 100% of their social security benefits. And if you want to retire before that, you need to save much more.
Start as early as possible! The monetary gap between starting to save at 25 rather than 35 is hefty. In this example, if Chris begins investing at age 25 and Jennifer waits until age 35, each investing $100 a month at a 5% annual compound rate of return, Chris will end up with $162K and Jennifer will end up with $89K at age 65. Even though Chris only contributed $12K more of his own money, he will still have nearly double as much as Jennifer. This is the beauty of compound interest. Your money yields a return, which increases your principal. If you have the same return again, you will make even more the second time, because that return was applied to your larger principal. This process repeats over and over, causing your money to grow exponentially.
When it comes to retirement vehicles, there are many different tax-advantaged accounts to choose from. By far, the easiest way to save for retirement is by investing in your company’s 401K. If your company matches, at least take advantage of it. That’s free money! You select a percentage of your salary, and your company automatically invests every paycheck. When it comes to saving, you want it to be automatic. Investing becomes easier when you don’t have to think about it. If your company doesn’t offer a 401K plan, consider an IRA. You can invest in either a traditional or Roth IRA. The main difference here is the tax benefit. With a traditional IRA, you can receive the tax benefit now by getting an immediate tax deduction, which lowers your taxable income. When you file your taxes, the IRS will give you a refund for that amount. You participate in the tax-deferred growth, but you will owe taxes on everything when you withdraw in retirement. With the Roth IRA, you don’t get an immediate tax benefit. However, when you withdraw in retirement and after the age of 59 and a half, you don’t have to pay any taxes. If you are under the age of 50, you can contribute up to $6K per year. If you are age 50 or older, you can increase that annual contribution to $7K. Personally, I prefer the Roth IRA. It eliminates the uncertainty of what taxes might look like in the future. I get the taxes out of the way now, so I don’t have to worry about them later. Also, bear in mind, some companies offer Roth 401Ks as well.
Tackle Debt
The average American has $90,460 in consumer debt, which includes all credit card debt, student loans, mortgages, car loans, etc. There are a couple ways to go about paying off debt.
1) Prioritize the higher-interest debt.
2) Pay off the smaller loans first.
In both scenarios, you’re still making minimum payments across all debts. After you pay off one debt, you reallocate those funds to pay off another debt. You repeat this process until you are debt free. The second method is called the ‘Debt Snowball,’ popularized by finance personality Dave Ramsey.
Buying a House and Funding College
These are two very common savings goals. To help you buy a first-time home, you can withdraw up to $10K from an IRA without taxes or penalties for a down payment. This is one of the exceptions to the early 10% IRA withdrawal penalty. For the goal of saving for college, one of the best vehicles is the 529 college savings plan. 529s are state-sponsored plans that allow you to contribute hundreds of thousands of dollars, depending on the state, to a tax-deferred account. The tax benefit is similar to that of a Roth IRA. You contribute after-tax dollars, and as long as the money goes toward college, all the gains are tax-free.
Wealth Accumulation
After you max out your 401K and IRA contributions, you can still invest surplus funds in a brokerage account. You can invest in virtually all the same things as an IRA. It’s just a fully taxable account. There’s no tax benefit, but you can withdraw at any time and use the money for anything like a dream vacation, car, wedding, etc. Or you can just use this account to build capital over the long-term.
Depending on your goals and financial situation, you don’t have to go in this particular order, and you can save toward multiple goals simultaneously. The more important thing is to set your goals and develop a plan to achieve them. Because of the compounding effect I illustrated above, the sooner you start, the more you will accumulate in the long run. Have a plan in place, budget what you can to a particular goal every month, make it automatic, and have the discipline to stick to your plan. With mostly zero commissions, financial firms make it easy to invest. You simply open an account online at the brokerage firm of your choice, link your bank, set up an automatic plan, and start investing. You will never work your way to financial freedom. You want your money to work for you. Start as soon as you can!