Once you clean up your budgets you will start to save significant money. But then a new dilemma presents itself:
How do you prioritize your savings?
Over the last few weeks this question has been posed to me several times and though I covered my response briefly in: 15 Money Mistakes You Can’t Afford to Make, I want to explain the reasoning behind the savings allocation I suggest.
I created the following infographic to demonstrate one great, risk-adjusted way to prioritize your savings.
How to Prioritize Your Savings
Cash On Hand
If you are unable to access your bank/ATM or use credit cards for several days, you need cash. Many people can’t imagine such a scenario. However, during a national disaster and especially when widespread power outages are a factor, this concern has proven all too real.
Doomsday scenarios aside, it’s also wise to stockpile fresh water and nonperishable food for short term survival situations (flooding, earthquakes etc).
Your emergency fund should cover all of your typical household and living expenses, for several months. Though this can be a dauntingly high amount to save, an emergency fund will provide you the freedom you need to make healthy life decisions. The emergency fund should be kept in an account that you won’t be tempted to raid!
The best way to determine how large to make your emergency fund, is by calculating your average monthly spending amount and multiplying it by at least 6 (months).
401K Account (W/ Company Match)
Once you have an emergency fund in place, a 401k account is usually a great place to start investing. 401Ks offer one of the highest contribution limits for a retirement account (You can currently defer $18,000 per year). Furthermore, contributions can significantly lower your taxable income.
If your employer matches your contributions, a 401K becomes mandatory for prioritizing your savings. An employer will only match (contribute on your behalf) up to a certain percentage of your deferred salary, so make sure that you’re putting in at least that amount.
Sometimes the funds an employee has to choose from are too expensive or perform poorly. If this is the case, you should still contribute at least the maximum amount that will be matched. Don’t leave free money on the table.
Individual Retirement Accounts
I’ve written at length about the benefits of IRA Accounts for investing but in short, before you consider taxable investments you should be contributing the maximum annual amount to either a Traditional IRA or a Roth IRA. By not taking advantage of these tax-sheltered accounts you’re missing out on one of the best ways to prioritize your savings.
More Ways to Prioritize your Savings
Once everything else is in place you can allocate a portion of your savings to higher risk, speculative investments. You could open a taxable brokerage account but keep in mind that not all investments are equally tax efficient so review your options carefully.
Peer-to-peer lending (P2P) is the process of providing micro loans to individuals or businesses in need of funding. This might be a good way to earn interest income over time. However, it’s a good idea to spread your investment over a hundred loans or more to reduce your overall risk.
Alternatively, you could put any remaining funds in a safe place for added security, such as a checking/savings account, certificate of deposit, money market account or a bond fund.
I never thought to have that much cash on hand. Thanks for the tip. We have done well in the other areas and it really pays off. Unfortunately when I was working full time I did not utilize the benefits a 401k and I regret it. They matched up to 6 percent. I wish I understood how it worked earlier but I am grateful to learn now so I can do even better in the future. Thanks for sharing.
Thanks for the comment,
I think $100 is a reasonable amount of cash for most people to keep on hand. The upper limit may work for people in areas prone to natural disasters.
6% is a pretty good match amount. I didn’t contribute to my last 401K either and it matched up to 5%. By the time I qualified for the plan I was planning my exit and hated the expensive funds they offered. I was there for 6 months longer though, so I too should have contributed to get the match. Oh well, lesson learned and I’m glad I didn’t have to purchase those funds!
This is a great defensive strategy for saving in the future. With this plan, one does not have to ride the psychological roller coaster the stock market can put you on. Instead, maxing out your ira and contributing to company match, like you explained, deploys a dollar-cost average that works best long term.
Thanks for sharing this knowledge.
Thanks so much for the comment,
For a lot of people the psychological roller-coaster of the markets is hard to escape, even with a plan in place. But if investors can change the way they visualize investing and if they have some money allocated appropriately before investing, it makes the task more manageable in the long run.
Right now stocks are so overvalued that it makes it hard to want to invest. I use a tactic of contributing to a settlement fund, thus getting in the 5.5K into my Roth and still having the option of allocating the money into my index funds when the prices drop.
I think the Cash On Hand priority is often missed. Most of us figure nothing will happen where we can’t at least go to an ATM or bank, but imagine a severe hurricane or other weather disasters that disables power for a long period of time?
Without at least some cash on hand, you could be up the creek.
I should also point out that an IRA, particularly in my case, a Roth IRA, is often overlooked, and the tax savings are unreal.
Yeah, I think the cash-on-hand priority comes into sharp relief during blackouts, floods, earthquakes etc. As soon as the electricity is out you find that your “preferred” or “reserve” credit cards, though heavy and colorful, can’t’ help you! Living in Colorado and never experiencing this, I still probably don’t keep enough cash-on-hand for a real emergency.