Congrats! Your budget is under control, you've paid off some debt, and you're now running a surplus. You are now ready to SAVE. So what do you do with that extra money in your bank account?
The first step is to get it out of your checking account. There are several reasons to set up different accounts for different purposes. The first is psychological; it is less likely you will dip into your retirement savings for a new pair of shoes if those funds are kept in separate accounts. The second is logical; some accounts offer more interest and potential for return but less liquidity.
Most people should have at least three accounts- a checking account for paying bills, a savings account for your emergency fund and short-term savings, and a retirement account that you do not plan to touch until you are at least 60 (typically a 401(k) or IRA). Some financial planners recommend that you open a separate account for each short-term and intermediate financial goal, however, that sounds like a lot of paperwork to me. I think it is absolutely fine to save for your wedding, home renovation, and upcoming vacation in the same account as your emergency fund and just track the overall amount you need for each goal. However, it goes back to the psychological- if you are more comfortable with four different accounts, or you want to be able to see how much you have saved for each goal right on your bank statement, then go for it.
Here is a run-down of common accounts that can be used for your savings goals:
Checking accounts
Savings accounts
Money market funds
CDs
IRAs
Company Retirement Plans
CHECKING- Interest rates are at historical lows right now (seriously, 4% mortgages?!). Good for loans, bad for savings. Especially bad for checking accounts, which often charge you fees and pay no interest. However, there are great deals out there. I recently switched from a large bank to a credit union, which has lower costs and actually pays me some interest to hold my money. Compare rates at http://www.bankrate.com/ or http://www.depositaccounts.com/, and make sure you understand all of the fees involved.
How much you keep in your checking account depends heavily on your spending habits, and how many people are accessing the account. If you are the only person on the account and you keep impeccable records, then you probably only need the amount to pay your bills and a buffer of a few hundred dollars. If you are like the rest of us and sometimes spend more than you plan in a pay period, or if both you and a spouse are drawing from the same account, then you should keep at least $500 in the account or keep it linked to another account in case of overdraft. Linking your account to a line of credit or savings account can prevent costly overdraft fees, but if you find yourself making a habit of accessing those funds then you need to reexamine your budget.
Remember that the purpose of a checking account is to keep money you plan to use in the very near future. Therefore, make sure you can access your funds easily and free of charge. Look at ATM, electronic, and check writing fees, and make sure either the bank or the ATM is convenient to your regular schedule.
SAVINGS ACCOUNTS- Even with the best checking account, chances are that you can get better interest rates with a savings account. Less liquid, more interest. Look online at http://www.bankrate.com/ and http://www.depositaccounts.com/ to compare rates, and don't limit yourself to the bank that holds your checking account. Online savings accounts, including Ally, ING Direct, and American Express, offer competitive rates and make it easy to transfer money to and from your checking account.
Great for: Emergency Fund, Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals
MONEY MARKETS- Money market accounts (MMA) and money market funds (MMF) typically offer slightly higher interest rates and more restrictions. Money market accounts are offered through banks, are FDIC-insured, have minimum balance requirements, and are limited to six withdrawals per month. Money market funds are mutual funds that are required to hold low-risk securities. They are not FDIC-insured. They usually require you to keep a minimum balance.
Great for: Emergency Fund, Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals
CDs- Certificates of Deposit are offered by banks, FDIC-insured, and often offer higher interest rates. In return, you agree to leave your money in this savings tool for a certain time period, and you will be penalized if you take your money out early. The longer the CD term, the higher the interest rate typically. Some people choose to "ladder" CDs, in which case you buy longer-term CDs but space out your purchases every month/quarter/year. For instance, you may buy a 2-year CD every six months. This way you receive a higher interest rate than if you just bought a six month CD, but you still have a portion of your money available every six months. If you really like CDs and choose them as your investment vehicle, then I highly recommend laddering. Be careful to read the terms of a CD to make sure it has low fees and fits your needs. I personally do not like CDs over one year right now because interest rates are so low and you are locking yourself in at that low rate.
Great for: Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals (as long as you time the maturity of the CD with when you will need the funds).
IRAs- Individual Retirement Accounts are personal accounts that you can start on your own to save for retirement, outside of a company retirement account. Traditional IRAs are available to anyone without a company retirement plan, or anyone who has a retirement plan but whose adjusted gross income (AGI) is less than $68,000 (if you file for taxes as single) or $112,000 (if you are married filing jointly). Roth IRAs are limited to those with an AGI of less than $125,000 (single) or $183,000 (married filing jointly). The maximum IRA contribution is $5,000 per year (phased out as you get near the maximum income limits). This may not seem like a lot, but if you put away $5,000 from the time you are 30 until you turn 65, and earn 8% a year on your investments, you would have over $850,000 at 65!
IRAs can be confusing because they are an account, not an investment vehicle. You can invest in a number of different vehicles within your IRA account, for instance, you may have one IRA with mutual fund and stock investments, another in a CD, and another with only bonds. You can switch the investments within your IRA at any time and move it to a new IRA account (rollover), but you cannot take the money out of that IRA "bucket" and move it to your checking account without penalties.
Traditional IRAs are tax-deferred, which means you do not pay income tax on your contribution when you earn it, and you don't pay capital gains tax as you earn money off interest and investments. You will pay income tax when you withdraw the funds. Great incentives to save, but the government isn't just giving you these tax breaks for fun. These funds are earmarked for retirement, and you will be penalized 10% of any funds that you withdraw before age 59.5, in addition to paying income tax on the whole amount! That means that if you have a $10,000 IRA and you decide to pull it out to go to the World Cup, you will owe $1,000 in penalties AND owe income tax. If you are in a 25% bracket, you would pay $2,500 in taxes, which means that you only get $6,500 of your $10,000. So make sure that you leave the money in your retirement account for retirement!
Great for: Retirement Savings
Roth IRAs do not offer the immediate tax deduction of a traditional IRA, but allow for the funds to grow tax-free and be withdrawn tax-free. If you are in a low tax bracket or expect to be in a higher bracket in the future (either because of your earnings or higher tax rates), then this is a very powerful tool. You pay the income tax at your current rate and can withdraw it tax-free in the future when your tax rate is much higher. The other amazing feature of a Roth IRA is its flexibility- you can withdraw your contributions at any time without penalty! You are penalized for withdrawing the growth in your Roth IRA, but even then you are given some exclusions, including a first-time home purchase.
Great for: Retirement Savings, First time Home Purchase
COMPANY RETIREMENT PLANS- 401(k)s, Simple IRAs, and SEP IRAs are just a few of the retirement accounts that your company may offer. Companies will often match their employees' contributions, so make sure you are always contributing to the max! A dollar-for-dollar match is a 100% return in the first year, so don't ignore it. As with IRAs, you are penalized for withdrawing your company retirement funds before age 59.5, and you may need a certain amount of service with the company before you are allowed to keep all of the contributions they make on your behalf. When you leave a company, you are able to roll your "vested" funds (your contributions and growth plus the amounts you are entitled to from the company contributions and its growth) to an IRA or your new 401(k) plan. Company retirement plans can have high fees, but new regulations are forcing disclosure of all fees and encouraging companies to offer independent financial advice. This is a huge benefit!
Great for: Retirement Savings
We have just touched on the main points of a few types of accounts that can help you save for your financial goals. In the following months you will see more detail about these accounts, particularly retirement accounts. In the meantime, please comment and tell me how you separate your savings into different accounts.
Sunday, January 29, 2012
Wednesday, January 11, 2012
Savings vs Paying Off Debt
We as Americans love to justify debt. Some arguments are more sound than others; for instance, it is easier to justify my student loan debt, which resulted from four years of excellent liberal arts education, than it is to claim that my frequent concert road trips warranted the many, many credit card charges. While I still proudly state that life experiences are priceless, it turns out that mine actually did cost money and I was responsible for paying it back. While trying to build an emergency fund, and save for a down payment, and pay off student loans, and invest for retirement. Sound familiar? So is it best to put the amount set aside for bettering your financial position towards paying off debt or increasing your savings?
Many financial experts reduce the argument to simple math- if you are paying a higher interest percentage on your debt than you are receiving in your investments/savings, then use your cash flow to pay off debt. However, with today's tepid stock market performance and point-nothing returns on savings, a person following this "simple math" might be tempted to pay off his mortgage before saving a penny for retirement! This is not a healthy, sustainable plan, nor is the cookie-cutter "save for emergency fund > pay off debt > save for retirement". Everyone's plan will be slightly different based on goals, personality, and security requirements, however, there are some basic guidelines.
Let's first distinguish between "good debt" and "bad debt." While the best debt is the one you've paid off, investment in an appreciating asset is typically considered "good debt"- a house, an education, or a business. "Bad debt" is acquired from anything that declines in value- car loans and credit cards (turns out the trips you've taken, the meals you've eaten, and the jeans you've worn are no longer worth the price you charged to American Express). The IRS actually recognizes the difference between the two, as they allow tax deductions for interest paid on home and student loans. Note that this is not a free pass to enter into a mortgage above your means or take out obscene amounts of student loans. Figure out how you'll afford the monthly payments in advance, and read the post "Indentured Servitude (or Student Loan Debt)" before taking on a big loan. Keep the total of ALL your monthly debt repayment amounts below 36% of your current monthly income (not the income you hope to make in 2 years).
DEBT- Start by listing all of your debts with the balance and interest rate. I personally do not worry about paying extra towards debt under 5% if it is a student loan or mortgage with tax-advantages. I also use 0% interest credit cards for large purchases (think fridge, computer, Home Depot supplies) and pay it over the time period to keep from putting a dent in my savings/ cash flow. I know that most personal finance bloggers are cringing right now, but come on. Free money for 6-12 months? One important caveat- if you cannot make all of the payments and pay it off during the 0% period, don't do it! You will get screwed in the end. Make sure you have the cash on hand to pay it off if necessary.
SAVINGS- Now make a list of your savings (even better, put your accounts in mint.com and have them show you the list). If you say "what savings?", there's a problem. Although I dispute the experts who say you should put six months of living expenses in a savings account before you touch your interest-accruing debt, I strongly encourage you to have at least the amount of one paycheck set aside in a savings account before you divert some of your cash flow to paying down high-interest debt. If your job is not secure, or you have a variable income, put aside a few month's worth of living expenses in the bank first. Base it off your own comfort level and employment situation. If you are saving for a down payment, wedding, or another big event you may need to pause your savings until your "bad" debt is paid off, but use your judgement. You don't have to put your home-owning dreams on hold just because you have a car loan.
RETIREMENT- I know that many people in their 30s do not believe in retirement. Maybe they don't think they will live that long, or perhaps they think that saving enough to actually retire on is impossible. Some think that they will save for it later, when they have more money to put away. Don't be one of them! The one point that all financial advisors agree upon is the power of compounding interest, and that the sooner you start saving the more you will have. Most working Americans save for retirement in either a 401(k) or an IRA, both of which offer tax incentives to save. If you have a 401(k) and your employer offers a match, always contribute up to the match, even if you have credit card debt. To not contribute up to the match is to turn down free money. The only exception is if you plan to leave your job within a year and will not meet your employer's vesting requirements. More about that in future posts.
If your employer does not offer a match, I recommend that you still contribute a small amount to the 401(k). If you do not have a company plan, open an IRA and set up automatic deposits for each pay period. Do this even if you are paying off debt and can only contribute $20 at a time. You will create the habit of contributing to a retirement account, and it will be easier to increase your contributions as you pay off your debt. Also, the small but growing balance will (likely) encourage you to pay off debt so you can start stepping up your contributions.
PAYING IT OFF- Once you have established a small safety net, start tackling your "bad" debt. Pay the minimum on all of your debt except the one with the highest interest, and contribute all of your extra payment to that one card/loan. Once you pay that one off, apply those payments to the card with the next-highest rate, and continue until you have paid off all of your credit cards and lines of credit. This is called the "snowball method", because as you pay off one debt your payment to the next debt grows. Dave Ramsey coined this term and offers a free calculator on his site, as does mint.com. If you have higher interest student loans (I consider those to be over 6%), apply some extra payments to the principal, but you can also start directing some of your debt repayment money into savings.
After your "bad" debt is paid off, and you are making a dent in your high-interest student loans, you can go back to building a decent emergency fund. Again, the size of your fund will depend on your personal situation. I am currently a salaried employee with a stable job, so my goal is 4 months of "must have" living expenses. If you work on commission, or have a family to support, you may need up to 12 months of "must haves" for protection.
No "bad" debt, emergency fund in place, now it's time to up your retirement contributions. The goal is 12-15% of your gross income, and you can count employer contributions towards that total. As we discussed in "The B Word", your total savings goal is 20% of your income, so where does the other 5% go? The fun stuff! It may be a house, a wedding, or a fund to live off of while you start your own business, go back to school, or sail around the world. Maybe your idea of fun (or peace of mind) is not owing anyone money. In that case, put your "fun" savings towards extra principal payments on your mortgage or low-interest student loans.
Debt repayment and savings building can be a long road, so it's important not to get discouraged. Celebrate milestones- every card, or every large chunk. Acknowledge when you cut your debt in half, or double your savings. This is not a short-term goal, you are instilling a life-long habit. Put savings aside for your security and your goals, because you're worth it.
All posts on this blog are for informational purposes only and are not intended as recommendations as they may not fit your unique situation. Check with an advisor or financial planner for personalized advice.
Many financial experts reduce the argument to simple math- if you are paying a higher interest percentage on your debt than you are receiving in your investments/savings, then use your cash flow to pay off debt. However, with today's tepid stock market performance and point-nothing returns on savings, a person following this "simple math" might be tempted to pay off his mortgage before saving a penny for retirement! This is not a healthy, sustainable plan, nor is the cookie-cutter "save for emergency fund > pay off debt > save for retirement". Everyone's plan will be slightly different based on goals, personality, and security requirements, however, there are some basic guidelines.
Let's first distinguish between "good debt" and "bad debt." While the best debt is the one you've paid off, investment in an appreciating asset is typically considered "good debt"- a house, an education, or a business. "Bad debt" is acquired from anything that declines in value- car loans and credit cards (turns out the trips you've taken, the meals you've eaten, and the jeans you've worn are no longer worth the price you charged to American Express). The IRS actually recognizes the difference between the two, as they allow tax deductions for interest paid on home and student loans. Note that this is not a free pass to enter into a mortgage above your means or take out obscene amounts of student loans. Figure out how you'll afford the monthly payments in advance, and read the post "Indentured Servitude (or Student Loan Debt)" before taking on a big loan. Keep the total of ALL your monthly debt repayment amounts below 36% of your current monthly income (not the income you hope to make in 2 years).
DEBT- Start by listing all of your debts with the balance and interest rate. I personally do not worry about paying extra towards debt under 5% if it is a student loan or mortgage with tax-advantages. I also use 0% interest credit cards for large purchases (think fridge, computer, Home Depot supplies) and pay it over the time period to keep from putting a dent in my savings/ cash flow. I know that most personal finance bloggers are cringing right now, but come on. Free money for 6-12 months? One important caveat- if you cannot make all of the payments and pay it off during the 0% period, don't do it! You will get screwed in the end. Make sure you have the cash on hand to pay it off if necessary.
SAVINGS- Now make a list of your savings (even better, put your accounts in mint.com and have them show you the list). If you say "what savings?", there's a problem. Although I dispute the experts who say you should put six months of living expenses in a savings account before you touch your interest-accruing debt, I strongly encourage you to have at least the amount of one paycheck set aside in a savings account before you divert some of your cash flow to paying down high-interest debt. If your job is not secure, or you have a variable income, put aside a few month's worth of living expenses in the bank first. Base it off your own comfort level and employment situation. If you are saving for a down payment, wedding, or another big event you may need to pause your savings until your "bad" debt is paid off, but use your judgement. You don't have to put your home-owning dreams on hold just because you have a car loan.
RETIREMENT- I know that many people in their 30s do not believe in retirement. Maybe they don't think they will live that long, or perhaps they think that saving enough to actually retire on is impossible. Some think that they will save for it later, when they have more money to put away. Don't be one of them! The one point that all financial advisors agree upon is the power of compounding interest, and that the sooner you start saving the more you will have. Most working Americans save for retirement in either a 401(k) or an IRA, both of which offer tax incentives to save. If you have a 401(k) and your employer offers a match, always contribute up to the match, even if you have credit card debt. To not contribute up to the match is to turn down free money. The only exception is if you plan to leave your job within a year and will not meet your employer's vesting requirements. More about that in future posts.
If your employer does not offer a match, I recommend that you still contribute a small amount to the 401(k). If you do not have a company plan, open an IRA and set up automatic deposits for each pay period. Do this even if you are paying off debt and can only contribute $20 at a time. You will create the habit of contributing to a retirement account, and it will be easier to increase your contributions as you pay off your debt. Also, the small but growing balance will (likely) encourage you to pay off debt so you can start stepping up your contributions.
PAYING IT OFF- Once you have established a small safety net, start tackling your "bad" debt. Pay the minimum on all of your debt except the one with the highest interest, and contribute all of your extra payment to that one card/loan. Once you pay that one off, apply those payments to the card with the next-highest rate, and continue until you have paid off all of your credit cards and lines of credit. This is called the "snowball method", because as you pay off one debt your payment to the next debt grows. Dave Ramsey coined this term and offers a free calculator on his site, as does mint.com. If you have higher interest student loans (I consider those to be over 6%), apply some extra payments to the principal, but you can also start directing some of your debt repayment money into savings.
After your "bad" debt is paid off, and you are making a dent in your high-interest student loans, you can go back to building a decent emergency fund. Again, the size of your fund will depend on your personal situation. I am currently a salaried employee with a stable job, so my goal is 4 months of "must have" living expenses. If you work on commission, or have a family to support, you may need up to 12 months of "must haves" for protection.
No "bad" debt, emergency fund in place, now it's time to up your retirement contributions. The goal is 12-15% of your gross income, and you can count employer contributions towards that total. As we discussed in "The B Word", your total savings goal is 20% of your income, so where does the other 5% go? The fun stuff! It may be a house, a wedding, or a fund to live off of while you start your own business, go back to school, or sail around the world. Maybe your idea of fun (or peace of mind) is not owing anyone money. In that case, put your "fun" savings towards extra principal payments on your mortgage or low-interest student loans.
Debt repayment and savings building can be a long road, so it's important not to get discouraged. Celebrate milestones- every card, or every large chunk. Acknowledge when you cut your debt in half, or double your savings. This is not a short-term goal, you are instilling a life-long habit. Put savings aside for your security and your goals, because you're worth it.
All posts on this blog are for informational purposes only and are not intended as recommendations as they may not fit your unique situation. Check with an advisor or financial planner for personalized advice.
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