In my 10/20/30/40 budget plan, I suggest you save 20% of your after-tax income. Everybody loves the idea of building a rock-solid savings. Unfortunately, beyond the outlines of that concept, few people know how to break down their savings goals, what types of accounts they should be contributing to, or what their options for savings are. The fact is that no situation is exactly alike. Your savings needs are going to be unique to you and your life goals. However, being knowledgeable about your options and know some good, basic rules of thumb to follow is always a good place to start.
HOW MUCH SHOULD YOU BE SAVING?
Building your savings now is a great way to make sure you’re fully prepared for your future. Whether the unthinkable happens and you need to tap into your emergency savings or you have long-term goals of buying a house, a new car, or vacationing in Bali…savings will help get you to and through those life moments. My rule of thumb is to save 20% of your after-tax income. That’s a good baseline percentage to shoot for, no matter how you’re saving. It won’t be easy to get there, but if you make saving 20% of your income a priority, you’ll be able to achieve many of the financial goals you have. Now, the only thing you have left to decide is how to divide up that 20% amongst different types of savings accounts.
WHAT SHOULD YOU BE SAVING FOR?
Shoving all extra cash into a generic savings account isn’t a bad plan, but a better plan is to know what you’re saving for and optimize the way you’re trying to meet those goals. I recommend taking these 3 steps:
STEP 1: CREATE AN EMERGENCY FUND
The first step I recommend is to zero in on building an adequate emergency fund. What’s adequate? Well, that’s different for everybody. Anywhere between 1-6 months of expenses, or approximately 25% of your after-tax income is a good idea. Whatever you do, don’t just come up with a random number and decide that’s how much you want to have in your savings. Here are some guidelines to how much should be in your emergency fund:
- 1 month of expenses should be your first initial “safety net.” That way, should something go wrong, you have at least one month to bounce back.
- 3 months of expenses should be the next goal. This gives you some wiggle room should something drastic happen – like losing your job or suffering from a medical emergency that leaves you unable to work right away. If you have two steady incomes coming into your household, you might feel comfortable moving on to another way of saving after you hit your “3 month” goal.
- 6 months of expenses (or 25% of your after-tax income) is probably your best final savings goal. It might take some time to get here, and that’s okay. But if you have 6 months of expenses saved up, you can comfortably start saving for other things (vacations, cars, buying a house, having kids) without worrying about diverting away from those goals should you need to tap into your savings account for some reason.
This is a one-time goal. Save 20% of your income to this goal until achieved. Once achieved, move to Step 2.
STEP 2: SAVE 15% OF YOUR AFTER-TAX INCOME FOR RETIREMENT
Many people have access to workplace retirement savings account. Usually this is a 401(k), but it might be a different type of retirement plan. Focusing on saving for your retirement through your employer plan is always a good decision – especially if your employer offers a contribution matching program. Start your savings plan by taking advantage of the amount your employer is willing to match to your workplace plan. For example, if your employer will match up to 6%, contribute 6% so that you’re maximizing the amount they’ll add to your 401(k) for you. If you contribute less, you’re essentially leaving money on the table – which is never a recommended course of action when it comes to saving. After you’ve begun to contribute to the “employer match” to your workplace plan, your second priority should be to max fund your Health Savings Account (HSA), if available. HSAs are exactly what they sound like – a savings account to cover qualified medical expenses, like having a child or a major medical event. Additionally, contributing to your HSA is an excellent way to help pay for qualified medical expenses in retirement, that will likely grow as you age. Furthermore, after age 65, your health savings account will act similarly to a Traditional IRA as any withdrawals for non-medical expenses after age 65 are taxed as income. Max funding a HSA will provide flexibility now and in the future. Take a minute to take your savings pulse. Is your workplace plan savings, plus your HSA savings less than 15% of your income? If so, let’s look at funding an Individual Retirement Account (IRA). After you’ve taken advantage of your “employer match” and have begun to “max-fund” your HSA, adding flexibility to your retirement plan through Roth IRA savings may be a good idea. While it’s intended for retirement savings, adding Roth IRA savings to your savings mix will provide flexibility down the road at any time for any reason, like funding college or a new home. Not everyone can contribute to a Roth IRA. Make sure you understand the income restrictions and contribution limits. If you’re not eligible to fund a Roth IRA due to income restrictions, it’s worth discussing with a financial adviser as there may be other strategies to fund a Roth IRA, if appropriate. So, what do you do if you’ve saved to the “employer match” to your workplace plan, “max-funded” your HSA and Roth IRA, and are still under the 15% savings goal? Return to your workplace plan and increase your funding. From there, you should speak with a professional to discuss the best course of action. Using a combination of your workplace retirement plan, HSA, and Roth IRA will help you save for retirement, provide flexibility, and create efficiency in how and when you pay taxation.
STEP 3: SAVE 5% OF YOUR AFTER-TAX INCOME FOR STUFF YOU WANT
Finally, you can start saving for large expenditures or stuff you want. I recommend 5% of your after-tax income. Once you get your emergency fund and retirement account squared away, these savings contributions can be specific to buying a house, a car, a vacation – you name it! If your savings goal falls within the next 3 years, I recommend using a savings account or cash investment. If the goal is 4+ years away, discussing your investment options with a professional may be appropriate, depending when you need the funds and your appetite for taking risk with your savings. The point of saving for these things in advance is to avoid going into debt when you need to pay for a big expenditure.
SAVINGS PLANS ARE LIKE FINGERPRINTS – THEY ARE UNIQUE TO YOU.
These three steps are meant to be a guide. Depending on your goals and your income, the savings account types and order of savings may change. The important thing is to create a plan of attack and then attack the plan. If you have questions about the big budgeting picture, check out our 10/20/30/40 budgeting guide. Still feeling overwhelmed? The best part about all of this is that you don’t have to do it alone. Let us help. Set up a free 15-minute consultation today.