Everyone knows it’s important to save money. At times, you’ll need a stash of cash to get you through a spell of unemployment, pay off an unexpected bill, fund a wedding or buy a home. And if you live to a ripe old age, you probably won’t be able to support yourself with the kind of work you’re doing today. You should have some money saved up to add to your Social Security benefit or pension in order to get by in retirement.
When to Start Saving
Saving is generally more valuable when it starts as early as possible in life. There are two reasons for this.
The first is behavioral. When you start saving at a young age, it becomes both a habit and an expectation. Of course you can live on 90 percent of your income and save the rest. Of course you sign up for your 401K immediately whenever you have the option. Of course you try to max out your contributions to your other retirement accounts. And of course you have an emergency fund to dip into when times get thin.
The second is mathematical. Due to the impressive effects of compounding interest - your principal earns interest, and then your interest earns interest too - small sums saved early on can grow into quite large ones later on. It bears repeating, a person who starts an IRA at age 25 and saves the current maximum ($5,500 in 2015) every year for 10 years, would end up with nearly 50% more money in her retirement account, compared to someone who started saving 10 years later, and deposited the same total amount over 10 years. This graph below shows how different the values at age 70 can be despite both participants putting away the same $55,000 over 10 years, with a 4% interest rate compounded annually.
But, even if you are just coming around to the possibility of putting aside some cash, it’s always a good idea to save, no matter what age you are.
Pay Off Debt or Save the Money?
Many of us need to pay for things – a college degree, a car to take us to work, a home to live in – before we’ve had time to save up enough to pay for it outright. So, we borrow. And the debt can follow us for a really long time. Many people face the dilemma, if I have a little extra money in my budget, should I use it to pay off debt or save?
Let’s consider the average U.S. household, earning $63,784 per year, according to recent data from the U.S. Bureau of Labor Statistics. After paying taxes and all the expenses of life, this household has about $5,252 remaining (about 10% of its after-tax income). What should they do with this money?
If you’re the average homeowner, you have little choice in the matter. A major portion of that amount is folded into your mortgage payment and gets added to your home equity (meaning, it’s used to pay off the principal you borrowed to buy the home). For many, a mortgage is a form of forced saving – just as long as the value of the house holds up. The average homeowner reduces their mortgage principal by about $4,221 each year. With the remaining $1,000 extra in their budget, the homeowner household might pay off a vehicle, pay down student loan or credit card debt, or put the money into cash savings or a retirement account.
If you’re trying to decide between saving and paying down debt, you need to consider the kind of debt you have, and its interest rate, and compare it to your savings options.
Generally, the interest rates you pay on your debt are higher than what you can earn by saving or investing. When that’s the case, you will be financially better off if you use any spare cash to pay off your debt first. Credit card debt is an easy target here, with average interest rates higher than 16%.
If the interest rates on your other debt - car or student loan or mortgage - is higher than what you could earn by saving or investing (consider that the average annual inflation-adjusted historical return of the U.S. stock market is just over 6%), you’d be wise to pay that down first too.
However, the decision can be complicated by tax factors. For example, you may be able to save money in a pre-tax account, like a 401(k) or traditional IRA. And some interest payments, like for some student loans and most mortgages, are deductible from your taxable income.
You should consider all these factors when you decide how to allocate your spare cash.
Where to Save Money
Once you’ve figured out the debt decision, you’ll want to get the most bang for each saved buck. Here’s one game plan that we think is a good bet:
Saving For Short-Term Needs
It will happen. Your car will break down, you’ll run up a big medical bill, or you or your spouse will lose your job. You need a plan for how you’ll deal with these financial blows. What you need is an emergency fund.
The average household with $63,784 in annual income could probably cut their budget in half in the case of unemployment. That’s because a large portion of the overall household budget goes to things like income taxes and social security contributions; while other discretionary categories, like food, clothing, entertainment and charitable gifts, could also be tightened when income goes down.
Sometimes the loss of a job leads to a severance package or unemployment checks, which can supplement the amount you need to take out of your savings to get by. The average family with a single earner with such job protections could probably squeak by for about 6 months on an emergency fund of about $6,000. A family that relies on self-employment earnings would need more, at least $15,000, to cover their expenses for 6 months if their income completely evaporates.
It’s probably wise for all households to keep an amount equal to 10% of annual income in an accessible savings account, at a local or online bank, for short-term needs.
Saving For Medium-Term Needs
Medium-term needs might include saving up a down payment for a house purchase; squirreling away some money for your children’s college educations, funding your daughter’s wedding, or planning a big-ticket vacation.
Among these kinds of expenses, only some have specific tax-advantaged ways to save. You can put money into 529 plans for future college expenses. You may also be able to use money saved in your retirement accounts for certain educational expenses. And your retirement savings may also offer options to help you make a down payment on home.
For more fun life expenses, like a fancy wedding or a trip to Alaska, you’ll need to save after-tax money. You can put it into investment accounts or regular savings accounts or cash-like things like a CD, depending on when you’ll need to use the money and on your tolerance for risk.
One option you might consider for your medium to long-term savings are I Bonds, sold through the U.S. Treasury at treasurydirect.gov. Each individual with a Social Security number can purchase up to $10,000 of them per year, and get an additional $5,000 worth in lieu of a tax refund. These bonds promise to protect your savings from inflation, and can offer additional benefits if you end up using them for educational expenses.
Saving for the Long-Term
After (or as) you build your short-term and medium-term savings, think about your long-term needs as well. To set yourself up for a comfortable retirement, try the following.
Capture any 401(k) match
Easiest retirement advice out there. If you have this option, divert enough salary into your 401k to get every matching dollar your employer offers. You’ll get an instant return on your money, sometimes as high as 50 or 100%, depending on the specifics of your employer match. Even better, your contribution is made with pre-tax money.
Think About Your Tax Situation in Retirement
It’s hard to predict the future when it comes to taxes. In general, if you think your overall tax rate will be lower in retirement than it is today, you’re better off putting pre-tax money into a retirement account. Factors that might make that likely:
- You live in a state with a sizeable income tax currently, and might end up moving to a state with more favorable tax rules for retirees.
- You are an average to high income earner, today, without many tax deductions to claim.
But you might be better off paying taxes today in situations like these:
- You’re currently living in a state with low or no income taxes, and you might end up moving to a state with significant taxes on retirement income.
- You are in a low income tax bracket currently, either due to high deductions, or relatively low income.
Pre-tax retirement accounts include things like 401ks, 403bs, and traditional IRAs. Accounts that accept after-tax contributions include Roth IRAs and Roth 401ks.
If you’re unsure about the taxes you’ll face in retirement, you could put some money in both types of accounts. Or you could place your bet on lower taxes in retirement. After all, contributions you make today come from the portion of your income that is taxed the most, while in retirement it might become the first part of your income which is taxed the least.
For example: if your taxable income today is $50,000, you’d pay 25% in federal income taxes alone on the $5,000 you could save in a pre-tax retirement account. But when you take the money out in retirement, it might form the basis for a lower annual income and thus be taxed at a rate of just 15%.
Invest Your Savings
If you leave the money in an account earning a paltry interest rate, like what most banks are offering in 2015, it will lose purchasing power over time, because of inflation. Most people should invest their long-term savings in a diversified portfolio of stocks and bonds.
Life will throw lots of expectable, and unexpected, expenses at you. Start living on less than you earn now, and set aside the remainder to take care of all of your future needs.