The money you make that isn’t going toward immediate expenses or paying off debt should be going toward longer-term goals. In other words, it should be saved or invested. But perhaps you’ve heard conflicting advice on where to put that money and what to save for. You might have been told you need three to six months of living expenses saved up as soon as possible, and you’ve been told to start contributing to your retirement account immediately to take advantage of compound interest (more time for your investments to earn you more money).
What should you do?
First, it’s important to understand the difference between saving and investing and how you should use them to prepare for your future. Savings is best used for short-term planning (to be used, say, in five years or sooner) and involves low risk; investment is used for long-term planning and involves higher risk tolerance.
Hopefully now you can see why solid financial planning requires a balance of saving and investing—a balance of cash savings and retirement investing. (Sometimes putting money toward your retirement is called “retirement savings” but really it functions as an investment, so we will refer to it as such in this article.)
Now that you know you’ll need a mix of both savings and investments to provide for your future one year from now and forty years from now, you need to determine if you should be putting more in one “bucket” or the other. Factors like your age, your level of debt, current and potential income, the economy, and if you have a family to support will all affect your unique answer.
Below is a general outline of how to approach cash savings and retirement investing for financial success throughout your life. For more detailed answers, consider speaking with a fiduciary.
Cash savings
Cash savings is money you’ve already paid taxes on and keep in a checking or savings account or certificate of deposit at your credit union. It is highly liquid, meaning you can access it quickly, easily, and with little to no penalty when you need it. This is important for both an emergency fund (which you won’t know when you’ll need!) and for short-term savings goals that aren’t more than a few years away (vacation, wedding, new car).
For most people, building up an emergency fund of cash savings will be a first financial priority. How big that fund is will vary from person to person, but an excellent place to start is $1,000 with a goal to work up to between three- and six-months’ worth of living expenses.
Why saving is safe: Money saved is considered “safe” because the dollar amount in your account won’t decrease unless you withdraw funds and you have easy access to it.
Why saving is risky: Because interest rates on most saving accounts doesn’t keep up with the rate of inflation, the money in these accounts will eventually lose purchasing power over time.
Retirement investment
If you need your money to make money, you need to invest it. Very few people could save enough for retirement by simply contributing to a traditional (or even high-yield) savings account! Retirement investing is a long game of investing, relying on a long period of time for compounding interest to work in your favor and for your investments to outlast any short-term market fluctuations. Remember, the value of investments won’t always go up: the shorter-term the investment, the higher the risk it could lose value.
While cash savings can be seen as immediately adding your net worth, retirement investments should be seen as adding to your future net worth. If you think of these investments as accessible funds, you’re more likely to live beyond your means and need them, which would incur steep penalties if you withdraw the money early.
The different retirement investment products, or “vehicles”, include 401(k)s, 403(b)s, traditional and simple IRAs, Roth IRAs, and SEP IRAs, among a few others. With any of these, the goal should be to use their tax advantages to your advantage (whether you pay taxes up front, or when you withdraw money), to contribute enough money to receive any free matching funds from your employer, to pay as few portfolio management fees as possible, and to reach the contribution limit while remaining financially stable.
If at first you concentrate your extra income to building up a cash savings fund, consider putting funds into retirement investments as soon as your risk tolerance allows—say after you’ve saved one months’ living expenses if single and three months’ if you have a family. As your savings needs change throughout life, you can slide this scale as needed, keeping in mind that money you contribute earlier into retirement investments will work harder for you than money contributed later.
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