The other day one of my friends asked me a question that I thought would be good to share here.
Basically, he asked how he should be allocating his savings between cash, taxable investments and retirement.
While it is impossible to determine this without having a ton of information about one person’s specific financial situation, a basic framework about how to make this decision is easy to explain.
Here are my thoughts for my friend and anyone else who is curious.
How Much Should Be Allocated To Cash?
Cash is a tricky thing. Unfortunately, savings accounts pay so little in interest that they rarely keep up with inflation, especially right now.
However, having cash available at a moments notice is a great way to make sure you don’t get yourself into a financial mess.
Personally, I suggest most people have a cash emergency fund that is anywhere between three to six months worth of expenses in something like a savings account.
The amount depends on a few factors, including how much money you have in other assets, how stable your jobs are, the potential types of emergencies that could pop up and how much they would cost you.
For some people, like self employed people or people with a highly variable income based on commissions, it makes sense to have a more robust emergency fund that could be as much as a whole year’s worth of expenses in cash.
Saving up three to twelve months of expenses is not a quick process. I would aim to save a month’s worth of expenses in an emergency fund (after paying off high interest rate debt, of course) and then diversify your savings efforts between an emergency fund, retirement and other goals including taxable investments.
I don’t imagine many people could hit this goal quickly and your youngest years offer the most benefit for future compounding returns. Don’t waste this time focused solely on filling up your emergency fund as fast as possible.
Investing for Retirement Is Important, Too
Investing for retirement is so important because the goal is so massive. You’ll have to financially provide for yourself for possibly thirty years or more. Your investments as well as Social Security and any other sources of retirement income you may have will be the key.
Compounding returns give you the ability to make the large goal a bit more digestible, but only if you are able to start investing today. The younger you are, the more you have time and potential growth you will have on your side.
That said, we personally invest at least 20% of our income for retirement and we’re only in our mid to late 20s. While that may be considered aggressive, we’d rather have the option to lower our contributions in the future.
The older you are, the higher percentage you’ll have to invest to get the same end result. However, all is not lost.
The more money you invest as a percentage of your income will result in a decrease in your expenses. If you plan to continue this decreased level of spending throughout your retirement, you may not need as much money as your current projections.
All of that said, I would suggest always investing to at least the amount you need for your employer to match your contributions.
Once you have a month worth of expenses in your emergency fund, increase your contributions to a level that makes you feel comfortable that you can achieve your retirement goals, emergency fund goals and any other goal you may have.
Just keep in mind, this money that you save early for retirement is the most valuable you’ll ever have. Don’t short change it for a fleeting want.
Taxable Investments and Other Financial Goals
People have goals other than having a financially successful retirement and saving an emergency fund. I get that. However, those two goals should be the main priorities early in one’s financial life. Even so, you can still invest or save money for other goals as well.
To invest or save even more money, you’ll have to have a decent sized income. Growing income is a great way to have more financial options, so kudos to you if you can achieve it.
People want to save money to have children, buy a home, pay for a car in cash or one of many other awesome financial goals. If you split your money up between all of these goals, it will take a long time to accomplish them all.
If you’re fine with waiting, then splitting up money is a viable option. If you aren’t, then it is time to decide which is most important to you and focus on that first.
Next, pick an investment that is suitable for your timeline for achieving that goal. You wouldn’t want to put all of your money in cash for a 20 year goal just as you wouldn’t want to invest all of your money in stocks for a 2 year goal. Finally, invest or save enough money each month to reach that goal by your timeline.
Investing for these types of goals will be much easier once you have your emergency fund fully funded. While it may be tempting to avoid completing your emergency to save more money for one of these goals, it could really hurt you should something awful happen.
This is especially true if you’re saving up to buy a home and you don’t have an emergency fund after the purchase.
Is This Model For Everyone?
Of course this model won’t fit everyone’s needs. You can tweak it to fit your particular situation, but the concepts don’t change much.
Emergency funds are essential to make sure you don’t dig yourself in a hole if something bad and unexpected happens.
Investing for retirement only gets tougher the older you are, since you have to invest more to get the same effect. Other goals will always battle for your money, but make sure to set the foundation for your future first.
The question is, how will you balance these competing money goals? Hopefully, the above thought process has helped you see what is truly most important to you and gives you a guide to help achieve your goals. Let me know what your plans are in the comments below.