Saving money is half the battle. What is the other half? Prioritizing how to use that money.
The savings pyramid
It’s hard enough to scrape together money to save. It can be even harder to figure out where to put it – is this particular $100 for college? Retirement? Emergencies? Your next vacation?
Over the years, I’ve come up with some rules to follow where savings are concerned. I call it my Hierarchy of Savings Needs, and it’s the method I follow myself. I hope it will help you make the big decisions.
Emergency fund first
If you’ve heard it once, you’ve heard it a hundred times. You need at least six months of living expenses – in cash – just in case. When you first start to have money to put away, it’s important to fill up this bucket first. That way, you have cash to fall back on when the roof leaks or the computer breaks and you don’t have to reach for the credit cards. Put this money in a boring old savings account, where you may not earn much interest but you can get at it if you need it.
After you satisfy your emergency needs, you can start putting away money for other, longer-term goals. Any money that gets matched comes next on the list for the obvious reasons – the returns are big, instantaneous and guaranteed. You’re most likely to get your hands on these through your retirement plan at work, like a 401(k). Another place you may see matching dollars is your state’s 529 plan, which is a college savings tool. It’s rare, but not unheard of, particularly for lower income residents: Colorado’s Direct Portfolio College Savings Plan offers a dollar-for-dollar match of up to $500 for lower and middle income residents. Kansas has a similar program, matching contributions above $100 and up to $600 per year.
Once you’ve maxed out your ability to grab matching dollars, saving in tax-advantaged accounts is your next best move. Some of these offer you a tax break for putting the money in (as with 401(k) accounts, traditional IRAs, Coverdell Education Savings Accounts (ESAs) and some 529s). All let the money grow tax-deferred while it’s in the account. And with Roth IRAs, although you are taxed on contributions, the money grows tax free forever and doesn’t require you to start taking it out at a particular time. All are great advantages when it comes to growing your savings. Each of these tax-advantaged accounts has specific requirements and limitations, so be sure to consult your tax advisor.
So what happens when you’ve funded your emergency cushion, grabbed all of your matching dollars, maxed out your ability to contribute to retirement and other tax-advantaged accounts, and still have money to save? By all means, save! If we’re talking about money for a short-term goal, put it into an account where a) you won’t lose it (that means no stocks) and b) you can access it when you need it (no long-term Certificates). If it’s for retirement or something else further down the road, consider mutual funds that give you the opportunity for growth.