Everyone wants investments, but far fewer have them. In some cases, a catastrophic health problem or some other disaster wipes out a person’s savings, but most of the time the issues are planning and discipline. To save and investment money, you need a plan and you need to stick to it.
The good news is that saving is easier than many think. Even those with small incomes — especially people starting out — can adjust their lifestyles to add to their bank accounts. That might mean living with mom and dad for a while, or brown-bagging lunch when the rest of the office heads to a trendy restaurant, but if you set goals and don’t waiver, you’ll succeed.
The important first step to managing a budget is creating a budget that includes routine saving. But where do you put the money? That depends on both your short-term objectives and long-term needs.
Short-term goals include funding your education, buying a home or a car, saving for vacation and preparing to have a family. Long-term savings cover such things as college education for your children and retirement savings for you and your spouse. A decision on how to invest your savings is tied to when you want to use the money.
Consider buying a house. Ideally, you’ll need a down payment, which might be as much as 20% of the purchase price. So a typical home priced at more than $200,000 can easily require a sizable five-digit nest egg.
Your savings must be readily available for buying a home or for getting insurance for a house. If you plan to buy within the next two years, you don’t want your down payment locked up in a five-year certificate of deposit. Stocks also might not be the way to go. Though you might be able to quickly grow your money in the stock market, you can lose it just as fast. Stocks can be great long-term investments, but no so good in the near term.
Instead, consider an interest-bearing bank account. Shop around before you decide which one to use – money market accounts often pay more interest than conventional savings accounts, for instance. Set up a separate account for your savings – don’t comingle them in your checking account. By quarantining your savings, you’re less likely to raid the funds to cover day-to-day bills.
The secret to any savings plan is deciding how much to put away. To reach the goal of saving $10,000 for the down payment on a house, look at your take-home pay and decide how much you would need to put away to reach the goal in, say, three years. Then decide how much you need to save from each paycheck. Build a spending plan that gets you there.
Saving for college education for your child and your retirement has a different set of challenges. The biggest obstacle is your own mind. Eighteen years until college seems like a long time, and so does 30 years to retirement. It’s easy to procrastinate such saving, but don’t yield to the temptation.
Fortunately, there are tools to help you reach these far-off goals. Many states offer tax-free college savings plans, known as 529s. You can contribute to these on your own or in some cases, through a workplace withholding option. Most come with fixed investment strategy pegged to the age of your child. Best, they allow investments go grow without tax and they remain tax-free if the money is withdrawn to pay college expenses.
Saving for retirement is made relatively easy with other tax-advantaged plans. The two most common are Individual Retirement Accounts (IRAs) and 401(k)s. IRAs come in two flavors: traditional and Roth. Traditional IRAs are tax-deferred plans – you can contribute $5,500 a year ($6,500 if you’re over 50), and the contributions are tax deductible. The money grows tax free until it’s withdrawn, so long as it remains in the account until you’re at least 59 ½ years old or fit a special circumstance. Ultimately, the money is taxed as income when it is withdrawn. Early withdrawals can come with sizable tax penalties.
Like traditional IRAs, Roth IRAs also grow tax free, but instead of reducing your taxes in the beginning, they save you money in the end. The money that goes into a Roth isn’t deductible, but no tax is paid on withdrawals if they are made after you turn 59 ½. So if you contribute $5,000, the same annual contribution limits that apply to traditional IRAs apply to Roths.
You can decide how you want to invest money in an IRA account, but it must be kept separate from other funds. In order to avoid penalties, it must be handled in accordance with the federal tax code.
Many employees use 401(k) plans to save for retirement. Like traditional IRAs, contributions are considered pre-tax income, which means you don’t pay taxes on the money when it goes into the plan. Employers often match a certain percentage of contribution. For instance, if you contribute 3% of your wages to a 401(k), the employer might match it with an additional 3% contribution. If you can afford it, contribute as much money as your employer will match. Think of the match as extra income and take advantage of it.
Since 401(k)s are employer-managed, workers must choose from investment options the employer selects. These are usually mutual funds and exchange-traded funds (ETFs). Some are managed funds that contain hidden fees, others are index funds that usually have low or no fees. Some funds are also designed to meet savings goals based on the number of years until you retire. It’s a good idea to review how the funds are structured, what fees they charge and how they fit with your objectives.
There are many investment alternatives, and it may be a good idea to discuss how to deploy savings with a financial advisor. Some key considerations:
- Your Age –If you are in your 20s, start saving for retirement by putting most of your money in equities. Stock values will rise and fall over time, but gains have been the long-term trend. As you age, gradually shift money to less volatile investments. Bonds are often a larger part of people’s portfolios as they age.
- Your Income – Investors with relatively small incomes will probably want to stick with more conventional investments. Short-term savings might go to a money-market savings account; long-term investments into stocks and bonds through IRAs or 401(k)s. If you earn a lot, you might consider other sorts of investments, including artwork and investment real estate. But for most investors, saving in banks and investing in stocks and bonds makes the most sense.
- Windfalls – If you have a windfall — like a sizable inheritance — consider the alternatives before you do anything. Remember the compounding advantages of saving and investing, and try to resist the temptation to spend the money. After all, it wasn’t part of your original plan.