Knowing What To Do, And Doing It, Are Two Different Things
In January of this year, Fidelity Investments published a report that said we need to be saving at least 16% of our net spendable income (total income minus taxes and charitable giving). It went on to say that we really need to be saving closer to 23% of net spendable income if we want to be sure to have enough money to fund most of our dreams and plans. Yet, in that same article, Fidelity reported that the actual American savings rate is actually in a range between 4.5% to 7% of net spendable income. That’s right, Americans are saving roughly one third of what we should be saving. So what does that mean? Does it mean we only have 4.5-7% of our money left after paying our bills to go towards savings? Or maybe it means that we aren’t serious about the American dream, including retirement, travel and helping our kids with college. In any case, let’s take a look at what we should be saving for, how much we should be saving, and why it matters.
Categories Of Savings
Before we discuss the categories of savings, we should determine WHY we need to save. We save money from each paycheck to 1) build wealth to fund our lifestyle, dreams and goals, 2)self-insure against disaster, 3) raise our families and 4) to help others through generosity. When there is enough savings to cover all four of these areas, we are well on our way to financial freedom. If that is the case, then there are four types of saving we need to maintain:
- Emergency Fund
- Family/Kids Savings
- Future Needs Savings
First and foremost is an emergency fund. This is money set aside for true emergencies so that we don’t rely on debt when an emergency strikes. In fact, the emergency fund is the number one way to keep out of debt, as it is the most cost-effective self-insurance. How much emergency fund is enough? Most pundits agree that somewhere between three months and six months of expenses is the right range for an emergency fund, depending on your risk adverseness. Once the emergency fund is fully funded, we do not need to continue to fund it. But every time we dip into the fund, we need to re-fill it to prepare for the next emergency.
The second reason to save is for retirement. Let me say it another way. Once we have funded an appropriate emergency fund, we need to start saving for retirement, and the earlier we start the better because of the power of compound interest. There are many theories about how much and where you should save for retirement but the fact remains that we must prepare for life after full time work and/or old age. It is not our children’s responsibility to take care of us when we are old but our own. How much do we save? As a general rule, target 25 times your annual expenses as the amount you want to have for retirement. And though this amount varies for each individual, there are some smart rules to follow:
- Start saving for retirement early, letting compound interest work over decades of savings.
- Take advantage of tax preferred accounts like 401K, Roth, SEP and IRA accounts to minimize taxes
- Take advantage of employer matching plans and/or other employer retirement benefits
How much should we be putting away for retirement each month? Experts suggest we save 15% towards retirement.
For those raising families or expecting to raise families, we need to be saving for known children expenses, including school, marriage, cars and other events (think summer camp and travel) that are assumed to occur. For most of us, this can be done over many years so slow and steady savings can meet your needs. Why not start savings accounts for each child on the day they are born? Where should we save this money? 529 Plans come to mind for their education. Also trust accounts or ESA’s. But they should be separate from our day-to-day funds and take advantage of tax preferred accounts if we know the money will be used for higher education. How much should we be saving each month? Experts suggest 3-5% of our pay.
Future Needs Savings
Life happens and it can be expensive. All of us have autos, homes, furniture, appliances and other items that wear out or need upgrading over time. We need to be saving for these eventualities. Since these savings are short term in nature, less than 10 years, the money needs to be invested in something that is safe but returns more than the cost of inflation. Maybe a safe low cost, low turnover mutual fund or an ETF. How much each month? Again, 3-5% of pay.
Total It All Up
Savings must be a part of the monthly family budget. Savings is as important as the rent, food and clothing. Why? Because savings, when invested correctly, generates the wealth needed to fulfill goals and dreams. Want to retire some day? Invested savings is the answer. Want to send your kids to college? Savings is the key. Want to stay out of debt? Saving, in the way of an emergency fund, is the only way to prevent credit card debt when (not if) an emergency occurs.
What are we looking at when it comes to savings as a percentage of net income? When you add it all up, it really is between 16-23% of our net pay. Wow! Some people even suggest it should be 30% of our net pay. That’s a lot. But it pales in comparison to the financial and mental cost of debt, worry and anguish that comes when “life happens” and we don’t have funds set aside to deal with the emergencies. Or don’t have the money when a car of some other piece of equipment wears out and we can’t replace it. What is the alternative? Credit card debt? Student debt? Auto loans? Line of credit? All of these option are expensive and ultimately steal away financial freedom.
Here’s the mindset we must have as stated by Warren Buffett: “We must spend what’s left after saving, not save what’s left after spending.” Instead of trying to save what’s left after spending, we need to make savings a priority and right-size our lifestyle to live comfortably on what’s left after saving.