When you start earning a steady paycheck the best favor you can do for your future self is to develop a habit right now at the starting gate where you commit to diverting a portion of each paycheck to saving and investing.
Money you manage to tuck into an emergency savings fund gives you breathing room if you’re laid off, have your hours reduced, or run into a big unexpected expense. Dollars diverted into a health savings account (HSA) gives you tax-free money to cover out-of-pocket medical bills. Investing in retirement accounts starting today—and not next year or next decade—locks in the power of compound growth.
But it takes commitment. Without a plan we all tend to spend more than we anticipate, leaving us without cash to save and invest. Here’s how to hatch a plan for spending, saving and investing.
The Three Bucket Approach
A popular way to think about how to use your money is to break down how you use your money into three main categories:
- Spending on Essentials: 50%
- Spending on Discretionary Wants: 30%
- Saving/Investing: 20%
Essentials are the rent and utilities and staying on top of loan payments. Discretionary spending is the “wants”; the wardrobe refresh, the meals out, travel, etc. Saving and investing is for establishing a baseline for your future.
Those percentages are just suggestions. If you want to join the FIRE brigade, you likely are going to need to devote more than 20% to saving and investing. But even if you expect to keep working longer, make it a goal to hit that 20% mark for saving and investing.
That leads to another decision: of that 20% of your income, how much goes toward saving and how much for long-term investing. Saving is money you need at a moment’s notice to cover bills or unexpected expenses. Investing is what you do for the long-term.
The Saving Component
There’s no hard and fast rule, but when you’re getting started, consider maybe using 5% of every paycheck to start building an emergency savings fund. Automate and keep at it until you have at least three months of living costs saved up. From there it’s up to you if you want to build in an even bigger emergency cushion (say 6 months of living costs) or divert this into another savings account: maybe for a future home down payment.
If you have a High Deductible Health Plan (HDHP) and are concerned about being able to cover the high deductible, your HSA is a valuable savings account: Every dollar you contribute is eligible for a tax deduction, and when you use the money to cover a deductible or other eligible medical expense you will owe no tax on the withdrawal. An HSA can also be used for your investing bucket: you can contribute money today with the intention of using the money, tax-free, to cover medical expenses years (or decades) from now.
The Investing Component
You might put 15% of your income toward your retirement. Academic researchers suggest that if you start in your 20s and save 15% you have a good chance of landing in retirement in fine shape. Wait until your 30s to get started and you will need to save 20% or more each year to have a secure retirement. If you have a workplace retirement plan where your employer makes a matching contribution, that’s a fine place to start saving for retirement. Or check out the tax advantage of contributing to a Roth IRA.
Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.