Where to start: Saving vs. Investing

For this conversation, let’s focus on just two areas of your finances: Saving and Investing. Before we get into what you should be doing to fund these types of accounts, it is important to distinguish between the two.

When it comes to saving, you should consider this to be “short-term” money. The term can be anywhere from two weeks to two years, or even two days. But since this money is being stashed away with the expectation that it is there for you in a pinch, it is important to not expose it to risk. Don’t worry about earning little to no interest on this account, as its purpose is to be safe and accessible at any time, not to grow. A great way to remember this is to think: Return OF capital, not return ON capital.

Investing is different. This is where you can afford to take some risk, as it’s intermediate to long term money. Anything you have invested should be considered “untouchable” for at least 3-5 years. Since you do not need this money for short term events, it can handle the ups and downs of being invested in the market. A simple example of an investment account is your 401(k) at work, or a Roth IRA. There are tons of different types of investment accounts, each with a specific objective, so I’ll save that information for a later write up.

Now that we have briefly covered the two types of accounts, let’s get into how you should be funding each. You should always focus on your short-term savings first. Work to have between 3-6 months of your income stashed in cash. This will cover you if you lose your job, have an unexpected major auto or home expense, or surprise medical bills. Once you have a solid savings account, you can focus on investing. First, look to your employer sponsored retirement account, or 401(k). Most 401(k)s have a company match, in which your company will match your contributions dollar for dollar up to a percentage of your salary (typically 3%.) Once you have taken full advantage of the company match, you can look to a Roth IRA to invest further, or just a non-retirement investment account.

To summarize: Focus on sending 10% of your monthly income to savings, which should be used for short term emergencies, and kept uninvested. Next, work to send an additional 10% to your investments, via your 401(k) or non-retirement investment account.

401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.

 Contribution limits apply to Roth IRAs. With a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free.