You are able to save on a monthly basis. What accounts should you be funding?
As previously covered, you should strive to save between 10-20% of your monthly income. But where should you be stashing this money? Savings Account? CD? Mutual Funds? Crypto? To answer these questions, we can refer to the “Hierarchy of Saving/Investing.” Think of a pyramid. Start with the foundation and move up with your funding ability. The ultimate goal is to be able to fund each of these areas simultaneously and I will explain an easy way to make it happen.
It begins with your emergency savings. A financial planning rule of thumb is to have between 3-6 months of living expenses in cash. The main emergency we’re looking to hedge against is the unexpected loss of a job. Having 3 – 6 months’ worth of expenses in the bank will take the edge off your job search and give you a little breathing room. It will also likely cover any unexpected auto or home expenses, or surprise medical bills. Remember to keep this account in cash. With this money, it’s not about return on capital, it’s return of capital and accessibility.
Next up, your 401(k). Start with the free money. Typically, your employer will match 100% of your contributions up to 3-6% of your pre-tax salary. For example, if you earn $60,000/yr. and get a 3% match, your employer will match your contribution, dollar-for-dollar up to $1,800 (3% of $60,000). It is important to remember that this is a MATCH, so in order to receive the company contribution, you must contribute yourself. Since your 401(k) is a retirement vehicle, any funding should be considered locked up until your retirement. That is why it is important to fill your emergency account before you work towards your 401(k).
Once you have taken advantage of that “free” money, it’s time to start funding a Roth IRA. A Roth is a great retirement vehicle for several reasons. First, though you should think of it as a long-term, retirement savings vehicle, since all of your contributions are made on an after-tax basis, your principal (the amount that you have contributed over time) is accessible any time, tax and penalty free. Another advantage is that the account grows tax-free. Your other retirement accounts (401(k), Traditional IRA) grow tax-deferred. When you pull funds from those accounts in retirement, they are added to your income and taxed. Money you pull from a ROTH comes out tax-free, a huge advantage, especially important if you think income taxes will go up in the future. The IRS sets limits on how much you can contribute to a ROTH every year. For 2024, it’s $7,000 (if you are over the age of 50, you can contribute an additional $1,000 as a catch-up contribution).
At the tip of the pyramid is what I’ll call discretionary saving. Funds at this level should be viewed as a means to accomplish specific intermediate-long term goals. The ultimate goal is to max out your 401(k) but some may want to work on saving for a down payment on a home before reaching that.
As always, don’t hesitate to reach out if you would like to review how your own pyramid looks, or have questions on anything else you think we may be able to help with. It’s who we are and what we do.
Any opinions are those of Collin Kagan and not necessarily those of Raymond James. Investments mentioned may not be suitable for all investors. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted.
