What Are You Saving For?

Carl writes in:

I am 21 years old and am still in college earning my degree. As of lately I have begun thinking about my future and what I will do with my money. I understand saving is a crucial part of living a successful financial life, but I am confused on how to attack such an issue. I have decided that I will definitely get a Roth IRA, but outside of that I don’t know what else to do with my money. I want to invest in the stock market in the long term most likely a index fund or a portfolio of low risk companies, would that be a form a saving?

I don’t if i should even bother with an online savings account and just focus on IRA and stocks, or should I have all three?

Carl’s certainly headed in the right direction. He’s clearly aware of the value of spending less than you earn and is interested in figuring out the best way to invest the difference.

However, there’s one big piece of the puzzle that’s missing here: what is Carl saving for? Without having clear goals in mind, it’s incredibly easy to make very poor choices when it comes to saving for the future.

Take the Roth IRA, for example. It’s a great vehicle for saving for retirement because, when you reach retirement age, you can take withdrawals from it without any taxes at all. However, it’s an extremely poor vehicle for saving for goals prior to retirement, since you can only withdraw your contributions.

On the other hand, savings accounts can be a great place to put cash if you intend to spend it in the near future. You don’t have the risk of losing value as you do with the stock market and you’ll earn at least a small return on your money.

Carl needs to spend some time thinking about what his goals are. Is he interested in saving for retirement (based on the Roth IRA mention, I’m guessing he is)? Is he saving for something in the short term – for example, is he considering a home purchase in the next year or two? Does he just want an emergency fund so that he can survive in the event of an inability to find a job after graduation? Or is he interested in long term investing (more than ten years or so) that he can use in his thirties or forties for a major purchase (like, say, a home to raise a family in)?

These different goals are wonderfully matched to different investment vehicles. If you want an emergency fund, you should be putting your cash in a savings account. If you want short term savings for goals in the next few years, you should look at short-term treasury notes, bonds, and certificates of deposit – stable investments that aren’t restricted and won’t lose money. If you’re shooting for long term savings (but not retirement savings), look at stock investments, preferably in index funds. If you’re saving for retirement, a Roth IRA is a great vehicle.

It’s likely that Carl is eyeing multiple goals. It’s also likely that, given his youth, that these goals are more long term in nature, but it is always useful to have an emergency fund on hand for any emergencies. I can say this much: if I were in Carl’s situation, just coming out of college with a strong desire to spend less than I earn, I would fully fund a Roth IRA, build up a few months’ worth of emergency fund, then start investing in index funds for longer-term things, like buying a home in my thirties. However, Carl’s priorities may be different.

The real challenge isn’t the actual investing. The challenge is figuring out your goals and knowing where you’re going with your life.

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  1. Rick is high says:

    Priorities are best basis for knowing what you’re really saving for. Because you know where your money would probably be going. It’s ok to save even if you’re not sure of what you’re priorities are too. Because you’d be prepared for unexpected things that may come your way.

  2. J says:

    I wish the Total Money Makeover had been in print when I graduated from college. It’s a nice simple framework anyone can follow. Get some basic savings, pay off debt, keep a budget.

    Likely a 21 year old’s first problem isn’t going to be investing, but paying off the mound of loans that will kill cashflow for ten years. Not to mention finding a job in this market, and avoiding a lot of the pitfalls that commonly befall someone right out of school, like buying a new car that they cannot realistically afford, partying too much, and buying up a giant stack of A/V equipment on credit.

  3. Well after I am debt free next year besides the mortgage, I’m saving for my peace of mind with a 6 month emergency fund. And then I’m saving to buy my dad a car with cash, and pay off the mortgage. Basically I’m saving to be independent.

  4. J says:

    To more directly answer the question of the poster, the answer is that you need the following conceptual money management tools:

    -an account for monthly bills, spending money, groceries, etc.
    -an account for other expenses you incur regularly, such as auto maintenance, travel expenses (e.g. plane tickets to go home for the holidays), gifts, taxes, etc.
    -an emergency account for things that are truly emergencies.

    That’s just day to day, and the actual implementation is left up to the user. Some people might do it with cash in envelopes, some others might use all online tools and credit cards. But the important thing is that you know where the money is and what it’s purpose is.

    As for investing, the above categories are probably best not contained in stocks, index funds, etc. You might be able to do something fancy with CD’s for the emergency fund, but most people will do just fine with a no-frills account and an attached money market savings account or high-interest savings account. The only advice I’d give is to understand how much you are spending on fees, and to shop around a few banks and credit unions to see where you can keep your money without paying the financial institution.

    As for the investment part, if an employer offers 401k and a match, that’s a good thing. But keep in mind one of the best “ROI” investments is to pay off debt — it’s a “guaranteed return” of the amount of interest you end up NOT paying. And with many, many college students leaving with tens of thousands of dollars in loans, it really stands in the way of making significant contributions to saving up for anything at all.

  5. Neal Frankle says:

    The best question for Carl to ask himself is, “What’s important about money to me?”

    Having explored this, he’ll get his list of priorities straight. Without considering this first, the exercise becomes much more difficult.

    Having said that, I like everything said in the response above.

  6. Matt says:

    If he’s still dependent on his parents, he probably doesn’t need an emergency fund right now, but he could potentially put the money in a 1-year CD that he can cash out around graduation time to use as an emergency fund. A Roth IRA is also a great idea, especially since the market is down and he is within the income limits.

  7. Michele says:

    I think besides writing up a budget on what he can live on, he needs to figure out everything he is saving for – perhaps a car in the short term, a house in 5-10 years, and retirement 30 years away. And then he should appropriately allocate his savings money for each of those categories.

  8. Johanna says:

    If Carl is anything like I was when I was a 21-year-old college student, he probably has no idea what his financial goals are. The transition between being in college and going out into the “real world” changed my thinking about money in big, big ways. Even though the “real world” for me was grad school, I was paying the rent instead of living on campus, buying groceries instead of being on a meal plan, and entertaining myself in the big city instead of spending all my free time at university social functions.

    It’s great that Carl is thinking about a Roth IRA early – I wish I had done that. And he can invest in the stock market *within* that Roth IRA – stocks and the IRA do not need to be two separate things. Beyond that, I’d advise him to keep the rest of his savings in a liquid form (like a savings account) for right now. Then, maybe a year or two after he graduates, he can revisit this post, think some more about his financial goals, and go from there.

  9. Gabriel says:

    I’m also 21 and dealing with this same question. The reason I’m saving is for my future kids. I know I want to be a mother, and I also know that I’d need the freedom (like the ability to walk away from a job) to make sure that my children receive exactly the sort of care I want them to.

    I think I tend to be an exception, rather than the rule. Most people I know my age tend to be very present minded.

    Carl, I wish you luck!

  10. KC says:

    The problems stem from the change in saving for a real item – like a plasma TV – to saving for less tangible items – like retirement. I’m in the less tangible stage. I’m saving for retirement, emergencies, a kid, a kid’s future, and a more stable adult life. I’m also saving for a car…when I need one (which could be tomorrow or could be 5 years from now). So nothing is tangible. It’s harder to safe for these inexact goals. But its something you have to do to be secure. Once you’ve established the ability to save – for specifics, for an emergency fund – then you have to take the next step, which is learning to safe for things that aren’t as easy to materialize.

  11. KC says:

    Sorry for the multiple misspellings above…safe should be save.

  12. Carrie says:

    At 21 I was doing the same thing as Carl – putting everything in my IRA, 401k, and brokerage account (I was 21 in 2005). In 2007/2008 I had pretty much nothing in cash (but a sizable portfolio) and lost a good chunk as the stock market started going down hill. I’m saving cash now (in addition to fully funding my Roth IRA – not eligible for a 401k yet because I recently switched jobs) for an emergency fund (I used to think I would just sell stock if I needed to but don’t want to do that now), travel, and car expenses (insurance, deductible, and someday another car).

  13. J says:

    Gabriel — keep in mind that you need to look after you, too. Knowing you want to be a mother is a very good goal, of course — but keep in mind that choosing that as a lifestyle choice doesn’t mean that you live off a pile of savings, it means that you do what it takes to live solely off one income.

    My sister knew that when she had kids she wanted to stay home, so she paid off her debts very quickly and started saving, big-time. When she got married, they immediately started living off her income alone and used her income solely for retiring other additional debt and piling up savings, as well. When the baby arrived she was happily able to walk away from her job, knowing that they not only had a decent chunk of change in the bank, invested, etc, but that they’d also been living on his income alone for several years.

    I’d also advise that what I thought was going to happen when I was 21 was in no way what actually happened by the time I was 31. So unless you are getting married in the next year and want to have your first kid by 22, I’d really suggest that you spend some money and time on things YOU want to do prior to being immersed in motherhood. Saving money is well and good, but there are any number of things you can do while you are single and unattached that will become considerably more difficult (or impossible) to do once you have a family. Enjoy yourself a little!

  14. J says:

    correction to above: They started living off of HIS income alone :).

  15. Battra92 says:

    I have thought about getting married but I know I don’t want kids. I would probably be a horrible father anyway (I once told a girl if we got married and had twins I’d name them Copy and Paste.)

    What I do want is a bit more freedom. I love my job and all but there are days I wish I worked 20 hours a week for the man and 20 hours for myself.

  16. Carl…I’m 24. We might be in completely different situations, but still to give you a few ideas of what I’m saving for.

    1. Emergency Fund
    2. Early Retirement
    3. Kids
    4. Vacation
    5. Extended Vacations
    6. Car
    7. Home Improvements
    8. Business
    9. Grad School

  17. The Personal Finance Playbook says:

    I agree that goals are important. Regardless of your goals though, almost everyone should be doing the things Carl asked about. Everyone should have an emergency fund and a retirement account. Anyway, best of luck to you, Carl.

  18. Nate says:

    Trent defines long term investing as ten years or so and recommends index funds for this type of investing. The S&P in March of 1999 was at around 1300. The S&P in March of 2009 is at around 684. So if you had the idea ten years ago to set aside money for a long term investment and placed that money in an index fund that tracked the S&P, you would have lost almost 50% of your money over that 10 year period. Additionally, the value of your money would have been eroded by inflation over those 10 years.

    My point is that over that specific 10 year period, and many others over the history of the stock market, buying and holding an index fund would have been a major mistake.

    If you want to play “buy and hold” you should be investing really long term, at least 20 years, unless you plan to get lucky.

  19. Defining life goals is definately the most important step in determining your financial goals. I write extensively on this very subject on my website, and is exactly the premise of my site; achieving your goals while managing your finances.

    I think Trent has a good point in determining what it is that is being saved for but also think it is important to know exactly what direction you hope to take in life so that you can develop a path in order to get there. Once you do that you can pave your path in financial successes and accomplish the goals and dreams which you set out to achieve.

    Good post Trent, and I encourage those who are interested in more reading on this subject to visit my site.

  20. Trent Hamm Trent says:

    Nate said “The S&P in March of 1999 was at around 1300. The S&P in March of 2009 is at around 684. So if you had the idea ten years ago to set aside money for a long term investment and placed that money in an index fund that tracked the S&P, you would have lost almost 50% of your money over that 10 year period.”

    You’re forgetting about ten years of dividends in this comparison. If you buy an index fund, you do collect dividends.

  21. Patrick says:

    Great post. Well said.

  22. Des says:

    @Battra92

    You might want to keep it in the back of your mind that you may change your mind on kids one day. I was vehement when my husband and I married that I never wanted kids. Then one day, after many happy years just the two of us (and the dogs, of course) it just clicked with both of us that we wanted children.

    I’m not saying that *will* happen to you too, nor am I suggesting that everyone needs to have kids. Just know that you and your goals and dreams will change over time. 10 years from now you won’t be the same person you are today.

  23. !wanda says:

    +1 to Johanna’s advice. Shoot, I’m 25, but I’m in a career where it’s very uncertain where I’ll be able to get a permanent job in 5 or 6 years. That makes it impossible to plan whether it makes sense to buy a car or house or how much to save for that house. My current strategy is to save “a bunch” and spread that out over investments with different time windows, with a bias towards the longer-term.

    If Carl is pretty aimless, it seems to be that adopting both very long-term (retirement) and very short-term strategies (cash) seem appropriate. No one wants to be old and broke, and retirement vehicles are so tax-favored that it seems silly not to invest in an IRA. Putting the extra savings in cash means that he’ll both have an emergency fund when he graduates and that he’ll easily be able to invest the money in a more appropriate vehicle when the outlines of his life become clearer.

  24. Nate says:

    Yes, I did forget to mention dividends.

    In 1999 the yield was 1.1% It was up to 1.8% i think in 2006. It is currently relatively high at 3+%, but only because prices have fallen so far in the last few months and some companies haven’t yet moved their dividends downward in response to their falling earnings.

    So even if you assume an average yield of 2% over the last ten years, you’re left with a rate that is substantially less than you would have earned if you had put your money in treasuries, cd’s and high yield saving accounts. If you take into consideration your capital losses due to the 50% price decrease, then there is no question that putting money in the index fund in 1999 was a mistake.

    I also didn’t mention the taxes on dividends and the expense ratio, which I know is small, but it is still that much less money at the end of 10 years.

  25. K says:

    I think a better answer to the question would be that regardless of your goals, everyone needs a few different savings/investment accounts. Your priorities will dictate how much to put in each.

    Essentials:
    -checking acocunt: For regular expenses (groceries, gas, rent, mortgage, utilities)

    -savings account (or 2): At a minimum, one as an emergency fund. This could be as little as $200 or as much as $20,000 or more depending on your needs. You may also want another account for short term savings (wedding, car, vacation, etc.)

    -401k if their employer offers a match: To pass this up is to give away free money.

    -a Roth IRA if they are eligible: This is a great opportunity to guarantee tax free income in retirement. In most cases, contributing 6-8% to a 401k and $5000/yr to a Roth from age 25 will be plenty for retirement.

    Optional: another taxable investment fund. For things like kids college, a house in the future, extra retirement savings if you maxxed out the other options or want to access some earlier.

  26. Battra92 says:

    @Des, I know people say that. It’s not that I don’t like kids or whatever I just don’t see them in my future.

    Oh well. ;)

  27. “The real challenge isn’t the actual investing. The challenge is figuring out your goals and knowing where you’re going with your life.”

    I think getting started is a challenge too. I don’t think it should be over looked. Some people know why they should invest but still don’t do it for whatever reason.

    -Nate

  28. Margo says:

    Carl,

    Let me make things a little easier on you:

    To get started:
    10% of gross for retirement
    10% of net for expensive next-five-years goals

    CASH:
    Between 21 and 30 or 35, most people will need cash for the following: a car, a down payment on a house, and a wedding. You might also consider graduate school or starting a business, but the first three are practically guaranteed expenses. Figure out what you think is reasonable to spend on each of these and that’s how much you should shoot for in cash savings.
    Late-model used economy car: $10K
    House, 10-20% down payment: $10K – 60K depending on your part of the country.
    Wedding, $0 – $25K depending on your taste and the size of your family.

    Even assuming you want a small car and a modest house in a low cost of living area, that’s $20K in cash outlays. How aggressively you save depends upon your timelines. You’ll have to save a lot harder to get a down payment by 25 than you would to do it by 30 or 35.

    I majored in Finance so I knew what it would take to save up a $20-30K down payment. I didn’t really want a house at 22, I still don’t, but I started with just $20 per week toward that goal because I know when I decide I want a house it’ll be time for the painful cutbacks to save up. Each year, I’ve grown that amount by $20 or so, and I add in 80% of all my found money and bonuses…and STILL I need to do $450-500 per month to meet my goal of 20% down on a modest place in my area.

    I am saving 7.5% of my net pay for a house and a car…10% would get me to my goals a lot quicker.

    Realistically, I might wipe out both funds to go to grad school, but what I use it for doesn’t matter…either way, these are “in the next five years” things so the money should be kept in cash.

    Even if your specific goals change over those five years, it’s almost guaranteed that you will want at least one cash-sucking big item.

    INVESTING:
    Don’t invest in a taxable investment account until you have at least $20K to play with. The account fees and transaction fees will kill your returns if you’re only investing small amounts. $4/trade for Sharebuilder sounds cheap, til you realize that’s 8% of $50.

    RETIREMENT:
    Aim for 10% of gross pay, plus whatever your employer gives you. A lot of employers have cut back on the 401K matches because of the economy, so you don’t want to count on the matching $ any more than you’d count on Social Security. 10% done every year from age 22 to age 65 should give you a comfortable retirement.

    MOST IMPORTANT:
    Bust your tail to impress the right people at work and grow your salary. If your paycheck goes up 10% so should the amounts you put into retirement and into savings…which will work out for you in the long run.

  29. Lis says:

    OMG – Trent posted a comment! :)

  30. plonkee says:

    @Battra92:
    I think that the point is that there’s a reasonable chance you’ll change your mind on something important over 10 years – not that it need be kids. It might be where you live, what you want to do for a living,…

    Goals are good, but overall your plans need to also have flexibility.

  31. Nik says:

    Carl, I’m 22 and just graduated college last spring. I was lucky enough to find a job right out of school but here is what I’ve been saving for:

    1. Debt repayment
    2. House down payment
    3. Retirement
    4. Emergency fund
    5. Starting a side business
    6. Vacations

    I’m hoping to get 2 or 3 of those out of the way before thinking of a wedding or kids, but my honest recommendation is to pay down that debt. As my loan payments come down every month, I have the ability to put more into my retirement account; its a great way to kill two birds with one stone.

  32. Nik says:

    Carl, I’m 22 and just graduated college last spring. I was lucky enough to find a job right out of school but here is what I’ve been saving for:

    1. Debt repayment
    2. House down payment
    3. Emergency fund
    4. Retirement
    5. Starting a side business
    6. Vacations

    I’m hoping to get 2 or 3 of those out of the way before thinking of a wedding or kids, but my honest recommendation is to pay down that debt. As my loan payments come down every month, I have the ability to put more into my retirement account; its a great way to kill two birds with one stone.

  33. Battra92 says:

    @plonkee: I don’t know it seemed mostly about kids.

  34. Christine says:

    The market is doing not producing very good results right now. While some say it’s the time to buy because the stock prices have fallen, who knows if they will fall further. It’s a gamble. What’s a guarantee…paying off your student loan and credit card. You will have a much easier time finding a first job and establishing your first apartment if you don’t have these hanging over your head.

  35. Gabriel says:

    Thanks for the input guys! J, I’m definitely not planning on motherhood yet. There’s so much to do and explore, and I’m hoping to travel a great deal and maybe do grad school in the future. What I meant in my comment was that future kids are what motivate me to stay focused on my financial goals – for various unpleasant medical reasons, it may be a long, hard, and expensive battle to have them. Keeping in financial shape now means that I have more ability to cope with future struggles.

    That’s doesn’t just go for kids, it’s basically the definition of a good emergency fund!

  36. worlwide S says:

    Don’t know if I am doing it right, and I still worry. 40 years old with a house that I rent out, work tax free and save around 35% of my income split between mutual funds and tax free savings. Getting married in the next year, will need a house somewhere (worldwide), want kids who get a good international education. Have around $60k in the emergency fund, a good 6 figure income and I still worry that I may go 2 or 3 months without tenants in the rental, where do I go next?

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