One question that often pops up on The Simple Dollar is the seemingly simple question of how much a person should be saving each month. People often want to hear a specific percentage or a specific dollar amount so that they have a benchmark or recipe to follow.
The easy answer to this question is as much as possible. The more you save for the future, the easier whatever it is that the future holds for you will be.
Tying that down to specific numbers is hard, but let’s give it a shot, shall we?
An Emergency Fund
The number one most essential thing I would encourage most people to do in terms of saving for the future is to have an emergency fund. An emergency fund is simply a wad of cash sitting in a savings account (which is about the most secure place for it, plus it earns a little bit of interest) that you can draw upon in case of personal emergency. If your car breaks down, you hit the emergency fund. If you have an identity theft issue, hit the emergency fund. If you have to fly halfway across the country to visit a dying relative, you hit the emergency fund. You get the idea.
Some people use credit cards as their “emergency fund.” I advise against that, for a few reasons. One, a credit card will fail you in some emergencies. It won’t help if you’re the victim of fraud or identity theft. It won’t help you if your wallet is stolen. It won’t help you if you hit your credit limit. It won’t help you if there’s a disaster.
Many people recommend having a specific amount in their emergency fund – say, a month’s worth of living expenses. I don’t suggest that, at least not any more. I think that simply sets the destination, and what’s more important here is the journey. What are you saving out of each paycheck?
Rather, I encourage people to set up an automatic transfer for their emergency fund savings and never turn it off. Most banks can set up a regular automatic transfer from a checking account to a savings account; many can do it right from their online banking service.
Simply set up an automatic transfer that happens about two or three days after your paycheck is normally received, and have it transfer 3% of your normal paycheck to a savings account for emergencies.
If you get paid $1,000 every two weeks, set up a $30 transfer to savings every two weeks, or a $15 transfer to savings every week if that works better for you. If you get paid $600 every week, set up a $18 transfer to savings every week.
And never turn it off.
Instead, just leave that savings account completely alone and tap it only for emergencies. Tap it when your car doesn’t start. Tap it when you need to fly home. Tap it when you lose your job and need to find a new one (turn off that automatic transfer until you have a fresh new paycheck coming in, of course, then turn it back on).
High Interest Debt Repayment
The next thing I would encourage people to address with their savings is their high interest debts. By this, I’m not talking about student loans, home mortgages, or car loans (most of the time). Rather, I’m talking about things like credit cards and (I really hope you don’t have any of these) payday loans. If you have a debt that’s charging you 10% interest or more, your top priority should be to eliminate that debt as fast as you can. That should trump other savings goals for the moment beyond an emergency fund.
If you need a specific number to aim for, I would aim for making a double payment on your highest interest loan. Whichever debt you have that has the highest interest rate, make a double payment on that each month. Whatever you owe, pay twice that, while also making minimum payments on your other debts.
At the same time, you should try to find other ways to reduce the interest rate on high interest debts you have. You can look for low or 0% interest balance transfers for your credit card. You can seek out personal loans from a credit union, particularly if you have collateral you can use. You can directly call the lender and see if you can get the rate reduced.
This should be your next goal after starting your emergency fund savings. This should trump other savings goals.
If you have no high interest debt, the next most important goal is retirement savings. You absolutely need to be saving for retirement unless you want to be in old age and scraping by on a meager Social Security check. Even if you have children who might be going to college, this should still be a higher savings priority for you so that you don’t run the risk of becoming a financial burden on them in your old age.
You should be aiming to save 15% of your annual salary toward retirement. That seems like a high number – and it is. For many Americans, saving for retirement will gobble up most of the money they’re wanting to save for the future.
The first place you should look for saving that money is your workplace 401(k), 403(b), TSP, or similar plan. If you’re unsure, ask your boss or the human resources office. What they’ll do is set things up so that money is deducted directly from your paycheck before you even receive it and put straight into your plan. If you’re confused by the investment options, just choose a Target Retirement Fund with a year close to when you’re between 65 and 70 years old.
Ideally, you’re going to choose to put in 15% of your pay. If your employer offers matching, you can subtract the amount they match from that 15%. If you can’t quite make it to that threshold, that’s okay, but you should come back later and try to bump it up to that level. It’s worth noting that 401(k) contributions are pre-tax, which means that the money is taken out before taxes are calculated. This means that you’ll pay less taxes now and thus if you contribute 15%, your paycheck won’t go down by 15% (it’ll go down a little less than that). However, you will have to pay taxes on that money in your 401(k) when you retire and start withdrawing it to live on.
If you don’t have access to a 401(k) or similar plan at work, you can still save for retirement with tax advantages by opening a Roth IRA for yourself. A Roth IRA is kind of like a 401(k) but it’s independent of your employer, you put in money out of your checking account instead of directly from your paycheck (but you can automate this), and when you take money out when you’re retired, all of it is tax free.
The key is to try to save 15% of your paycheck in a retirement account of some kind. Aim for 15%. If you can’t do that right now, contribute as much as you possibly think you can, then revisit that decision in a few months and see if you can bump it up a little.
Define Your Own Goal
If you are saving 3% of your income for emergencies, have no high interest debt, and are saving 15% of your income for retirement, you’re in really good shape. Right there, you’re ahead of at least 80% of American households, and if you’re looking to save more, you have a lot of options that depend heavily on what your personal goals are.
Some people aim to pay off all debt. This minimizes their monthly bills and makes it easier to save more or to make lifestyle choices like changing jobs or careers. Usually, this is done by making the largest payment possible each month on whatever debt has the highest interest rate.
Others might start saving for a specific goal, like replacing a car or buying a house. In those cases, you’re essentially preparing in advance to avoid debt, with the interest from your savings helping a little. Having a good down payment on any debt will significantly reduce the interest rate on the debt and the size of the debt, which means much smaller payments and/or a smaller length of debt. Ideally, you can reach a point where you’re always saving for a car and just withdraw money when it’s time to replace a car without using loans at all.
Some people might choose to save for their child’s college expenses using a 529 college savings account. Such an account lets you invest money so that it grows rapidly and, if you use that money for educational expenses, you don’t have to pay taxes on all of those earnings. While this is nice, it should be a lower priority for parents than an emergency fund, eliminating high interest debt, and saving for retirement.
The key thing to note here is that “how much should I be saving this month” is very much dependent on how much you’re earning each month and your current financial situation. There is no ready-made dollar amount that works for everyone – or even works for any two people. However, the amounts above are good starting guidelines that will help most people tremendously, no matter what their life looks like specifically. An emergency fund helps virtually everyone. Eliminating high interest debt helps virtually everyone. Saving for retirement helps virtually everyone. If you have those things checked off, you’re in good shape and ahead of most Americans and you have some leeway as to what to do next.