Welcome to my hands down favorite part of budgeting. The part where you get to plan for the future and watch your money grow. Without saving and investing, you cannot build wealth. You don’t need to be making six figures to build wealth. The secret to building wealth is starting early. So, congratulations, you’re in the right place.
At this point, you should have calculated your income, projected your expenses, and accounted for debt payments. Now, it’s time to allocate the leftover income to savings and investments.
I do want to make a small note here that I have not touched too much on how to decide between increasing debt payments above minimum or putting that money toward investing. I hope to offer more insights about this topic in the future, but currently, I do not have enough experience or expertise to do so. If you are stuck in your decision, I encourage you to go to good ol’ Google and research away! There’s plenty of great resources out there. In the meantime, I’ll proceed as if you already know what you want your debt allocation to be.
There are three main things to consider when deciding how to save/invest:
1. Do you have an emergency fund? ($1000 or 6 months of expenses)
2. How much does your employer match your 401k?
Emergency Fund
The absolute first thing to consider when deciding where to save and invest is whether you have an emergency fund. If you don’t have $1000 or six months of expenses saved, stop what you are doing and figure out a way to reach that goal ASAP. If you don’t have the emergency fund, the only type of investing you should be doing is reaching your employer match on your 401k. Any other leftover income should go straight to your emergency fund.
Employer Matching
Employer matching is a beautiful thing that is legit free money. I know that employer matching is an overused term that is thrown around a lot, but just look at this math for a second to understand why it’s such a big deal.
Consider Jane who earns $60,000 in pretax income each year (eligible compensation). Her employer will match up to 6% of her eligible compensation that she contributes to her 401k. If Jane contributes $0, her employer will match that and contribute $0 (boo). If Jane contributes $100, her employer will also match that and contribute $100 as well. The maximum that her employer will contribute is $3,600 each year (.03*60,000). So, if Jane contributes $3,600 of her salary, the employer will match that and contribute $3,600 as well. If Jane goes over this amount and contributes $4,000 this year, the employer will still only contribute $3,600.
That $3,600 is FREE MONEY. That is $3,600 that Jane did not have before that she has now. Sure, it’s illiquid and will only serve her in retirement, but also due to compounding interest that $3,600 will be worth much much more in 40 years. If that $3,600 sat in an investment account with 7% average annual returns for 40 years, it would be worth a whopping $53,908. This is exactly why you should invest early even if it’s a small amount.
Anyways, I digress. Since we have to make a decision about how much we should be contributing to our 401k, let’s talk about some factors to consider.
1. Employer matching- get all the free money if it’s at all humanly possible. Cancel your Netflix subscription, eat ramen, I don’t care just do it. If you can’t max out the match, do your best to get as much as you can.
2. Contribute above the employer match if you still have income leftover that hasn’t been allocated to expenses or debt payments. The maximum you can contribute per year is $19,500. If you still want to contribute more to retirement and get those sweet tax benefits, consider also contributing to a Roth IRA (I can talk more about this in a future post).
3. Balance your retirement contribution with other shorter-term investment goals. See next section.
Shorter Term Investment Goals
The next thing to consider is whether you will contribute to other savings and investment accounts that will serve you for shorter term investment and savings goals. Some of these goals could include:
1. House
2. Wedding
3. Further Schooling
4. Vacation that can’t be covered by one year of salary
At the time that I’m writing this, I haven’t fully researched or figured out the best place to put these funds (especially the medium run ones that you could probably invest). The short-term ones should probably be placed in a pretty safe savings account because you wouldn’t want to risk losing the money to the volatility of the market right when you would need it. Again, feel free to do some research on the best vehicles in which to funnel these funds!
A tip that I have for determining how much to allocate to these savings goals is to figure out how much total you will need and then divide that by the number of years you have to reach the goal.
For example, Rachel wants to get married in 5 years. She knows her wedding will cost $30,000. Therefore, she must save $6,000/year or $500/month. Again, since this is a relatively short-term goal, she’d want to put this in a separate savings account or a high yield savings account. You never want to put your savings into an account that you frequently withdraw from or that you use for other things.
Tying It All Together
Hopefully by now you have a clearer idea of what you’re going to do with your leftover income. Remember that your first priorities are to build up an emergency fund and meet the employer matching threshold on your 401k. Then you can consider increasing your 401k contribution or putting money away for a different financial goal. Contributing more to your 401k means better tax advantages whereas your financial goal may be time sensitive. Definitely weigh the pros and cons of each to figure out your allocation.
Although I’ve laid out a pretty clear hierarchy of saving and investing, it’s important to note that the amount and method that you decide to contribute and utilize towards these different areas are highly personal and totally up to you! If you’d rather have a highly liquid source of cash and are willing to sacrifice some investment money in order to bulk up your emergency fund, more power to you. If you feel comfortable with less cash on hand and would like to max out your 401k then great! Financial planning is all about you and there is no one way to do anything. I am just here to give you all the info and considerations you should be taking into account when making your decisions.
Feel free to comment below or DM me on Instagram or Facebook (linked on the side) if you have any other questions. Although I can’t advise you on your specific situation, I always like to talk through different financial concepts and ideas that you might want to learn more about!
-Julia