Over the past couple of weeks, I’ve written about separating wants from needs (including some scary statistics regarding credit cards) and evaluating your current financial situation.
In today’s post, I’m going to continue with the financial independence thread and discuss the importance of automating your savings.
The thing about “wants” and credit cards is that they can quickly separate you from your hard-earned money. If you haven’t paid yourself first (automated your savings), you can quickly run into the problem of having more month than money – and with nothing set aside for emergencies or the future!
I love the following advice from Warren Buffett that illustrates this concept:
“Do not save what is left after spending, but spend what is left after saving.”
If you can’t tell by now, I love numbers and statistics, and I’ve got a few more for you to chew on, as it relates to savings in America.
- 26%: Percentage of adults that have no money set aside for emergencies
- 4%: Personal savings rate of Americans (hint: this number should be AT LEAST 10-15%)
- 36%: Percentage of adults that have no money saved for retirement (including more than 25%of those aged 50-64)
I could go on, but let’s focus on these three numbers for now.
Now that you’ve evaluated your financial situation and, most importantly, identified just where your money is being spent, now is the time to zero in on how to save that money you’re freeing up after cutting some of the unnecessary expenditures.
First things first – why bother saving? YOLO (mom and dad – YOLO stands for “you only live once”), right? I’ll save later, you might say. I’m happy to report that you can do both – live now AND save for the future.
I’d even argue that saving now will improve your life in the short term by alleviating worry, knowing that you’re covered if something comes up, and that you’re planning ahead for a life of freedom by setting aside money for your retirement years (whatever that might look like for you).
You’ve heard it before, but life happens. Emergencies happen. Unexpected expenses happen. If you don’t have money set aside for such things, you’re going right back to charging that expense to your credit card. And the cycle of debt continues.
If you don’t take anything else away from my financial independence posts, I want you to remember this: spend less than you earn, and save or invest the difference. Period. Do this and you’re already in a much better situation than many people, and you’re well on your way to financial freedom.
What’s the best way to ensure that you live below your means? Pay yourself first. By paying yourself first, you’re not tempted to go out and spend all your money; you don’t even see it in your checking account since it is taken out before it gets to you.
I referenced the 50/20/30 budget last week, with the “20” representing the percentage of your income that you should strive to save (to include extra payments to debt). If you’re not there yet, don’t panic – remember this is a goal. What I don’t want is for the number to lead to inaction if you feel it’s not realistic for you right now. The main thing is to save SOMETHING as you get going.
Getting your expenses under control will allow you to beef up the “20”.
To give you a starting place, I’d consider the following steps, and in this order. They worked for me.
401(k)/403(b) Contribution and Match
If your employer offers a 401(k) or 403(b) plan with a match, be sure you’re contributing at least the minimum required to qualify for the match. Note: a 403(b) is a retirement plan just like a 401(k), but is for employees of the government, public schools, non-profits, and religious organizations.
A couple of things here: an employer match is about as close as you’re going to get to a free lunch. Assuming you meet the requirements, this is money that your employer is GIVING you. Even so, some 25% of people that participate in their company’s 401(k) plan miss out on at least some of the company match. Not contributing the minimum required for a match is leaving money on the table!
Not only are you taking a giant step to make sure that you’ll have some money set aside for you in the future, but the money that you contribute to a retirement plan is taken out of your paycheck before taxes. In other words, by doing this, the income that you pay taxes on will be less, leading to a lower bill come tax time.
For example: if you make $50,000 a year, and you contribute $2,000 a year to your 401(k) plan, you will pay taxes on $48,000 of income, not $50,000. Every little bit helps!
AND, the employer match is actually giving you a little bump on your personal savings rate!
Emergency Savings
With your retirement plan match squarely in place, turn your attention to emergency savings. If you don’t have anything set aside currently, let’s start small. Try to set aside one month’s worth of living expenses. Still too steep for now? Not to worry. In that case, do your best to build up at least $500 in your emergency savings coffer.
Need help automating the emergency savings piece? Speak with your payroll department to have a portion of your paycheck direct deposited into a savings account. Yet another way for your money to be told where to go, without you even seeing it.
Debt Repayment
Once you’ve got your retirement plan match in place, and you’ve got a month’s worth of expenses in emergency savings, it’s time to get that bad debt (credit cards, retail store cards, car loans) taken care of since this is the debt that carries the highest interest rates.
When it comes to targeting your debt, you’ve got a couple of different options. The math says that you should focus on paying off the debt with the highest interest rate first, and then move down the list from there. Doing so would mean you’re paying less in interest over time.
For most people, however, I think it makes more sense to follow what is commonly referred to as the “snowball method”. This is the approach I took, and I like it because it generally allows you to see progress more quickly, and build that positive momentum as you move to pay off the rest of your high-interest debt.
It works like this:
- List all of your debts, in order of smallest balance to largest balance. Remember, we’re not focusing on the interest rate you’re paying in this method.
- Pay the minimum required balance on all of the debt, except for the one with the smallest balance. For those of you following the 50/20/30 budget, these minimums are part of your “50” bucket.
- On the smallest balance, pay the minimum required AND apply any extra money you have to this balance. The extra money applied to debt repayment here would be considered part of the “20” in your budget.
- Once this first balance is paid off, take the total amount that you were paying toward that balance, and add it to the minimum required balance on the next smallest debt. Remember, you’re used to paying it anyway, so now just roll it to the next one.
- Repeat until you’ve cleared all of your bad debt.
Visualize the snowball gaining speed, and you’ll be more likely to stick with it when you see your efforts pay off – pun intended!
Once you’ve got the retirement plan match, one month’s worth of coverage in emergency savings, and your bad debt taken care of, then you can go back and build up that emergency savings buffer to the recommended minimum of 3-6 months’ worth of expenses, and/or increase the amount you contribute to your 401(k) or 403(b). Doing either of these will also help raise your personal savings rate so that is more aligned with the recommended 15-20%.
Speaking of expenses, I hope you see yet again the downhill impact that reducing unnecessary expenses can have. The fewer monthly expenses you have, the less you’ll need to have on hand in your emergency savings bucket, and the sooner you can get to saving for the future!
Cutting out unnecessary expenditures truly lays the groundwork for so much positive financial growth and flexibility!
Don’t be one of the statistics above. Automate your savings and take control of your money!