In these difficult economic times, many people think that they should change their saving and investment priorities. However, no matter what the economic climate – good, bad or neutral – your financial priorities and where you save or invest money should remain the same. The key questions are: What is the order of your priorities? And where should the money associated with each priority be invested?
Your Emergency Fund
When you think of savings and investments, you probably think of dividends and growth. Yet, while specifically not intended for dividends or growth, an emergency fund is actually the first and most important part of your savings portfolio.
Parents also need to consider
Everyone, regardless of his or her income, depends on a regular stream of income to paymonthly bills. But what if that income is temporarily stopped due to a layoff or thrown out of whack by a large, unexpected expense? That’s where the emergency fund comes in.
Ideally, your emergency fund is equal to at least five months worth of living expenses (eight to nine months if you’re self-employed). It should be in a safe, liquid account (such as a savings or checking account covered by deposit insurance, or an insured money market mutual fund), which guarantees that the full amount will be there and easily accessible if and when you need it.
CDs, individual bonds, non-money-market mutual funds and individual stocks don’t qualify: CDs and individual bonds aren’t liquid and non-money-market mutual funds and individual stocks aren’t completely safe. Nor is a home equity line of credit suitable for your emergency fund because it’s neither savings nor an investment, but rather equity built up in your home, and, therefore, should not serve as a substitute for an emergency fund.
Saving for a Home and Retirement
Once you have an adequate emergency fund established, what’s next? For most people, especially if you’re young, the next priority is saving to buy a home. This, however, should preferably be done in conjunction with beginning to save for retirement (although, for many, saving – or at least, saving a lot – for retirement may have to be delayed until the money needed for a down payment is saved).
While most people would like to save enough for a 20 percent down payment on a home, the reality of today’s high home prices means that saving 5 percent to 15 percent of the cost of a home you hope (and can afford) to buy is more realistic.
How should this money be saved? Exactly the same as your emergency fund: in a safe account. Unlike an emergency fund, however, short-term CDs (one to 24 months) are also acceptable if you’re certain you won’t be buying the home for a year or two.
No matter what you’re saving for, you should not invest money in higher-risk investment vehicles, such as bonds, non-money-market mutual funds or stocks, unless you’re certain you can leave the money invested for at least five (and preferably 10 or more) years. In almost all cases, you’ll need the money you’re saving for a down payment on a home in less than five years. And that simply won’t give those savings time to navigate the peaks and valleys that risk-based investments virtually always run.
Once you’ve saved enough for a down payment on a home, your most pressing (and longest term) savings priority should be retirement. How much should you save? The rule of thumb is 20 percent of your gross income per year, which, of course, many people simply can’t meet. Don’t get discouraged, it’s just a goal. (And, if you’re guaranteed a lifelong pension – over and above social security – once you retire, that amount can be factored into and lessen the 20 percent yearly figure.)
When it comes to investing the money you’re saving for retirement, begin by trying to max out your yearly contributions to any 401(k), 403(b) or deductible IRA for which you are eligible. This is especially true if your employer matches all or part of what you invest, since it’s really a form of free money. Try to invest at least enough in your 401(k) or 403(b) to take full advantage of the employer’s match. If you’re not saving for a home, don’t make the mistake, as many people do, of only investing up to the amount the employer matches.
If you’re already maxing out your 401(k) or 403(b) or a deductible IRA savings each year, that doesn’t necessarily mean you’re saving enough. If you have the ability to save more, then take advantage (if you qualify) of a non-deductible IRA, especially Roth IRAs (which, though not deductible, do grow tax-free and, generally, when withdrawn after age 59-1/2, come out tax-free – both contributions and earnings).
Where to Invest for Retirement
Given that most people begin saving for retirement when they’re relatively young (and, therefore, have an investment window of 20 to 40 years), money saved for retirement should be invested in a well-diversified portfolio of stock-based mutual funds. This portfolio should be more aggressive (more "growth" funds than "value" funds) while you’re young. As you get closer to retirement age, you’ll want to ratchet back on the aggressiveness of the portfolio.
Whatever your age and investment window, the aggressiveness of your portfolio should also be governed by how much risk you feel comfortable taking and how much risk your situation dictates you have to take. For example, a couple in their 30s who is risk-averse and has saved a good deal toward retirement may be able to have a retirement portfolio much less aggressive than would be usual at that age.
On the other hand, a couple who isn’t able to start saving (or saving a substantial amount) toward retirement until their 50s may, by necessity, have to invest that money more aggressively for a longer period of time than might be usual for most people of that age.
Saving for College
Despite most parents’ urge to help their children, don’t even think about saving for your children’s college education until you’re saving 20 percent of your income each year toward retirement. Given the high cost of retirement and the high cost of college, trying to save enough to cover the cost of your children’s education may undermine your ability to save enough money by the time you reach retirement age.
Remember, as much as you might like to pay (or substantially help pay) for your children’s education, the reality is that your kids can get loans and other types of financial aid for college, and then have 20, 30 or 40 years to pay those off (while also saving toward their own retirement). If you’ve paid for your children’s education at the expense of having saved enough money for your retirement, you run the very large risk of having to face some very difficult choices at retirement age (such as continuing to work well into your 70s or 80s, downsizing your home, downsizing your lifestyle, or all of the above) just to make ends meet.
If you have the wherewithal to save adequate amounts for your retirement and still have money available to save toward your children’s education (or, you can’t save for college, but your child earns or is given money to save for his or her education), where should that money be invested? The best options are Coverdell ESAs and 529 programs.
ESAs – Originally introduced as Education IRAs, Coverdell ESAs offer a number of benefits when saving for higher education. The biggest benefit is that although money invested is not tax-deductible, it grows tax-free and is withdrawn tax-free as long as the amount withdrawn in a given year is used for qualified educational expenses and does not exceed the beneficiary’s qualified education expenses for that year.
ESAs provide additional benefits, including:
• Up to $2,000 can be invested per beneficiary annually.
• Money can be used for expenses at virtually all college, university, vocational and other post-secondary educational institutions anywhere in the United States.
• Money can also be used to pay for qualified educational expenses at private elementary and secondary schools.
• Money can be invested in virtually any investment vehicle, and the investment vehicle can be changed.
529 Plans – Most states offer some form of 529 plan that is managed by a private investment, mutual fund or other large financial firm. While the specific investment choices vary with each 529 plan, most offer a choice between various aggressive, conservative and middle of the road portfolios of mutual funds, bonds and fixed investment vehicles. All 529 plans include most of the advantageous provisions of Coverdell ESAs, with the exception that money invested in a 529 plan cannot be used for precollege private or secondary school.
In addition, 529s offer a number of advantages over Coverdell ESAs, including:
• Much higher contribution limits. Limits vary with each plan, but they are much higher than the $2,000 yearly ESA limit.
• No income limits on those who contribute.
• A large choice of 529 plans. Investors are allowed to contribute to their own state’s or any other state’s 529 plan.
• In some states, state tax benefits.
• Additionally, while 529s do not offer the virtually unlimited investment options offered by ESAs, they do offer flexible investment choices. Most plans now allow you to actively manage your account by switching your portfolio distribution from year to year. So you can take your relatively aggressively invested 529 portfolio – which the portfolio should be when your child is 10 to 15 years from entering college – and progressively make it more conservatively invested – which it should be when your child is less than five years away from entering college. (Some 529 plans will automatically reallocate portfolios in this manner.)
One Last Bit of Advice
The reality is that not everyone – in fact, most people – will not be able to reach all of the investment priority goals addressed here. That’s OK. Start saving as much (even if it’s very little) as possible, as early as possible, in the prioritization order listed above. The worst mistake is not to try to save at all.
Visit our Family Finance pages for more tips, advice and resources to help you manage your money now, and plan for the future.