One of the most common questions we get is about how to prioritize your savings. If you’re like most Americans, you may have some credit card debt to pay off, an emergency fund to build up, and a retirement to invest for, but your savings to fund these goals are shall we say…limited. While financial planning should always be customized according to your individual situation, here are some general guidelines to consider:
1. Make sure you have a minimal emergency savings first. One economic study found that people should have at least a minimal emergency fund of $2,500 to avoid financial hardship. You can keep it in a savings account or even in your checking account as a protection against overdraft fees. (With a rewards checking account, you can actually earn more interest than in a savings account.) Either way, be sure to not invest it in anything risky and only use it for genuine emergencies.
2. Max the match in your employer’s retirement plan. It’s hard to beat a guaranteed 50% or 100% return on your money. Plus, you’ll at least be putting something away for retirement.
3. Pay off any debt with interest rates over 4-6%. If the rate is below 4%, you’re probably better off investing any extra savings. If the interest rate is 4-6%, you can go either way depending on how comfortable you are with debt and how aggressive an investor you are. If the interest rate is over 6%, you’re likely to save more in interest by paying down the debt than you would earn by investing the money. Focus on the highest interest rate debts first to get debt-free as soon as possible.
4. Build up your emergency fund. Next, you’ll want to have access to enough cash to cover at least 3-6 months of necessary expenses and maybe even as much as a year’s worth. Your number may depend on how risky you feel your income is. Do not count credit card limits or home equity lines of credit as these can be cancelled, especially if you lose your job, which is when you’ll probably need it the most. If you’re planning on selling investments or borrowing from your retirement plan, make sure you’ll still have enough available, even if the market takes a significant downturn.
It may feel like a lot of saving before investing more for retirement, but keep in mind that this amount is unlikely to make or break your retirement plan. On the other hand, not having it can really get you in trouble. One option is to save for both emergencies and retirement at the same time by contributing to a Roth IRA since anything you don’t withdraw for emergencies (you can access Roth IRA contributions any time and for any reason without tax or penalty) can grow and be withdrawn tax-free for retirement. Just be sure to keep the Roth IRA in cash until you have enough emergency savings elsewhere. At that point, you can invest it more aggressively for retirement.