In a previous post, I outlined the basics behind the 50/20/30 budgeting rule. In this post, we will look more closely at the 20% of that rule.
20% to Savings
In the 50/20/30 budgeting rule, 20% of your after-tax income should go to savings. There are many ways to save, and these various avenues provide different benefits. Ideally, your savings should include an emergency fund in a savings account and a diversified portfolio to help you prepare for your future and retirement.
Emergency Savings Fund
An emergency fund is a savings account with funds set aside for unexpected expenses. A good rule of thumb is to have approximately 3-6 months’ worth of living expenses in an emergency fund. To do this: start by calculating your costs for critical expenses such as housing, food, health care, utilities, transportation, and debt repayment. Multiply this total by 3 or 4 and set this amount aside into a savings account that you can withdraw from without penalty. If your income isn’t steady or you’re in an industry where layoffs are common or the economy is in a recession, you may want to increase your emergency fund to 5-6 months’ worth of living expenses.
Expert tip: Choose an online bank savings account for your emergency fund as they offer higher interest rates while being a safe place to park your money.
After establishing an emergency fund, the next part of your savings contribution should be to a retirement account. There are three main types of retirement accounts: IRAs, 401(k)s and Roth IRAs.
IRAs vs 401(k)s – Individual Retirement Accounts (IRAs) and 401(k)s are retirement plans that enable you to delay paying taxes until your money is withdrawn. The big difference between the two is that IRAs are opened by individuals on their own through a broker or a bank, whereas 401(k)s are offered by employers. Many employers offer a 401(k) match, which means for every $1 an employee contributes to their 401(k), the employer matches $1 (or a fraction of a $1) to that individual’s 401(k) as well.
If your employer offers a 401(k) match, it’s best to contribute enough money to your 401(k) to get the maximum match. However, if your employer doesn’t offer a company match, it may be wise to open an IRA instead, as 401(k)s have a limited selection of investments and may require higher administrative fees.
Roth IRAs – Unlike IRAs and 401(k)s, Roth IRA contributions are after-tax, so there is no immediate tax benefit, however, Roth IRAs offer tax-free growth and tax-free distributions as long as the account is owned for at least 5 years and distributions are made after the age of 59 ½.
There are income limitations and annual contribution limitations for all 3 retirement accounts
There can be significant penalties for withdrawing before the allowable distribution age
There are minimum distribution requirements for IRAs and 401(k)s
Other Savings & Investment Vehicles
There are many other savings and investment vehicles available that come with various advantages and risks. Savings vehicles should offer interest or dividend income with relatively minimal risk. These include certificates of deposit (CDs), money market funds, treasury bills & notes, and bonds.
One little-known type of savings bond that can pay a high interest rate while being 100% backed by the federal government is Series I Savings Bond (also called I Bonds). This type of bond is intended to protect the investor against inflation, so when inflation is high, interest rates for I Bonds increase. The government sets the rate of interest twice a year for the following 6 months. Investors can redeem the I bond after 12 months but lose 3 months of interest if cashed in before 5 years.
It’s important to remember that diversification is the best way to minimize risks that come with investing. Ideally, your savings portfolio should include a mix of various types of savings vehicles.