Day 6: GOBankingRates wants to help you Live Richer. For a month, we’ll be sharing daily tips for how you can do just that, with advice on budgeting, saving, investing, making the most of your career and managing debt — plus money advice for every phase of your life. Check back each day during our 31 Days of Living Richer to learn everything you need to know to set yourself up for financial success and live the richest life possible.
So, you’ve finally committed to getting serious about saving and investing. Congratulations! Over time, even small steps, thanks to the power of compound interest, can reap big rewards in the long run. But if you’re just starting out, it can be hard to decide which you should prioritize, long-term retirement money or short-term savings.
Go Back To Day 5 of Living Richer: How To Save a Little Each Month (It Goes a Long Way)
And Day 4: How To Live Richer on a Budget
The truth is that both a savings account and a retirement account are critical portions of an overall savings and investment strategy. But if you’ve only got a limited amount to start with and you want to know which choice is more important than the others, there are ways to help narrow down which might be the best choice for you. Here are six questions you should ask yourself to determine whether retirement or short-term savings should be your first step.
Do You Have an Emergency Fund?
If you’re just starting out and have absolutely no savings or investments of any kind, most financial experts would suggest that an emergency fund should be your first move. Even if you can only set aside $500 or $1,000, you’ll be well on your way to having a cushion of safety. According to a recent survey from GOBankingRates, a whopping 40% of Americans have less than $300 in savings. This means that even a minor unexpected expense, such as a car repair, could force the average American family into debt. That is a perilous financial situation to be in, so direct your first savings toward your emergency fund. Once you’re in a position where minor unexpected expenses won’t derail your finances, you can set your sights on longer-term investment goals.
And Check Out Day 3 of Living Richer: 5 Budgeting Apps That Can Help You Live Richer
Do You Have a Workplace Retirement Plan?
If you have access to a 401(k) or other retirement plans at your job, you should take full advantage of it. Not only will you likely get a tax deduction for your contributions, but a workplace retirement plan typically includes matching and employer contributions. For 2020, employers offering defined contribution plans, like 401(k) plans, made an average $4,020 contribution to employee accounts. That’s essentially free money that your employer adds to your account every year. Coupled with the tax benefits of an employer-sponsored retirement plan and the power of compound interest over time, you should always take advantage of these plans if they are offered. In this case, retirement contributions might take the nod over a short-term savings account.
How Old Are You?
Your age can help tip the scales as to whether you should prioritize short-term savings or long-term retirement investments. If you’re young, you have lots of years ahead of you to earn and save, so you can afford to ride out the ups and downs of stocks or other investments in a retirement account. However, if you’re already approaching retirement, you can’t afford to suffer a huge hit to your nest egg, as you won’t have the time it takes to fully recover. In this case, as an older investor, you should likely prioritize conservative, short-term savings.
One thing to note: If you’re already over age 50, the IRS allows “catch-up” contributions of an additional $1,000 into IRA accounts and $6,500 into 401(k) and other employer-sponsored plans annually. If you’ve already got an emergency fund and earn enough to tuck away large sums of money, you might consider taking advantage of these additional contribution limits and put them in conservative investments in your retirement accounts, such as CDs.
Do You Have Dependents?
If you have dependents, you’ll need to make sure that you’ve got adequate short-term savings to cover any number of family needs, from schooling and uncovered medical bills to class trips and other expenses. Funding for the short-term needs of your dependents should garner the lion’s share of your attention until you have an adequate amount in your savings account.
However, this doesn’t mean that you should save until every possible expense for your children is covered. As part of your college savings plan, for example, don’t forget to factor in the vast amount of student loans and financial aid that will likely become available to you. In other words, prioritize your dependents and their short-term needs but don’t divert all of your savings toward college planning and away from your own retirement, which doesn’t come with financial aid.
Do You Have a Short-Term Goal, Like Buying a House?
Retirement savings carry lots of benefits, but they also have many restrictions. With some rare exceptions, you can’t take withdrawals from tax-advantaged retirement accounts until age 59 1/2; doing so generally triggers taxes plus a 10% penalty. Thus, if you have a short-term savings goal, such as buying a car or a house, retirement accounts are not the place to put those funds.
As a side note, many financial analysts suggest that you shouldn’t put money that you’ll need in the next five years into the stock market, as the risk of an irrecoverable loss is too high. Thus, if you’re looking to buy a house in five years or less, not only should you keep that money in short-term savings, you should also avoid high-risk investments with those funds.
Do You Have Adequate Insurance?
Depending on what phase of life that you’re in, various forms of insurance are vital to own. From auto and home insurance to life, health and disability insurance, policies sufficient to cover unexpected surprises can help you from draining your emergency fund or going into debt. If you don’t have adequate coverage, you’ll need a significant emergency fund. However, if you’ve got all your bases covered, you can likely divert your savings into your retirement accounts.
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