Does this sound familiar? You, wide awake at 2 a.m.: I’ll never save enough to send the kids to college. At 3:45: Or to pay off the house. At 5:15: And, good grief, what about retirement?! I’ll have to eat cat food! Whether you’ve saved a lot or saved zip, money worries don’t have to keep you up at night—just follow this easy strategy, which tells you what to save for first and second (and why). If you’re a novice, start at the beginning. But if you’ve already put money aside, then you’ve probably knocked off a step or two here, so start reading at the point that applies to you.
2 of 7Brian Rea
Step 1: Start Building Your Emergency Fund
Clunkity-clunk-clunk. Your car has been making that noise for months and needs to be fixed. The problem? You don’t have any liquid cash for repairs. That’s why establishing a rainy-day fund should be your number one objective. Given the still fragile economy and the rocky job market, you need to have a cushion in case you are hit with a loss of income or face an unforeseen expenditure. Don’t assume that you can skip this step and use your credit card instead. “Ten years ago, you could have. But with the recent tightening of credit, you could easily get in a bind that costs more than what you can charge,” says DeDe Jones, a financial planner in Denver. (And, ideally, you shouldn’t take on any high-interest credit-card debt, either.) Begin by setting aside 5 to 15 percent of your income until you have squirreled away enough to establish your emergency fund. It should cover one to two months of your bare-bones budget—what you need for basic expenses, such as utilities, groceries, and the mortgage or rent (not after-work drinks or a Netflix subscription). Each time you get paid, have this money deposited into a dedicated savings account or a money-market account. (Find some of the best interest rates at IngDirect.com and SmartyPig.com, an online bank that focuses on setting financial goals.) And if you think you’ll be tempted to blow your stash on, say, a smart new bag, place this money in an account that isn’t linked to an ATM.
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Step 2: Begin Saving for Retirement
Why is it important to set up your emergency fund first, then start socking away for retirement? Because unless you’re a member of the 65-plus crowd, using retirement funds to pay for expenses usually isn’t a good idea. After all, you’ll have to pony up taxes on your withdrawals, and you may even get hit with a penalty. Start by setting aside at least 3 percent of your salary. If you’re self-employed or your company doesn’t offer retirement benefits, opt for an individual retirement account (IRA). If your workplace contributes to your retirement (according to the benefits consulting firm Aon Hewitt, 65 percent of employers offer some sort of matching benefit), ideally put enough in your 401(k) to receive the full matching amount. Once you’ve been saving for one to three months and you’re accustomed to a slightly smaller paycheck, move on to the next step.
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Step 3: Top Off Your Emergency Fund
You’ve already gotten a start on your just-in-case account and you’ve been saving for the long-term, so now it’s time to add even more cash to your emergency stash. Most financial planners recommend that you ultimately have three to six months’ worth of living expenses set aside. If you have a fluctuating income (say, you’re paid on commission), you may need to save even more—about six to nine months’ worth, says Jones, since a calamity could come at a time when your income is reduced. If possible, use a tax refund, a bonus, or a recent raise to help fortify your rainy-day fund. And going forward, track your spending carefully (Mint.com is a great resource) to determine where you can cut back in order to save more.
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Step 4: Pay Off All Credit-Card Debts
Yes, that’s right: Tackling your credit-card bills is step four. Why not pay them down earlier? For one thing, you don’t want to accumulate even more debt if you’re faced with an unexpected expense. And it’s crucial to get started on retirement savings. If you don’t have any rotating balances, go ahead to step five. But if you do, begin by making a list of all your card bills, then start paying off the one with the highest rate first—this will eliminate the balance that costs you the most. Then move to the card with the second-highest rate, and so on. (Do this regardless of which card has the lowest balance or the highest annual fee.) If you can, transfer a balance from a high-rate card to a low-rate card. To find one with a no- or low-balance transfer fee, go to CreditCards.com or check with your local bank, which may offer a promotion. And if you have some equity in your house, “consider refinancing your mortgage and consolidating your debt, which allows you to deduct the amount of interest you’ve paid on your taxes,” says Amanda Gift, a financial planner in Norfolk, Virginia. However, be sure to proceed with extreme caution. If you combine your credit-card debt into your mortgage and then fail to make your payments, you risk having your home go into foreclosure.
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Step 5: Boost Your Retirement Savings
The extra bump in retirement savings that you need to make now depends on your age, the amount of savings you already have, and your anticipated costs for later in life. Use the retirement-savings calculator at Kiplinger.com to find out your monthly savings goal. If possible, save the legal maximum every year: $16,500 for a 401(k) or $5,000 in an IRA. If you’re 50 or older, you’re allowed to make so-called catch-up contributions—additional annual deposits of up to $5,500 in a 401(k) or $1,000 in an IRA. Once you’ve been hitting your target for a year or more, go ahead to the final step.
Keep in mind that funding your retirement should be a high priority—even higher than saving for your kids’ college education. You may have heard this before, but it bears repeating: You can borrow for college, but you can’t borrow for retirement. “For one, federal financial-aid formulas don’t include retirement savings when determining the amount of aid your child receives, so you won’t be penalized for having a large fund,” says Joseph Hurley, an accountant and the founder of Savingforcollege.com, a college-planning website. Plus, you can withdraw money from retirement accounts and use it to pay for college expenses without incurring a penalty. You will, however, have to pay income tax on any money you take out.
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Step 6: Save for Your Kids’ College Tuition, Pay Off the House, or Tackle Any Other Big Goal
Congratulations! If you’ve gotten this far, your finances should be in tip-top shape. So it’s time to address your remaining priorities. Create savings goals and sock away money until you hit the targeted amount. If you’re saving for multiple objectives at the same time, keep the funds in separate accounts rather than lumping them all into one. (That way, you won’t wipe out your emergency fund when you’re, say, remodeling the kitchen.) Among the major goals you may still want to hit are these.
Saving for your kids’ college tuition: When it comes to this expense, defining the anticipated cost is tricky. Will your child attend a four-year private school or a public one? Run the numbers for both scenarios to see if saving 100 percent is realistic for you. Use the calculator at Savingforcollege.com, which factors in the rate of tuition inflation. Be aware that the cost may well exceed what you’re going to be able to provide. For example, the site suggests you save $686 a month (!) to send a now five-year-old to college in 2024, assuming you’ve already saved $5,000. Therefore you may ultimately decide to modify your budget so you can save more or adjust your savings expectations. If you do put away money for college, consider a 529 plan. It allows contributions to grow tax-deferred, and withdrawals used to pay for college are federally tax-free. (Go to CollegeSavings.org for info.)
Eliminating other debt (such as a car or home-equity loan): If you plan to use your savings within five years, keep your money in an account that’s stable and liquid, like a CD or a money-market, savings, or interest-earning checking account.
Buying a cabana in the Florida Keys, remodeling the kitchen, or some other lifelong dream: As long as you have more than five years before you head for a warmer climate, you can afford to take some risk, so go ahead and invest a portion of your money in the stock market.