Accumulating a rainy-day fund

The future is unpredictable. Take the uncertainty simply surrounding your job: You could lose your job, or you might want to leave it. Because you don’t know what the future holds, preparing for the unexpected is financially wise. Enter the emergency or rainy-day fund.

The size of your emergency fund depends on your personal situation. Begin by considering how much you spend in a typical month. Here are some benchmarks for how many months’ worth of living expenses you should have:

• Three months’ living expenses: When you’re starting out, this minimalist approach makes sense if your only current source of emergency funds is a high-interest credit card. Longer-term, you could make do with three months’ living expenses if you have other accounts, such as a 401(k), or family members and close friends whom you can tap for a short-term loan.
• Six months’ living expenses: If you don’t have other places to turn for a loan, or if you have some instability in your employment situation or source of income, you need more of a cushion.
• Twelve months’ living expenses: Consider this large a stash if your income fluctuates greatly or if your occupation involves a high risk of job loss, finding another job could take you a long time, or you don’t have other places to turn for a loan.

Saving for large purchases

Most people want things — such as furniture, a vacation, or a car — that they don’t have cash on hand to pay for. I strongly advise saving for your larger consumer purchases to avoid paying for them over time with high-interest consumer credit. Don’t take out credit card or auto loans — otherwise known as consumer credit — to make large purchases. (Don’t be duped by a seemingly low interest rate on, for example, a car loan. You could get the car at a lower price if you don’t opt for such a loan.)

Paying for high-interest consumer debt can undermine your ability to save toward your goals and your ability to make major purchases in the future. Don’t deny yourself gratification; just figure out how to delay it. When contemplating the purchase of a consumer item on credit, add up the total interest you’d end up paying on your debt, and call it the price of instant gratification.

Investing for a small business or home

In your early years of saving and investing, deciding whether to save money to buy a home or to put money into a retirement account presents a dilemma. In the long run, owning your own home is usually a wise financial move. On the other hand, saving sooner for retirement makes achieving your goals easier and reduces your income tax bill.

Presuming that both goals are important to you, you can save toward both goals: buying a home and retiring. If you’re eager to own a home, you can throw all your savings toward achieving that goal and temporarily put your retirement savings on hold.

You can make penalty-free withdrawals of up to $10,000 from Individual Retirement Accounts (IRAs) toward a first-time home purchase. You might also be able to have the best of both worlds if you work for an employer that allows borrowing against retirement account balances. You can save money in the retirement account and then borrow against it for the down payment on a home. Consider this option with great care, though, because retirement account loans generally must be repaid within a few years or when you quit or lose your job (ask your employer for the details).

When saving money for starting or buying a business, most people encounter the same dilemma they face when deciding to save to buy a house: If you fund your retirement accounts to the exclusion of earmarking money for your small-business dreams, your entrepreneurial aspirations may never become reality. Generally, I advocate hedging your bets by saving money in your tax-sheltered retirement accounts as well as toward your business venture. An investment in your own small business can produce great rewards, so you may feel comfortable focusing your savings on your own business.

Saving for kids’ educational costs

Do you have little ones or plan to have them in your future? You probably know that rearing a child (or two) costs really big bucks. But the biggest expense awaits when they reach young adulthood and want to go to college, so your instincts may be to try to save money to accomplish and afford that goal.

The college financial-aid system effectively penalizes you for saving money outside tax-sheltered retirement accounts and penalizes you even more if the money is invested in the child’s name. Wanting to provide for your children’s future is perfectly natural, but doing so before you’ve saved adequately toward your own goals can be a major financial mistake.

This concept may sound selfish, but the reality is that you need to take care of your future first. Take advantage of saving through your tax-sheltered retirement accounts before you set aside money in custodial savings accounts for your kids.

Investing short-term money

So where should you invest money earmarked for a shorter-term goal? A money market account or short-term bond fund is a good place to store your short-term savings. See Chapters 7 and 9 for more information on these options. The best bank or credit union accounts (covered in Chapter 6) may be worth considering as well.

Understanding retirement account perks

Where possible, try to save and invest in accounts that offer you a tax advantage, which is precisely what retirement accounts offer you. These accounts — known by such enlightening acronyms and names as 401(k), 403(b), SEP-IRA, and so on — offer tax breaks to people of all economic means. Consider the following advantages to investing in retirement accounts:

• Contributions often provide up-front tax breaks. By investing through a retirement account, you not only plan wisely for your future but also get an immediate financial reward: lower taxes, which mean more money available for saving and investing. Retirement account contributions generally aren’t taxed at either the federal or state income tax level until withdrawal (but they’re still subject to Social Security and Medicare taxes when earned). If you’re paying, say, 30 percent between federal and state taxes (see Chapter 4 to determine your tax bracket), a $4,000 contribution to a retirement account lowers your income taxes by $1,200.

  Modest income earners also may get an additional government tax credit known as the Retirement Savings Contributions Credit. A maximum credit of 50 percent applies to the first $2,000 contributed for single taxpayers with an adjusted gross income (AGI) of no more than $18,500 and married couples filing jointly with an AGI of $37,000 or less. Singles with an AGI of between $18,500 and $20,000 and married couples with an AGI between $37,000 and $40,000 are eligible for a 20 percent tax credit. Single taxpayers with an AGI of more than $20,000 but no more than $31,000, as well as married couples with an AGI between $40,000 and $62,000, can get a 10 percent tax credit.

• Your employer may match some of your contributions. This cash is free money from your employer, and it’s use it or lose it, so don’t miss out!
• Investment returns compound tax-free. After you put money into a retirement account, you get to defer taxes on all the accumulating gains and profits (including interest and dividends) until you withdraw the money down the road. Thus, more money is working for you over a longer period of time. (One exception: Roth IRAs offer no up-front tax breaks but permit tax-free withdrawal of investment earnings in retirement.)

Grappling with retirement account concerns

There are legitimate concerns about putting money into a retirement account. First and foremost is the fact that once you place such money inside a retirement account, you can’t generally access it before age 59½ without paying current income taxes and a penalty — 10 percent of the withdrawn amount in federal tax, plus whatever your state charges.

This poses a problem on several levels. First, money placed inside retirement accounts is typically not available for other uses, such as buying a car or starting a small business. Second, if an emergency arises and you need to tap the money, you’ll get socked with paying current income taxes and penalties on amounts withdrawn.

You can use the following ways to avoid the early-withdrawal penalties that the tax authorities normally apply:

• You can make penalty-free withdrawals of up to $10,000 from IRAs for a first-time home purchase or higher educational expenses for you, your spouse, or your children (and even grandchildren).
• Some company retirement plans allow you to borrow against your balance. You’re essentially loaning money to yourself, with the interest payments going back into your account.
• If you have major medical expenses (exceeding 10.0 percent of your income) or a disability, you may be exempt from the penalties under certain conditions. (You will still owe ordinary income tax on withdrawals.)
• You may withdraw money before age 59½ if you do so in equal, annual installments based on your life expectancy. You generally must make such distributions for at least five years or until age 59½, whichever is later.

If you lose your job and withdraw retirement account money simply because you need it to live on, the penalties do apply. If you’re not working, however, and you’re earning so little income that you need to access your retirement account, you would likely be in a low tax bracket. The lower income taxes you pay (compared with the taxes you would have paid on that money had you not sheltered it in a retirement account in the first place) should make up for most, if not all, of the penalty.

But what about simply wanting to save money for nearer-term goals and to be able to tap that money? If you’re saving and investing money for a down payment on a home or to start a business, for example, you’ll probably need to save that money outside a retirement account to avoid those early-withdrawal penalties.

If you’re like most young adults and have limited financial resources, you need to prioritize your goals. Before funding retirement accounts and gaining those tax breaks, be sure to contemplate and prioritize your other goals (see the section “Setting and Prioritizing Your Shorter-Term Goals” earlier in this chapter).

Taking advantage of retirement accounts

To take advantage of retirement savings plans and the tax savings that accompany them, you must spend less than you earn. Only then can you afford to contribute to these retirement savings plans, unless you already happen to have a stash of cash from previous savings or an inheritance.

The common mistake that many younger adults make is neglecting to take advantage of retirement accounts because of their enthusiasm for spending or investing in nonretirement accounts. Not investing in tax-sheltered retirement accounts can cost you hundreds, perhaps thousands, of dollars per year in lost tax savings. Add that loss up over the many years that you work and save, and not taking advantage of these tax reduction accounts can easily cost you tens of thousands to hundreds of thousands of dollars in the long term.

The sooner you start to save, the less painful it is each year to save enough to reach your goals, because your contributions have more years to compound. Each decade you delay saving approximately doubles the percentage of your earnings that you need to save to meet your goals. If saving 5 percent per year in your early 20s gets you to your retirement goal, waiting until your 30s to start may mean socking away approximately 10 percent to reach that same goal; waiting until your 40s means saving 20 percent. Start saving now!

Surveying retirement account choices

If you earn employment income (or receive alimony), you have options for putting money away in a retirement account that compounds without taxation until you withdraw the money. In most cases, your contributions to these retirement accounts are tax-deductible. This section reviews your options.

Selecting retirement account investments

When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps the federal, state, and local governments from taxing your investment earnings each year. You still must choose what investments you want to hold inside your retirement account shell.

You may invest the money in your IRA or self-employed plan retirement account (SEP-IRAs and so on) in stocks, bonds, mutual funds, and even bank accounts. Mutual funds (offered in most employer-based plans) and exchange-traded funds (ETFs) are ideal choices because they offer diversification and professional management. See Chapter 10 for more on mutual funds and ETFs.