It's April and that means we're in the midst of National Financial Literacy Month. I decided to focus on one of the most basic components of personal finance: saving. Our parents urged us to save and you probably urge your kids to save. Saving seems like simplicity itself - you just sock the money away for the proverbial rainy day.
That's a great idea, of course, but there are many possibilities for your savings, whether you're a young adult making your first strides into the worlds of work and money or you're getting older and juggling competing priorities. It's helpful to have some ideas on saving smart.
Some of my colleagues at Schwab gave this topic some serious thought and developed a list of savings priorities. What follows is a ladder of suggestions. Focus on the first rung and work your way up. Of course, your situation may change how you climb this ladder (for example, some people can't participate in Roth IRAs), but this should give you a good framework for making decisions.
- Take full advantage of your 401(k) company match. If your company sponsors a 401(k) plan and offers to match a percentage of contributions, your first savings priority should be to take full advantage of this terrific benefit. It's as close to free money as you're likely to get, providing an immediate, no-risk return on investment. In fact, the company match is so valuable that you should do it even if you are paying high-interest credit card debt.
- Pay off non-deductible consumer debt. When you've maxed out the 401(k) match, use your savings to eliminate credit card and other non-deductible consumer debt, such as car loans. Start with the debt with the highest interest rate and work your way down. As an example, say you have a credit card balance that is charged an interest rate of 13 percent. Unless you can receive a higher (risk-free) rate of return somewhere else, it just doesn't make mathematical sense to hang on to this debt.
- Create an emergency fund. Stockpiling an emergency fund should be your next priority. A cash cushion for the unexpected will help you weather a storm without going into debt or raiding your retirement account. Your goal should be to keep three months of essential living expenses (six months if your job stability is uncertain) in a very safe, liquid account. For homeowners, a standby line of credit can also serve this purpose, but remember you will generate interest expense if you tap it.
- Contribute more to a retirement account. Notice that the first rung on this ladder was to contribute enough to a 401(k) to receive the maximum company match. If you have covered the intervening rungs, additional savings should be earmarked for your 401(k) or other retirement account. If you don't have a 401(k) or a 403(b) at work, think about opening an IRA or Roth IRA and then funding it to the max. Remember, if you're covered by a retirement plan at work, your IRA deductibility may be limited; Roth IRA participation is restricted by income.
- Save for your children's education. If you're taking full advantage of 401(k) and other retirement plans and still have money to save, you may want to put it in a college fund for your kids. Note that your retirement should take precedence over their college education, since there are many ways to pay for college but few ways to pay for retirement - 529 plans can provide a great opportunity for college savings. The investments grow tax-deferred and withdrawals are tax-free if used for qualified education expenses. Coverdell Education Savings Accounts are more flexible, but much more limited in terms of contributions and eligibility.
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