A friend of mine recently asked me a question:
“Should I be putting extra money into emergency savings or an IRA at the end of the month?”
Allocating funds and/or setting priorities for saving is something that many people struggle with.
Order to Prioritize Your Savings
- Most experts will agree that first and foremost you should fund a 401(k) or other employer-sponsored retirement account up to the point of match – you’re maximizing your return in this way because the match is free money. If you don’t receive a match, skip this step and save for retirement in an IRA instead.
- You should then work to build your emergency fund. Advice varies on the amount, but 3-6 months of non-discriminatory expenses is safe for most people.
- If you have big expenses coming up, such as a new car, a wedding, a big trip or something similar, set aside some portion of your savings to fund that future spending – this helps smooth your spending over the course of a year and is much better for your budget than incurring those big expenses all at once.
- Next, you should contribute to a Roth IRA if you’re eligible. If you’re not, you can contribute to a traditional IRA and do an immediate Roth IRA conversion.
- Finally, and only once you are debt-free AND satisfied with your savings in items 1-4 above, you might consider investing in taxable accounts.
Items 3 and 4 can and should be done somewhat concurrently – you need to strike a balance between short-term goals and long-term security. How much you should put towards each depends on how much of your salary you are able to save, and whether you’ve contributed to an employer-sponsored plan.
If you did contribute to an employer-sponsored plan, you can choose to save as much as you need for your short-term goals, and put the rest towards retirement. You can instead choose to save 10% of your salary towards retirement, and put the rest towards short-term goals. Or, if you’re in the enviable position of having more than enough to meet all your objectives, you can split the money right down the middle, putting half away for retirement and the other half towards those big-ticket items you’re saving for.
The friend who asked me the original question is in college – chances are family and/or financial aid are paying for many of her big expenses, and her paycheck is more for daily expenses such as food and entertainment. She is also unlikely to have an employer-sponsored retirement plan. Finally, she is so young that contributing to her IRA now could have big payoffs down the road. So for her, I might tweak the standard advice – depending on exactly how much money she is talking, I might tell her to build an emergency fund of $1,000 or 3 months of the expenses she is responsible for, whichever is larger. Then I’d encourage her to contribute at least half of the annual limit to an IRA (preferably a Roth IRA). If she still has money left over, I’d likely recommend she split it, saving half for post-grad expenses such as furniture and work attire and putting the other half towards maxing out her IRA.
When Should You Pay Off Debt?
Advice may also change if you are trying to get out of debt, in which case you want almost no savings beyond a small emergency fund and employer-matched retirement savings. If you are single, or married with one spouse not working, the lone salary matters much more – so you might need a bigger emergency fund.
The point is, like so much else in the world of personal finance, there is no easy answer to the question of what to do with extra funds. Every situation is different, and every person has a different risk tolerance. Once you are debt free, do your best to balance investing for the future with planning and saving for shorter-term expenses – and of course work on building a buffer for emergencies. Next up, Should You Use a Roth IRA as an Emergency Fund?
What is your preference? Emergency fund, pay off debt, or retirement first?