Throughout our lives, we are advised to save for college, retirement, or unexpected emergencies. While these are all important things to save for, this ignores a lot of opportunities and creates a big gap in savings. Consider John Smith, a 40-year-old plumber who has a healthy emergency fund in the bank earning a whopping 0.25%, is contributing to his 401(k) at work, and even regularly contributes to a Roth IRA. Outside of these things, John isn’t saving anywhere else. So, he is covered for emergencies tomorrow and has a nest egg for retirement at age 60, but what about the many things that could come up in the next 20 years?
This is a very common scenario. It is a good thing that John is diligent about his retirement savings, and that he has some money saved up for an unexpected emergency. Let’s assume for a minute that John also wants to finish his basement in the next 5 years. He has done his homework and expects this project to cost around $50,000. If he wants to pay cash and gets started saving, it requires him to fund the entire project from his own cash flow. Sure he can set aside $10,000/year for the next 5 years, but isn’t there a way for him to save that puts less stress on his wallet? Of course! Rather than letting his savings waste away in the bank, or go into a retirement account that restricts his ability to draw the money back out, John has other options. One option is a standard brokerage account which would allow him to invest his savings and potentially earn more than the bank is paying. Since it’s not a retirement account, John is not restricted on how or when money goes into or comes out of this account. Now let’s assume that John is saving monthly and is earning an average of 4% on his investment. He only needs to set aside less than $755/month. In fact, over the course of 5 years, he will only have had to save $44,700 of his own money to pay for the basement.
One thing I often discuss is putting a purpose behind your money. The first step to this is figuring out what you want to accomplish with your time and money, then prioritizing those goals. Once you know what is important to you, and the timeline you have to accomplish it, you can really put some purpose behind where and how you save. I mentioned a brokerage account as one option, but there are a number of different ways John could theoretically put his money to work for him.
Investing, as with anything else in life, comes with give-and-take. I explain to clients that money in the bank is designed to be accessible and safe, but as a trade-off does not grow very much (if at all). Therefore, “bank money” should be earmarked only for needs or expenses that will come up in the next year or two. Retirement money provides special tax treatment, and if invested properly, should be growing (even if you’re already retired) to outpace inflation and ensure you don’t run out of money. But because of the IRS regulations, there are some limits on how much money can and should go into and out of those retirement accounts. So, in order to really take control of your money, you need to save in something that fills in the gap left between emergencies and retirement. Finding this balance is unique to everyone, so of course, I recommend consulting with a financial advocate who understands your personal situation and can explain the gives and takes of the options available to you.
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Written by: Justin Meyer