“Mom, how much should I save?” my daughter asked, hoping to start out on her first real job the right way. Savings was also on the mind of a woman I met recently at a networking event. She mentioned that she put away her small bills on weekdays and larger bills over the weekend, and before she knew it, she had saved a surprisingly large sum, which she took to the bank. Good for her.
So here are a few tips and rules of thumb that will answer my daughter’s question.
Start with a Budget: If you never seem to have extra cash to put away, start by analyzing your expenses for a month. Allocate what you spend into two pockets: “needs” and “wants.” “Needs” are expenses that are necessary for living, such as food (dining out doesn’t count here), shelter, clothing (again, shopping as entertainment doesn’t count here), student loans, and other debt. “Wants” are discretionary expenses that you believe make life worth living, such as dining out, movies, concerts, and shopping for sport. Your savings should come out of the second pot.
Saving for Major Expenditures: Rather than maxing out your credit cards, it is better to save for major expenditures like home improvement projects, a new car etc. Figure out how much you need to save each month to accumulate the amount you need, and put that amount away before you spend on discretionary items. This is a good habit that our forefathers practiced before the dawn of easy credit. It will also save you from the slippery slope of accumulating credit card balances and the resulting interest payments that will surely affect your credit score and financial stability over time.
Saving for Retirement: If you are a twenty-something, like my daughter, saving for retirement could not be further from your mind. But the powerful effect of compounding interest shows how even modest amounts put away early in life add up to an estate-worthy amount when you are ready to retire. There is an example often cited by financial planners of two individuals of the same age, one who started saving a certain amount every year for 10 years and then stopped, but left the savings untouched, in a tax-deferred account, earning 8% per year until age 65. Her friend started 10 years later, and put away that same amount each year until she reached age 65, and still did not catch up with the first individual. Let’s give this example some numbers. Individual A put away $1000 a year for 10 years (a total of $10,000) starting at age 25 and accumulated $1.08 million at age 65. Individual B put away $1000 starting at age 35 for 30 years (a total of $30,000) and accumulated $991,000 at age 65. Point made: Start saving for retirement early, even if it is a small amount. Put it in a tax-deferred account like a 401K or 403b at work or an Individual Retirement Account (IRA) and let it accumulate.
Saving for College: The same principle applies to saving for your child’s college education. There are plenty of college savings plans that are tax sheltered, such as the Michigan Educational Savings Plan (MESP), that also allow you to deduct contributions against your state taxes. Open one up for your child at birth, and encourage relatives and friends to donate to the plan rather than spending on gifts that your child will soon outgrow.
Still need that rule of thumb? Experts cite the 50/30/20 rule: 50% of your paycheck for “needs,” 30% for “wants,” and 20% for savings. Of course, it is all contingent on where on the salary ladder you are. There are savings calculators available on the Internet to help you determine how much you should save for retirement based on your age, salary, and lifestyle. But saving anything is better than nothing, so dust off your piggybank and start today, even if it is with pennies. After all, to quote Ben (Ben Franklin, that is): “A penny saved is a penny earned”.
Ina Fernandez, CPA has over 25 years of investment experience, and is currently Managing Director at Birmingham, Michigan-based Liberty Capital Management, Inc.