We talk a lot about saving, both here and on our campaign site for America Saves. We offer advice, encouragement, and education about saving for the future. Today, in honor of Financial Literacy Month, we’re talking about the concept of saving at a broader level—we want to give a basic understanding of saving to help readers get a handle on the topic.
It seems obvious; we save to be able to afford something in the future. For most of us, the big savings goal is retirement. But people save to afford vacations, a home, a new vehicle, a college education, etc. Incentives have developed in our economy over time that encourage us to spend rather than save. (As we discussed in our post about Inflation, savings can diminish in value due to inflation, so it seems like a better idea to spend the money today rather than save.)
But if we don’t save, we end up relying on debt or a guaranteed income to get by. But if our income stream stops, and we max out our credit, then we’re facing financial disaster. We don’t want to see people having to lose their homes to foreclosure or max out all of their credit cards to get through a crisis. And Social Security is not meant to be one’s sole income in retirement—it’s merely a supplement to help prevent abject poverty.
Bank savings accounts are the most common place to store money, but these accounts typically earn very little interest. For saving to be worthwhile in the long term it needs to earn interest greater than the rate of inflation. Bank accounts don’t always do that. In fact, bank savings accounts usually earn less than 1% interest. The advantage is there is no limit on accessing your money, and you pay no penalties for withdrawal.
Money Market Accounts will require a minimum balance before you can establish an account, and you’ll be charged a penalty if you drop below the required minimum. These accounts may also have limits on how much money you can withdraw and how often. They earn higher interest than bank savings accounts.
CDs, or certificates of deposit, require you to store your money for a set period of time, and you will be penalized for early withdrawal. A CD will typically offer the highest interest rate you can get from your local bank or credit union. Like other bank-based savings account, CD’s are very low risk and will guarantee a safe return.
The most common retirement account is the 401(k), which are offered by employers. You get to fund the account before taxes are calculated on your income, which carries tax advantages in the short term (but you will pay taxes on your withdrawals when you retire). Employers will frequently match some portion of your 401(k) deposits, which is a significant benefit.
IRAs, or Individual Retirement Accounts, offer special tax breaks to allow you to set aside money into personal retirement savings. You’re limited in how much you can contribute to an IRA. Traditional IRAs are pre-tax, like 401(k), so your contributions today reduce your taxable income. But when you withdraw funds in retirement, you’ll pay taxes on that income. A Roth IRA is funded post-tax. So you pay your taxes today, then put money aside for retirement, and you don’t pay extra taxes when you retire.
Stocks & Investment Funds
We’ll talk more about investing in a future post, but be aware of investment funds as a potential savings vehicle. These funds can grow more than any other kind of savings, but they carry greater risk. The stock market is volatile, so investing too much in any one company will leave you vulnerable to sudden losses.
Besides buying individual stocks, one can invest in mutual funds, which spread the investment out over many companies, and make your investment safer, but involve some trade-offs.
A common savings goal we urge people to set is establishing an emergency savings fund. This creates a cash reserve that is quickly accessible in the event of an emergency.
As for how much to save, experts advise having enough income on hand to get you through a period of joblessness. The average duration of unemployment for American workers is just over 6 months. So a good starting point for an emergency fund is six months’ income.
Part of the savings process is adding to your savings fund over time. Regular deposits, no matter how small will add up. Saving over a lifetime for something like retirement gives you plenty of time, but you should not wait to get started. Begin making deposits, even small ones, so that your savings can grow.
Besides accumulating deposits, the interest your savings earns will compound over time. See our post on the Basics of Interest for more information and learn the Rule of 72.
Besides setting aside money and ensuring your funds earn adequate interest, the other important thing to do is control spending. By budgeting wisely and spending less, you not only set aside more money for potential savings, you develop better habits that you will need when you retire.
Most people can’t change their spending habits overnight. Well before retirement comes, you need to get in the habit of living on a budget, spending less, and making your dollars go farther. Developing these habits ahead of time will be vital to making the transition to a fixed income in retirement.