I have been talking with a young friend about a lot of different financial topics over the past couple of months. I realized that the challenges my young friend faces are the same things that almost all young adults deal with. Over the next few months, I'll be sharing some of our conversations. Maybe you're wrestling with some of the same questions. Or, like me, maybe you have a young friend you could share these conversations with. ~ Karen
I've managed to save some money. But I have no idea where to go from here. What should I do with it? Right now, it's in a savings account because I know it's safe there. I don't know if I should be investing some of it; the idea scares me. You know that making financial decisions is hard for me! But if you could give me some insight or ideas on this, I'd appreciate it.
Dear Young Friend,
I should start out by saying that I'm really proud of you for managing to build up some savings in spite of all the challenges you've faced. It's not easy being on your own, paying your own way, and dealing with things like car problems!
And it means a lot to me that you trust me enough for us to talk about your finances. I hope the ideas I share with be useful.
At long last, I am writing to you with some thoughts about what you might do with your savings. So here goes:
I know you don't have a lot of cash, but you may still want to consider shifting some of it out of your basic savings account. You can probably earn more on it, or reduce your income taxes – either now or down the road – or maybe both. Let's start by thinking about how and when you might need access to your money.
You'll probably want three different "buckets":
Savings that you can easily access, like in a checking, savings, or money market account, is Bucket #1. This would be money for small emergencies, or those expenses that only come up once in a while like your car registration. Keep at least enough here to cover your deductible if you had a car accident or a visit to the emergency room. Maybe $500 or $1000 would be enough. Do more if that makes you more comfortable.
Savings you could get to if you had a bigger emergency, but that you don't really expect to need in the next year or two, is Bucket #2. This is the bulk of your emergency fund. Since you don't know for sure when or if you'll need it, you don't want to invest it in something whose value could go up or down; you might need the money right when the value of your investment dropped! But it would also be nice to earn more interest than you get on a regular checking or savings account. So this money should probably go into a CD.
How much should go here? Ideally, your emergency fund could cover your expenses for at least 3 months; 6 is better. And if your job isn't very stable, you might try to get to 9 months.
Money that you want to put away for the long term should usually be invested rather than saved. That's Bucket #3. Investing gives you the chance to earn more than savings, but with some risk. After you take inflation and taxes into consideration, savings accounts and CDs usually lose money. It's not enough to matter over just a year or two. But time magnifies the impact of losses just as it compounds gains.
If you're putting that money away for 5 or 10 or 20 years or more, like for retirement, you want to use that time to compound growth and earnings. That means you need to invest the money. The most common way to invest is to put it in mutual funds. (More about that next time I write. But if you don't want to wait, read this.)
This investment could be in a regular account or in a retirement account. The retirement account has tax advantages compared to a regular account.
Next time, we'll talk about how to find a better interest rate on the money in Buckets 1 and 2. And then on, we'll get into the investing and retirement accounts thing. But if you'd rather dive into investing and retirement accounts first, let me know.
You probably have questions, too. Send them, so we can talk about them.
I guess that's it for now.