Sunday, April 29, 2007

Essential savings goals

I believe in 6 essential savings goals.

1) A diversified retirement portfolio.
2) A readjustment account.
3) A short term emergency fund.
4) A statistical readjustment account.
5) A freedom fund.
6) A 6 month expense emergency fund.

In that order.

1) A retirement portfolio should be made up of diversified funds and packages. A 401k is not the end-all of retirement planning. In fact, I would advocate fully funding a private package like a Roth IRA. It can be a balanced portfolio in of itself, but with the tax benefits and low maintenance fees it is superior, in my opinion, to a 401k. A 401k (or 403b) should only be contributed to before the Roth if there is an employer match - which there quite often is. Contribute up to the match, then contribute to the Roth IRA. It has limits also, and they change every tax year so you need to start planning your Roth contributions at the beginning of each year, contribute each month (to maximize your purchasing power, called dollar-cost-averaging) and then when you are capped, funnel the rest into the 401/403.

2) I previously wrote a post about my readjustment account. This is an essential savings vehicle that normalizes your budget and allows you to weather months that come with large bills. It also helps you evaluate your real yearly spending. Rather than your monthly bills jumping around, you see each month what your lifestyle is costing you. It is rather difficult to have a solid savings plan if you have a $300 bill one month that you are not properly prepared for. This should be a checking account, as it needs to be accessed often. Another advantage? If you are short on money before your paycheck comes you've got a nice pool of cash to borrow from without touching your savings.

3) A short term emergency fund is not an emergency fund that financial advisers insist you have. That's important too, but this fund is for little things that crop up in the course of the year. Things like the car breaking down, although that is eventually covered by the statistical readjustment account (goal 4). The last thing you need to do is dip into your 6 month emergency fund, which is there to cover you if you are temporarily ill or unemployed. This fund needn't be large, a couple thousand at the most. I recommend a savings account associated with your bank, so you can instantly move money to your checking via online if needed. Also why we don't want this fund very large; we lose the benefit of the high-interest savings our 6 month emergency fund enjoys.

4) Read the post on the Readjustment Account for information on how this works. This is similar, but it really is an emergency fund. It need not be entirely liquid, so a high-interest online savings account will do nicely. It takes some calculating, and some diligence in paperwork, but I think it's worth it. The car repair example is perfect. How much do you spend on maintenance for your car? Oil changes, radiators all adds up. Get as much data as you can, add it up, divide it by the number of months you collected it and there is your average monthly spending. Do this for several other categories and you have your monthly expense for this account. This can be included "virtually" in your regular Readjustment Account checking account, and it provides a nice cushion in that account.

5) The freedom fund is to give us that high that credit card lenders prey on. We love to spend, we love to buy. Our freedom fund should be a set amount that we allow ourselves to spend every year on...well, anything! Frivolous spending on fancy pillows can be purchased from this account. The only catch is you need to be disciplined, if you empty your account for the year on one purchase...tough beans. There's always next year. I feel this is essential as someone who is married, because we don't always want to feel tied to our spouse for every purchase because our budget is so tight.

6) Here's the one that experts all recommend, and I couldn't agree more. A 6 month emergency fund saves you from an unexpected illness or job loss. This is something whose principle shouldn't be touched (and needn't grow unless your regular expenses do). It's not an investment, its not a spending account, its there to shield you from financial disaster should disaster strike. This should be in very safe CDs or high-interest savings. And I wouldn't feel bad about skimming the interest off to fund, say, the freedom account.

The best part about it? By the time you have fully funded all of these savings vehicles, you're essentially saving 20-30% of your income. If a long-term disaster does strike, you can minimize the damage by temporarily halting your paycheck distributions to one or more of these funds. You slowly reduce your dependency on 100% of your paycheck, thereby living well within your means, and assuring your financial security overall.

So where to begin? Financing all these savings vehicles can be overwhelming, to say the least. Later I'll explain how I started (and, in fact, I'm still working towards some of these goals).

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