A reader asks what to do with her extra cash. Laura recommends an action plan called PIP that can solve just about any financial dilemma.
While keeping that much in savings may sound boring, the goal for your emergency fund is safety, not growth. The idea is to have immediate access to your cash when you need it. That’s why I don’t recommend investing your emergency money, unless you have more than a six-month reserve.
If you don’t have enough saved, make a goal to bridge the gap over a reasonable period of time. For instance, you could save one half of your target over two years, or one third over three years. Put it on autopilot by creating an automatic monthly transfer from your checking into your savings account.
If you’re like Erica and already have enough saved, consider moving it into a high-yield savings or money market account that pays slightly more interest for large balances. You can find the best federally insured banks and credit unions at sites like Bankrate.com and DepositAccounts.com
Resource: Online Bank Comparison Chart (PDF) free download—a review of 7 of the best online banks!
Another important aspect of preparing for the unexpected is having enough of the right kinds of insurance. Here are some common policies that you probably need:
- Auto insurance if you drive your own or someone else’s vehicle.
- Homeowners insurance, which is typically required when you have a mortgage.
- Renters insurance if you rent a home or apartment.
- Health insurance, which is legally required under the Affordable Care Act, known as Obamacare.
- Disability insurance, which replaces a portion of income if you get sick or injured and can no longer work.
- Life insurance if you have dependents or debt co-signers, who would be hurt financially if you died.
How to Invest for the Future
Once you start building an emergency fund and have the right kinds of insurance, begin the second goal that I mentioned: invest for retirement. That’s the “I” in PIP, right behind prepare for the unexpected. If you’re like most people, you’ll need to work on both of these goals at the same time.
In last week’s post, Are You Making Investing Too Complicated?, I explain exactly how to invest for retirement. Unlike your emergency fund, money in your retirement account should never be tapped until you retire.
Another huge distinction between saving and investing is safety. Remember to keep savings safe. However, safety comes at a cost because it gives you no or little return. To beat inflation and earn enough to accumulate one or more million dollars for retirement, you must invest and take some amount of risk.
Use qualified retirement accounts, like a workplace plan or an IRA, to get extra tax savings that work in your favor. Some employers match a certain percentage of your contributions to a 401k or 403b, which turbo charges your account. So always invest enough to max out any free matching at work.
Erica says she’s contributing to her company’s 403b, which is terrific—but she didn’t say how much. My recommendation is to contribute no less than 10% to 15% of your pre-tax income for retirement.
For 2015, you can contribute up to $18,000, or $24,000 if you’re over 50 years old, to a workplace retirement plan. And by the way, those limits apply to just your contribution. If your employer provides matching, you can exceed those amounts.
Contributions to a retirement plan at work can only come from your paycheck. In other words, you can’t move money from your savings into a 401k or 403b. You must adjust your payroll deduction to increase or decrease the amount you invest.
Also see: The Rules for Using a Spousal IRA
Always tackle your high interest debts first because they’re costing you the most. They usually include credit cards, car loans, and personal loans with double-digit interest rates.
How to Pay Off High-Interest Debt
Once you account for the first two parts of my PIP plan by preparing for the unexpected and investing for the future, you’re in a perfect position to also pay off high-interest debt, the final “P.”
Always tackle your high interest debts first because they’re costing you the most. They usually include credit cards, car loans, personal loans, and payday loans with double-digit interest rates.
Remember that when you pay off a credit card that charges 18%, that’s just like earning 18% on an investment after taxes—pretty impressive!
Common low-interest debts include student loans, mortgages, and home equity lines of credit. These 3 types of debt also come with tax breaks for some or all of the interest you pay, which makes them cost even less. So don’t even think about paying them down before implementing your PIP plan.
Let’s say Erica identifies the right amount to isolate for her emergency fund and purchases any missing insurance coverage and still has cash left over. She could use some or all of it to pay down her only debt, which are low-rate student loans.
However, since Erica is ahead of the curve, financially speaking, another acceptable option for her would be to work on other goals. These are icing on the cake once you’ve put your PIP plan into motion. They might include saving for a house, car, vacation, a child’s education, or any other goal that aligns with your values and dreams.
Also see: Should You Pay Down Debt or Invest?