When we manage our finances we typically pay for necessities and make monthly payments on debt, so these are the items that get our attention. Saving on the other hand, tends to get the least attention because it seems optional. We can’t skip paying our rent or a car payment, but we can skip a deposit to our savings (or so it seems). But our saving plan needs to be as much a part of managing our finances as making payments and eliminating debt. As we’ll see in the next few paragraphs, sticking to a regular saving plan can actually help us to eliminate debt. But first, let’s review what a saving plan should look like.
Our saving plan should cover three essential areas: having cash on hand for unexpected bills, having money put aside to cover expenses in case our income is interrupted, and having a large amount for later in life when we stop working or work in a reduced capacity.
The first saving area or our cushion account contains an amount that we set aside for cash-on-hand to cover things like replacing a broken appliance or an unexpected car repair. Even if we use a credit card in these situations, the cushion account allows us to pay the balance in full when the bill arrives. This keeps us from adding short-term debt or paying interest on a credit card balance. The amount in this cushion account could be $2,000, $3,000, or even $5,000 depending on our feelings about the amount we should have on hand. And since we want the money to be available, a cushion account is usually kept in a regular or money market savings account.
The second area of savings or our emergency account, contains an amount that keeps our personal economy going (pays the bills) in a situation where employment changes. It’s a safety net for our finances if we’re suddenly unemployed or our income changes for the worse. The amount in this account could be enough to pay for three, six, or even twelve months of expenses depending on our thoughts about our employment picture. These amounts for a person with $2,250 in monthly expenses are shown below.
Emergency Fund Amounts
One Month Three Months Six Months One Year
$2,250 $6,750 $13,500 $27,000
It’s easy to see how quickly we can get into trouble if we don’t have an emergency fund and our income stops. Without it, we’ll either start withdrawing from our long term savings (if possible), or start taking on a large amount of debt to keep going. As far as where to keep our emergency fund, there are a variety of recommendations. All things considered (interest rates, quick access, etc.), and I’ll expound on this another time, I think that an insured money market checking account makes sense.
The third area of savings is our long-term or retirement account. This is our IRA, 401(k), or other retirement fund or account that we’ll use to replace income later in life. Referring back to the amounts for the emergency fund above, the amount needed to cover just one year of expenses was $27,000. Consider the amount needed to cover expenses for 30+ years of retirement.
30 Years of $27,000 in annual expenses = $810,000
And this amount doesn’t consider inflation and how expenses will increase over time. The amount could actually be larger. I’ll discuss at another time how we determine a more exact amount that includes inflation, and interest we could be earning or return on investment with this large amount. For our purposes now, we can see that our long-term savings amount could be a very large number and that we need to take saving for that period in our lives very seriously.
Once we establish our saving plan and the amounts for each account, we need a sure way to actually save. The most successful method is through automatic deposits. With automatic deposits, reaching our saving goal isn’t dependent on our making (and not forgetting) a deposit. And when saving is automatic we can determine about how long it will take to achieve the goals in our plan.
Using the example above, let’s assume that we’ve established the following saving plan.
- Cushion Account $2,000
- Emergency Fund $13,500 (six months of expenses)
- Long Term Retirement Account $810,000
Next, we’ll assume that we can save $50 each week through an automatic transfer from checking/debit into our cushion (regular savings) account. At this rate, it should take about 40 weeks (about 10 months) to reach our cushion account goal.
Cushion Account $2,000 = $50 weekly deposits x 40 weeks
When the account has reached $2,000, the deposits continue and when the balance is $2,500, we establish the account that will hold our emergency fund and move $500 (the overflow) from the cushion account to the emergency fund. Every time that the cushion account has an overflow of $500 (or whatever amount we choose), we move the overflow to the emergency fund. The reason that we use an overflow amount is because we may have to withdraw from the cushion account for something unexpected. When this happens, the automatic deposits replenish the cushion account. If we changed the automatic deposit from the cushion account to the emergency fund, then the cushion account would be reduced whenever we needed to pay for something unexpected. By sticking to our automatic deposit plan, we ensure that our cushion account will always have an adequate balance. We move the overflow when it’s available.
If all goes well and we don’t need to withdraw from the cushion account, the emergency fund goal is reached in about 5 years.
Emergency Fund $13,500 = 27 deposits of $500
We could shorten the amount of time needed to achieve our goal by increasing our weekly deposit, but not everyone is in a position to save more than $50 each week. And if $50 is too much of a bite out of weekly income, we can deposit a lower amount. The goal is to save what we can through regular deposits and to allow it to grow to the amounts that we’ve established for our saving plan. The two hardest parts to saving are getting started, and not interrupting the deposits.
Once our cushion account and emergency fund goals are met, if we don’t have a retirement account (IRA or 401(k)) through our employer, we can use the overflow to establish one and begin to deposit up to the annual allowable amount. Deposits to these types of accounts also lower our income for tax purposes, so there’s an added benefit. (I’ll blog a much more in-depth look at retirement accounts later.)
Establishing a saving plan requires short, medium, and long-term thinking based on our current and foreseeable expenses. This 3 Tiered approach uses these three time periods to determine the amounts for each of the parts of our plan. We establish and fund a cushion account, emergency fund, and long term savings account, in that order. The cushion account protects our emergency fund and long term savings by providing immediate cash for unexpected expenses. This also keeps us from taking on more short-term debt. The emergency fund protects our long term saving and personal economy by providing for expenses in the event that there’s an interruption in income. Our long term savings provides us with income later in life when we retire or work in a reduced capacity.
The “overflow” method keeps the cushion account fully funded by rebuilding it when we make withdrawals, and allows us to direct the overflow to the account of our choice. As debt is eliminated or income increases, we can increase our saving level to shorten the time to reach our savings goals. But we have to establish a plan, start saving, make it automatic, and stick to our plan. This approach is a major step toward financial independence.
Thanks for reading!