My QDT editor, Alyssa, was recently talking to her best friend about a financial dilemma. Erica, who is 28 years old, has accumulated a lot of savings, but she has no idea what to do with it. So Alyssa told her to email me for an answer.
Erica says:
“I’ve saved up $40,000 over the past two years, but it’s just sitting in my checking account. I know there must be a better place for it, but I’m torn between investing, paying off student loans or saving for a house.
I contribute to a 403(b) retirement plan through work and have about $85,000 in student loans that charge 4% interest. Is there a rule of thumb for how much of my savings I should use for these different purposes?”
Here’s a specific strategy to follow any time you’re not sure what to do with your money.
What to Do with Extra Cash
First, I want to congratulate Erica for being such a terrific saver! There are worse problems to have than not knowing what to do with a flush bank account.
Nevertheless, it can be unsettling to have a lot of money sitting idle.
Whether you’re a good saver or you get a cash windfall from a tax refund, an inheritance or the sale of a home, it’s a major opportunity in your financial life. So I want to make sure you don’t squander it.
Maybe you’re like Erica and have extra cash that could be working harder for you, but you’re not sure what to do with it. You may even be paralyzed and do nothing because you have a deep-seated fear of making a big mistake with your cash.
In some cases, having money sit idle is exactly the right financial move. But it depends on whether or not you’ve accomplished three fundamental financial goals, which I’ll review in a moment.
To know the right way to manage your extra cash, you need to step back and take a holistic view of your entire financial life. Consider what you’re doing right and where you’re vulnerable.
To make good financial decisions, think about using a three-pronged approach. I call it the PIP plan, which stands for:
- Prepare for the unexpected
- Invest for the future
- Pay off high-interest debt
Let’s examine each one so you understand how to use the PIP (prepare, invest and pay off) approach for your situation.
1. Prepare for the Unexpected
The first fundamental goal you should have is to prepare for the unexpected. As you know, life is full of surprises. Some of them bring happiness, but there are infinite devastating events that could hurt you financially.
In an instant, you could get fired from your job, need to travel to see a loved one, be the victim of theft, get an oversized tax bill, experience a natural disaster, get a serious illness or lose a spouse.
Being prepared for what may be around the corner is a work in progress. It should change over time, because it depends on factors like whether you have a family, your total amount of debt and your income.
While no amount of money can reverse a tragedy, having safety nets — like an emergency fund and insurance — can protect your finances. That will make coping with a tragedy much easier.
Everyone should accumulate an emergency fund equal to at least three to six months’ worth of your living expenses.
For instance, if you spend $5,000 a month on essentials — like housing, utilities, food and debt payments — make a goal to keep at least $15,000 in an FDIC-insured bank savings account.
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 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.
Another important aspect of preparing for the unexpected is having enough of the right kinds of insurance. Here are some common policies 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.
2. Invest for the Future
Once you start building an emergency fund and have the right kinds of insurance, begin the second goal I mentioned: Invest for retirement. If you’re like most people, you’ll need to work on both of these goals at the same time.
Here’s 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 401(k) or 403(b), which turbocharges your account. So always invest enough to max out any free matching at work.
Erica says she’s contributing to her company’s 403(b), which is terrific — but she didn’t say how much. My recommendation is to contribute no less than 10-15% 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 401(k) or 403(b). You must adjust your payroll deduction to increase or decrease the amount you invest.
3. 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, 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 three 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, 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, because 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.
How to Manage Extra Money
When it comes to managing extra money, always consider the big picture of your financial life and choose strategies that follow my PIP plan: Prepare for the unexpected, invest for the future and pay off high-interest debt.
Review your situation at least once a year to make sure you’re still on track. As your life changes, you may need more or less emergency money in the bank or different insurance coverage.
When your income increases, take the opportunity to bump up your retirement contribution — even increasing it one percent per year can make a huge difference.
And here’s another important tip: When you make more money, don’t let your expenses increase as well. If you earn more but maintain or even decrease your expenses, you’ll be able to reach any financial goal you dream about much faster.
Your Turn: Are you sitting on savings you don’t know how to manage? Will you implement any or all of the PIP plan?
This post originally appeared at Quick and Dirty Tips, a network of podcasts and digital content offering short, actionable advice from friendly and informed authorities. Laura Adams, host of the free Money Girl podcast, is a personal finance expert and award-winning author.
The post Got Extra Cash? Here’s How to Make It Work for You appeared first on The Penny Hoarder.
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