So you’re getting ready to begin saving for the future. Your parents always told you to do it. You see advertisements on TV that say you can’t be successful without it. The government even takes a bit of every paycheck to ensure you have some sort of retirement savings when you reach a certain age. If everyone does it, it should be easy, right?
The truth is, it isn’t all that difficult. The problem that most people encounter is that they make decisions about what to do without setting goals first. Like anything in life, if you don’t set clear goals up front, you’re probably going to go down a path that isn’t going to lead very far. Here’s an example:
You’re a 22 year-old young professional who has aspirations to retire at 55. You’d love to spend time traveling the world with your future wife (who you haven’t found yet) and visiting your children and their families. Since this has always been your plan, you’ve started putting aside a significant amount of money in a Roth IRA every month. You figure it’s a good idea since you’re in a lower tax bracket today, you can avoid paying higher taxes on your earnings in the future. On the surface, this seems like a logical choice!
Fast forward four years, and you’ve just received a big promotion at work. You’ve been dating a girl for three years and are ready to get engaged. The logical next step is to buy a ring.
Your fiancee is incredibly particular, and you realize you will have to spend over $20 thousand to make her happy.
Since you’ve been saving a significant amount of money for the last four years, you should be in good shape, right? Wrong. While you’re in a better position than someone who didn’t save at all, there are still some downsides to your plan.
When you withdraw money early from a Roth IRA, you are required to pay a 10% early withdrawal penalty, as well as taxes on any earnings you have accrued. While 10% may not seem like a whole lot, it could be equivalent or more than the amount of earnings you had generated on your account over the last four years. On top of that, you still have to pay the taxes on your earnings. You would have been in a better position just putting the money in a savings account with little to no return.
That’s where goal setting andplanning comes in. A piece of advice I have for any new investor is to chartout short, medium and long-term goals before creating an action plan. Itdoesn’t need to be anything complicated, but it should cover off on theimportant milestones in life (I have listed a few below):
While you won’t be able to perfectly plan for these, it’s important to at least plot out when you think they’ll happen and the expected cash outlay associated with it. These are major events that’ll require you to be prepared, and you could find yourself moving backwards in your financial plans if you’re not ready. Here is a simple way a young person right out of college could map out some of their major milestones over the next five years.
While this is a very rough diagram, it makes one start to realize the significant cash outlays they need to plan for in the future. Let’s take the mortgage in this example. If in five years this individual is planning on buying a house, they would need to be saving ~$417 a month in order to prepare for a $25,000 down payment. Of course, this is assuming they generate no returns on those savings. There are a variety of more liquid investment vehicles a person could use in the first few years to generate a return on their investment, and then transition their holdings to cash as they get closer to buying. The important point is, it’s much more manageable to plan for $417/month in savings if you have an idea that you will need it down the road. It will also influence how you intend to save that money.
The moral of the story is, simplysaving money doesn’t mean you’re doing what’s best for you. While it puts youahead of a lot of people, you’re going to be in a much better position if youtake some time to define your future needs and design a strategy that fits it.
If you’re looking for additional tools and tricks to help with planning and goal setting, please visit https://www.personalcapital.com/. This is a great service that allows you to link your accounts, analyze your investments, and set savings goals; all for free!
I agree with Patrick’s perspective on this. Setting goals and then planning the specific actions needed to achieve them is the only way to make true progress towards ensuring financial preparedness for the future (at least to the extent that you can plan for these types of events).
One thing that you want to ensure you are considering is not only the timing but the financial tools/accounts you are using to save for such outlays. The example above covers this concept (saving in a Roth IRA but needing cash for a down payment on a home), but this is an element that should be carefully thought about with pros and cons weighed before making decisions.
For example, if you have a large upcoming purchase that you can accurately predict the timing of, opening a CD may make sense. Think of something like a wedding – if you already know the date of the event and the timing you’ll need access to the cash (i.e., the invoice from the venue comes 1 month before the wedding date), a CD will likely be a good candidate for where to park your money.
If you have a similar large upcoming purchase but you cannot be sure of the timing, a regular savings or money market account would likely fit the bill. I would think of things where you have an idea of the timing, but no exact certainty. The example that comes to mind is shopping for a new house. You may know that you’ll buy a house sometime in the next 3-6 months, but if you find the perfect house in Month 1, you need your assets to be liquid enough to act – you won’t want to find yourself waiting for a CD to mature.
For further-out capital needs, you can afford to bear some risk (according to your level of risk tolerance) by investing in the market – because with a longer time horizon, you’ll want to have your money working for you and growing, not just sitting in a savings account earning fractional percentages of interest. Even if there is some downward movement in the markets, you’ll likely have time to have your assets recover before needing the money.
While we could list every possible example we can think of, we still couldn’t cover every possible scenario. As you are setting your goals, also consider:
- The time between now and when the cash is needed
- The certainty of that timing
- Tax Implications
- Risk Tolerance
- Liquidity Needed
- Potential other financial needs that may supersede what you are saving for