“It’s not about how much you make. It’s about how much you save.” – my grandma
My grandma always says this to me. It’s a great guiding principal, especially right now. It’s the end of the year. Perhaps you received some cash gifts for Christmas or earned a holiday bonus. You are contemplating what to do with that money. This money can be a great way to set yourself up for a strong financial new year. Go ahead and buy your drone that Santa forgot to leave you, but save 50 – 90% of the money you’ve just been given. But where should you put it?
When I was a kid, my parents had opened a savings account for me and also put money in CDs (certificates of deposit). And as far as I knew, that was how one saved money and there was nothing else to know. I learned the compound interest formula just fine through these accounts because as a minor, I was offered better interest rates than my parents. At one point, my CD had a 5% rate and I could use that number for some interesting calculations with the Dollar Dog Savings Club worksheet I was sent quarterly. My regular share savings account had a decent rate of around 1% or 2% as well. I thought saving was just the coolest thing. The credit union gave me money just for saving, which I was going to do anyways. I loved going with my mom to cash her check and to deposit my birthday money in my account. I saved the majority of my gift money and eventual wage earnings for my college education. I loved watching those numbers go up and up. As I got older, I started predicting what those numbers might be if I saved certain amounts from working.
As an adult, though, my savings incentive is much smaller. I will never see a 1% interest rate on a regular savings account. When I cover banking with my students, I have groups research all different local banks. In winter and fall 2016, I didn’t see one bank offering higher than 0.1% interest unless it was a Money Market Account, which requires large balances (10k or 25k). After working several months and having already bought my car, I was searching for ways to make my money grow while it was sitting around waiting to be used. I thought about opening a CD, but the rates weren’t great. In fact, they were terrible unless I opened a 5 or 10 year CD.
Over the past two years, I have learned a myriad of ways to save and to grow my money. I am actually amazed when I think about how much I didn’t know for most of my life. I have 5 of the account types outlined below and am opening the 6th very, very soon. When you come into a windfall of money, choose a way to make that money appreciate, rather than depreciate in some gizmo. You can save the money (store it for future use) or invest it (put it away hoping it grows over time) in any of the following places:
1. Regular Savings Account
This one is pretty straight forward. Everyone should have one of these paired with your checking account. You won’t earn very much on the money housed here, but you can access it immediately if you need. It’s basically cash on hand. I keep around $2000 in my regular savings. Generally, you can only make 6 transactions per month on this account but should you run into an emergency, it should be simple to transfer money from your savings into your checking account and spend it. Any money kept here is FDIC insured, meaning you will always be able to take out the full amount in the account up to $250,000. Think back to learning about the Great Depression in school: banks don’t actually have everyone’s full account values present in their vaults, but should everyone want to take out their cash, they can.
2. High Yield Savings Account
This is my favorite new toy in personal finance. It functions almost exactly like a regular savings account, but, as the name implies, it has a high yield. The one I have is currently earning 1.20%. The catch is that this account is offered at select banks. I’ve noticed online banking institutions can offer these (“Can” is a loose term. Most banks can offer these but they choose not to because it’d cut into their profit margin. I digress…). An online bank doesn’t have the cost and upkeep of a brick and mortar institution so they can offer a higher rate. I use Barclays for my high yield savings account. It requires you to link an external account in order for you to transfer money in and out. I have my checking account at my credit union linked, which is also where the majority of my paycheck goes. When I get paid on Fridays, I can also transfer money into the Barclays account. It shows up on Monday. It takes about 2 days for money to transfer back, so this money can’t be used in a true emergency. I used this account to save up the down-payment on my house. This account is pretty low now but I will be using it to save up my 6 month of expenses emergency fund.
3. Certificate of Deposit – CD
This savings instrument was highly popular in the 70s and 80s when banks offered very high rates on them, like 14%. You can get a fraction of that today. The rate on the CD is locked in and guaranteed for the term of the CD, unlike the previous two savings account which have fluctuating rates. You can get a CD with a term as short as 3 months or as long as 10 years. This means that is how long you agree to not touch your money (and let the bank use it for other things). If you take money out before the term is up, you have to pay a penalty. There is usually a minimum balance required. Right now, my credit union is offering a 59 month CD with a 2.32% interest rate. The minimum deposit is $500. If I wanted guaranteed growth and could stand to be apart from my money for 5 years, I would totally open this CD. I personally want more flexibility with my money and am working on other ways to grow wealth so a CD is not part of my current plan. My grandma is a big fan of CDs.
4. Individual Brokerage Account
I used to think that only rich people had money invested in the stock market. When I was 25, I set a goal for myself to build up enough wealth by the time I was 35 that I could invest in the stock market. But in today’s world, there are so many ways for people to access the market with lower account values. Last year the New York Times reported in their year-in-review that the best way to invest in the market was through low-cost, passive index funds. I didn’t know anything about that so I did a lot of research and found that it was, in fact, an inexpensive way of investing. Investing, though risky, has a far better pay off than mere savings.
As someone who was only ever used to guaranteed growth, no matter how small, the thought of losing money in the stock market was terrifying. Opening an account of just $100 and seeing what happened provided me a psychological safety net. I originally planned to invest $100 every month and let the account build up. I would learn as I watched my money cycle up and down. In just a month’s time of watching the market and watching my account value, I eased into the idea of investing in the stock market. I read the articles that the stock app on my iPhone generated about the S&P500 and became more comfortable about what to expect from the market. When my grandfather died in February, I added an additional $1000 to the account and invested in the S&P and in May I invested $100 into a different mutual fund I had been researching. I also own 10 shares of a single stock. Then I decided not to invest anymore until I developed a goal for the money. My account fluctuates around the $1400 range this month. Anyone looking to start investing in a low risk way, I highly recommend opening an account with Charles Schwab because they have the lowest expense ratios for index fund investments. Vanguard is often lauded as the best of the best on index fund investing, but Schwab is currently beating their cost.
5. 401(k) or 403(b) Retirement Account
This is your employer sponsored retirement account and I hope you already have one! 401(k) accounts are for people working in the private sector and 403(b) accounts or for people working in the non-prof world. They have all the same rules: $18,500 contribution limit for 2018, savings are pre-tax meaning it lowers your income that is taxed now and you pay the tax on it when you use it in retirement. You can’t access the money until you are 59.5 years old, unless you pay a penalty. Your employer may potentially match your contributions, so you can basically get free money as long as you are contributing. My employer does not make any contributions to our 403(b)s because they contribute to STRS at a 14% match. If you have a pension fund at your job, I really encourage you to still have some other kind of retirement account that is solely in your name and you can make investment changes to.
While you can’t take your Christmas cash and add it to this account, you can totally up your contribution amount for the coming year and use the cash on hand for your day-to-day purchases. Contributions to these retirement accounts are payroll deducted so you set it up through HR and make changes to it through HR. By my last check this year, I will have contributed $1800 to my 403(b) which I set up in the spring. I will be adjusting my contributions downward to $25 per check temporarily while I make some adjustments to my plan.
6. 457(b) Deferred Compensation
This is a government employee retirement account option and is the greatest thing on earth. I am not kidding. I found out about this account type in November of this year and opened one as soon as I discovered it was available to me. I will be contributing $100 per check to my 457. A 457(b) is a unique account that is referred to as “Deferred Compensation.” It has the same contribution and tax rules as a 401(k) and 403(b). But. And this is a big but… But you can access the money as soon as you “separate from service.” Meaning, if you quit or are fired from the job through which you opened the account, you can now access the money in there. There is no waiting until you are 59.5 or paying penalties. The money is yours for the taking.
I love this account because it can be thought of as a unique emergency fund. In my mind, the biggest emergency I could encounter is losing my job, since I have good health insurance and my car can only cost me so much. Losing my job and needing to pay the bills for a few months would be a most stressful experience and if I have this account that suddenly becomes available to me the minute I don’t have that job anymore, I am good to go. I also love this account because the S&P500 index is available to me at an even lower expense ratio than at Charles Schwab. If you are a teacher or a government employee, make opening a 457 account a top priority this January.
7. Traditional IRA (individual retirement account)
If you don’t have access to a 401(k) at work, you can still save for retirement through an IRA. Unfortunately, you can only save $5500 a year instead of $18,500. You can actually have both if you want. This account also lowers your taxable income just like the 401(k). You can take your extra Christmas cash and put it in an IRA if you wanted to. For someone who freelances or hasn’t settled into a career yet, an IRA could be a great investment option. An IRA might also be appealing if your employer sponsored retirement account doesn’t have many low cost options. That is, if there are many fees involved in the 401(k) account, you might want to contribute the maximum $5500 to your IRA first then save more in the work account. It all depends on your situation.
8. Roth IRA (individual retirement account)
Man, I wish I had opened one of these when I was 18 like someone told me to. A Roth IRA has a different tax advantage than all the other retirement accounts discussed so far. Instead of lowering how much you owe in taxes now, you use money you’ve already paid tax on to fill this account. But you don’t have to pay any taxes on the growth years and years from now when you actually retire. If you are in the 10% or the (new) 12% bracket now, a Roth IRA is ideal for you because you have the potential to be in the 22% or 24% tax bracket when you retire. You are essentially avoiding an additional 10% of taxes on this money by paying the taxes today. Even if you think you might never get into the 22% tax bracket, a Roth IRA is a great account to have in your line up of personal finance tools. Definitely use your Christmas Cash to fund a Roth IRA. I’ll be opening mine in the next two months. I took some bad advice by not opening a Roth two years ago, thinking there was no advantage to having it at this point. But I am still in a low tax bracket and I still have 30 – 40 years to let money grow completely tax free. After 5 years of opening a Roth IRA, you are allowed to take out any contributions you’ve made without penalty. It can be a back up emergency fund if you need it to be. You just can’t touch the growth until you are 59.5.
No matter what you do with your extra earnings this year, I hope you expand your opportunities by making that money work for you. Do what works for your life and your comfort level. Money is the tool you use to build safety and comfort for yourself, so don’t do anything that will make you uncomfortable. Reference the graphic below if you need a quick way to remember the difference between all of these tools.