Lately, I have had a lot of questions from people who are feeling ready to do something with their finances. Sometimes it's a matter of making your way out of a difficult financial situation (recovering from illness or unemployment, finishing a degree, paying off a debt, etc...), but often it's just a sense that you've been just wandering along without any particular plan or purpose. Thanks to a flood of shiny ad campaigns from the big brokerage houses, people often think this boils down to opening a retirement account somewhere. Here is what I tell people to think about before you go shoving all your money into an IRA.
Retirement Accounts are Great...But Not If You Need Money Now
The reason personal finances is so hard is that it demands that we think near-term, mid-term and long-term pretty much all at once. Like any financial advisor, I love getting my clients on track for the post-65 years. But dreams of a cushy retirement are only moderately comforting if you unexpectedly have to replace your car next week. Worse yet, if you do have to reach into your retirement account for an emergency, you will probably pay a penalty 10% of your hard-saved earnings for the privilege of getting your money back. All of those well-advertised retirement accounts (401k, IRA, Roth, Pensions, etc...) are great vehicles for the long-term. And unless you have reached your 60's, they are pretty useless for dealing with life as it is right now. Put the retirement account on the list, but not at the top. Instead—start with your emergency fund.
Life is Poetry, Budgets Are Fiction: Why You Need An Emergency Fund
How many times has someone told you that all you need to do is create a budget and stick to it? The advice usually comes with an ugly but orderly spreadsheet and a sort of smug assurance that all you need to do is follow the numbers. But experienced advisors are usually happy to admit it—budgeting doesn't work. The reason of this is simple, really. You don't live in a spreadsheet.
It isn't just that people have emotions and stressors that flicker through their thinking, changing their decision-making moment by moment. We all know what it's like to leave the house with one plan for the day only to have chucked the whole thing out the window by lunchtime. The problem is that even if we stick to the plan, the world won't necessarily cooperate.
Budgets depend on the illusion that we can forecast the future, so they don't tend to leave room for broken tail lights and dry cleaner emergencies, much less emergency room visits and sudden layoffs. You can't control these things, and you can't plan for them, but you can create an emergency fund that will soften the blow. And this is the crucial part of thinking short-term—emergencies can happen next week or next month or even tomorrow. Make sure to start (but not necessarily finish) your emergency plan before you start on the long-term thinking.
Saving is Simple. Leaving the Money Alone? Not So Much
As every Top 10 Financial Tip list will tell you, you should auto-deposit part of your check every month into a savings account. But those lists often fail to mention what the savings is for. Creating an emergency fund and saving for a big purchase are very different things. In fact, you are almost always better off to use separate accounts for them. Let's call this second account the "Occasion Fund." You use it to build up money for the big occasional spend (wedding, new place, the big birthday party...). Discount the need for these things at your own peril. Sure you can survive without them, but survival is not our goal here, and life demands some celebrations.
Unless you possess superhuman discipline, you will find yourself reaching for a just a little extra money from somewhere when they come up. It's better to have these moment in your plans. A word of caution, though—unless you are far wealthier than I, that fund won't cover every event you could turn into an occasion. This fund is all about mid-term thinking. Before spending out of this account look a little further into the future to decide which of the upcoming events in life most merit the spend.
Life Doesn't Work Step By Step
In the orderly world of planning, we want to tell you to do all these steps in order: first put aside 3-6 months expenses for the emergency fund, then start the long-term retirement planning, and then the occasion fund. But the truth is, this is rarely realistic. You do need to start putting money in for emergencies first. But it won't be long before that opportunity for a weekend away comes up. So, don't fight it. Split your automatic savings between the emergency account and the occasion account. Sure, it will take you a little longer to meet your goal in both accounts. But life, unlike financial plans, is about a lot more than the end goals.
And remember what I said about that Budget spreadsheet? I can't tell you when or why, but some day you are going to spend down one or both of those accounts. Stuff happens. Having charge of your finances means being knowing you have the know-how to build it all back up again.