Written by Laura Shin,
Reposted from LearnVest
When it comes to our
personal finances, we all start out with the best of intentions.
We’re going to stick
to our budget. We’re going to have the biggest emergency fund ever seen, and
we’re going to sign up for every last insurance policy we need. We’re also
going to start saving for retirement from day one, and live happily ever after
in Barbados. Enter real life. That’s where you’re faced with tricky questions
like, should you put your raise toward your emergency fund, your credit card
debt or your IRA?
At LearnVest, we tend
to call these “this or that” questions: As in, should I fund this financial
goal first or that one? Sometimes it can seem like questions that involve
retirement are trickiest of all. Why? Because it’s easy for retirement to seem
like the least pressing concern, but it is also the one with the highest price
tag—and the one you’ll be rewarded for most if you start saving early.
And most of us
severely underestimate how much we need to save. Today we’ll show you how to
prioritize retirement against your other financial priorities. Once you’re
clear on that, we’ll set you straight on just how you can make all the right
moves and retire to [your island of choice], Mai Tai in hand.
Setting Your
Financial Priorities
Before we dive into
retirement vs. other financial priorities, let’s set a few ground rules. First,
the best way to set up your budget is what we call the 50/20/30 Rule. (You can
read all about it here.) In
short, the 50/20/30 Rule states:
·
No more than 50% of
your take-home pay should be spent on Essential Expenses, which are strictly defined as your housing,
transportation, utilities and groceries. Nothing else.
·
At least 20% of your
take-home pay should go to Financial Priorities, which are defined as retirement contributions, savings
contributions and debt payments. And we’re not counting any retirement contributions
you make through your employer, such as a 401(k) or a 403(b).
·
Lastly, no more than
30% of your take-home pay should go toward your Lifestyle Choices, which encompasses everything else: shopping,
the babysitter, entertainment, personal care, the gym, cable, gifts, your cell
phone, dog food, and more.
(Want to see how your
own finances stack up against the 50/20/30 Rule? Run them through our Smart Budget.) Today, we’re going
to focus in on that 20% slice: How exactly do you prioritize retirement over
savings and debt? Doesn’t it all kind of feel equally important? Well,
actually, we have a few guidelines for you.
How to Rank
Your Financial Priorities
1.
Retirement comes first.
Retirement is the
number one financial priority for pretty much everyone for three reasons:
1.
Inflation causes the
value of every dollar to shrink year after year, so by the time you retire,
you’ll need much more money every year to live than you currently live on now.
2.
We’re living longer
than ever and health care costs are rising so we need to save up to take care
of ourselves for a longer period in retirement than previous generations did.
3.
Today’s retirees can
rely on Social Security or pensions. But we won’t be able to. Pensions are
becoming much less common and the future of Social Security is up in the air.
It’s up to us to save what we can for retirement.
2. Emergency
Savings
This is your second priority
because if you don’t have an emergency fund and an emergency pops up, you’ll
either
·
Rack up credit card
debt
·
Have to borrow from
your retirement savings in order to cover the emergency
What, exactly, is an
emergency fund for? If you don’t know, we’ll walk you through how (and where) to build one, and
the only reasons you should
be spending yours. Having these savings in place will protect not
only you but also your top two other financial priorities.
3. Debt
Debt may be third on
this list, but that doesn’t mean it’s not a high priority. Yes, it comes after
retirement and emergency savings, but it also comes before your Lifestyle
Choices spending. That means that every month, you make your debt payments
before you, say, buy a new phone or that Thanksgiving plane ticket home or the
new work shoes you need. Why? Because debt is a huge burden, and because–in the
case of credit card debt–your debt can grow. For that reason, when you tackle
your debt, you should:
·
First work on paying
down credit card debt over other kinds of debt.
·
Among your credit card
balances, pay minimums toward everything but your highest-interest rate debt.
Put as much as you can toward that.
·
Once that is paid off,
prioritize your next-highest interest-rate debt. Non-credit card debt, such as
from student loans, is lower in priority than credit card debt because the
amount does not increase the longer you hold it.
Are You an
Exception to the Rule?
While these are
helpful guidelines that apply to most people, there are specific situations
which mean you should allocate money a bit differently toward your Financial
Priorities. Here are five scenarios in which real life bumps up against the
rule, and the best advice might actually be something more tailored to the
person’s specific situation:
1.
A recent college grad
who is making $30,000 a year and has $50,000 in school loans but no savings
2.
A 55-year-old who has
a three-month emergency fund but is behind on retirement savings and has
$10,000 in credit card debt
3.
A 35-year-old single
mother with a two-year-old and no emergency savings
4.
A 45-year-old single
woman who has six months of emergency savings, no debt and is on track for
retirement, but who has just been diagnosed with a serious illness that could
put her out of work for several months
5.
A 30-year-old who was
just out of work for eight months and not only depleted her emergency savings
but also got into $10,000 worth of credit card debt
Unfortunately, because
these situations are unique, it’s hard for us to give a hard and fast rule
about how each person should prioritize their Financial Priorities. For that
reason, if you fit one of these profiles, you might want to see a Certified
Financial Planner® to get appropriate advice for you.
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