Help a Reader: What Should He Save for First?

Here's a question I received last week from a reader:

I'm a college student (22) who will be graduating in a few months, and I'm just starting to get my finances set up properly. I have a few questions.

You talk a lot about retirement accounts (ROTH IRAs and 401ks), but I was wondering about other things you'll need money for long before retirement. Weddings, cars, houses, etc. I've traditionally heard that you should save 10% of your income (though I think you suggest 20-30%).

What portion of that should go to retirement and what should go to short term savings for cars and houses? Because you can't put short term savings into retirement accounts, where do you suggest it be put (high interest online savings accounts, CDs, non retirement investment accounts). Is it a good idea to get that money tied up in stocks, which may or may not be at a good price to withdraw at when you need it?

I told him I'd open up the questions for all of you to answer since you all are smarter than I am. ;-)

Let him know what you think in the comments below.

Comments

[plonkee]

Personally, I've been saving/investing about 30% of my salary since graduating, and I started off by putting most of it into high interest savings accounts (25% of total salary) and the rest into a retirement account (5% of total salary). As time has passed (about 5 years) I've moved a higher percentage towards investing, and added a non-retirement investment account.

I started with more savings until I had a really good cushion and enough to put a deposit down on a house, but since I haven't got any more goals that needs stacks of cash to accomplish in the next 5 years, I'm weighting it more towards investments.

[segfault]

Don't know if something changed with your layout, but your site no longer displays properly under Safari under Mac OS X.

[Teri]

I think 10% would be the bare minimum you want to save - for retirement. But you need to save for a whole lot more on top of that.

Personally, I think the best thing you can do is get used to saving. Are you going to make considerably more than as a student? Don't start spending your newfound income right away. Set aside a big chunk which you are not used to having anyway.

We saved 50% of our income out of school, but still way more to play with than the lean college years. But we put most of this to a house. You really have to put some in retirement, but we didn't put much in as we had a huge hurdle of buying a home in the most expensive area of the country - so most our money went to that. But looking back we did save about 10%/year to retirement all the same.

In the early years we saved maybe 10% retirement, 40% home. Maybe a little extreme because the area - hopefully it is not so expensive for you. Then we had kids and dropped to 1 income and saved little, but always the 10% retirement, even if we had to move it from savings. Today we are building our cash reserves and so we are doing about 10% retirement/10% cash reserves. Next year I am hoping 15%/5%. In the next few years I am aiming for 25% retirement and not much need to save up cash except for next car purchase. Once we max out retirement vehicles (long way to go) then we would consider other investments. Point being what goes where definitely shifts with time. Looking forward retirement is the main big thing. In the past there were many competing financial goals.

I would start with a high-yield savings account for now and maybe CDs once you build up a decent amount of cash for emergencies - leave some liquid, some in CDs. For down payment on a home, wedding, cars and such you don't want to risk it in the market though there are some options if you have a long horizon - I would say 7-10 years. I have been considering a balanced fund for my next car purchase (10 year horizon).

Personally I am 30 and just bought my first car over $5k. we couldn't spend money on cars and meet all our other goals, but now that we are established I am aiming to pay $15k-20k cash for our next cars (each). Just to say maybe some of these things will have to wait on the back burner as you reach other goals. Depends on your situation. & most definitely your priorities.

Good Luck!

[Blaine Moore (First Time Home Owner)]

I'd definately try to get at least 5-8% (preferably 10% or more) towards retirement, and then put the rest into an online savings account with a high APY. Build up your cash reserves until you have 6 months to a year of cash available as an emergency fund, and then start earmarking for your house and other purchases. If you know that you are going to have time before looking, you could start creating CD ladders and such, or keep the majority in online accounts.

Once you have your down payments all set and are ready to get a house, you can try take the cash out and then rebuild. If possible, keep 6 months worth of cash in the account (which after the house may be more like 4 or 5 months) and build back to a year. Then start maximizing your retirement savings.

Definately try to keep living on a budget lifestyle; if you save your money now before you get used to spending it then you'll have a much easier time putting it away.

[Anonymous]

I've based my level of retirement savings on the guideline of saving as much as I can afford to save while I can. That is, I'm saving for retirement well in excess of the amount I think I need to put away right now. The idea behind that is pretty simple. There are lean years. Layoffs happen. Children go to college, with the corresponding expenses. Putting more money into my retirement accounts early means that I have more dollars enjoying the benefit of a very long period of compounding.

Simply put, save at least the bare minimum that you calculate you need to save. Add as much as you can to that, whenever you can. That makes weathering the storms much easier.

None of that provides any guidelines for someone determining how to allocate savings amount competing needs. The first two things on my savings list when I graduated were building an emergency fund and enough retirement savings to get the full benefit of my employer's 401(k) match, in roughly that order. If you can't afford to save that much, you need to either figure out how to increase your income or decrease your expenses.

[Lord]

Yes, 10% for retirement is too low. I wouldn't recommend less than 15% unless you are in a stable employment industry. Cash out any high debt and save an emergency fund. This will enable you to take advantage of opportunities that arise. Any money beyond 20 years should be in equities as they are lower risk. At your age any beyond 15 or even 10 years should be; use this as an opportunity to learn investing and take advantage of long term compounding. Make your wish list and prioritize. Move from credit to cash for anything that depreciates. You probably have to borrow for that first car. Don't for the next one.

[Kevin]

I'm about to finish graduate school, so I've been thinking this over quite a bit recently. Given all the "musts" of retirement, emergency funds, debt elimination, etc., it's hard to decide how to prioritize things.

My approach will be to try to keep my lifestyle about the same and save all my new income, so I'll probably be saving at least 50% at first. I'll be entering the job market with modest student debt (10k say), a totally worn out car I own outright, and no other debt. I'm planning on starting with a "sprint phase" with the following priorities:

#1. Get 1.5 months' expenses in checking. This serves as insurance against bounced checks and overdrawal fees, and is also the start of an emergency fund.
#2. If my employer offers a 401k match, start investing enough money to get the full match, but no more. If I have a 50% match and get 8% returns on my 401k, the nominal yield on this money is 62% the first year and 8% tax-free in subsequent years.
#3. Pay off any existing debt higher than a car loan APR. This would include credit cards and high interest unsubsidized student loans. The nominal yield here is whatever the loan APR is -- 15%-20% for student credit cards, say. (I've managed to avoid this, but I list it for completeness).
#4. If my car is still running, I'll start saving to buy a modest used car ($9,000, say) in cash. If not, I'll buy a car with a traditional car loan. Yes it's debt, but I need to get to work to earn a salary! Here the nominal yield on the downpayment/outright money would be a car loan APR, roughly 6%.

At this point I'd say things were mostly in order. I'd switch to putting about 15% of my income toward retirement and probably leave it there for the rest of my career. I'd also set up a recurring deposit to build up an emergency fund at the rate of 1 months' expesnes per year for 5 years. Other people might make this a higher priority but I'll be in a stable industry with very little chance of layoffs or injuries. The rest of my savings would go toward a house downpayment. I'd put the emergency fund, car savings, and downpayment savings in something secure like a money market or online savings account.

[Dus10]

Everything is different for everyone, but starting your retirement savings early is the best chance you have at having a nice nest egg when you retire. Traditionally, the suggestion goes to start with investing to the full match of an employer, and then gradually increase the amount to save for retirement. However, you may be best served by doing it backwards. For instance, saving $10K a year for the first ten years and never contributing again will yield over $2.5M in forty years with an average annual return of 8%. So, set a lofty goal, stick with it for five to ten years, and then start scaling back, but always take advantage of the match you are given by your employer.

You are at a point in life where your expenses are probably a low as ever. Take advantage of it and save for retirement, and make sure you build up an emergency fund of about six months worth of expenses. After that, start saving up for all the other things... like a home, then maybe some cars... but most people spend their lives paying for cars; it is something that could make you super wealthy if you can avoid it.

[Margo]

I graduated in May 2004. By the end of 2007, my net worth will be slightly higher than my annual salary. I'm 24 1/2 now.

Savings percentages from other people are irrelevant unless you know how much they make - it's a heck of a lot easier to save 30% on an engineer's salary than on a journalist's.

How I established my financial footing:
(1) Stayed in cheap college housing, with roommates, for 2.5 years after school. I saved ridiculous amounts of money then. Before I moved to my own place, I saved the difference in the two rent payments ($200 or so) plus my annual performance bonus, in a Furniture Fund.
(2) As soon as eligible, sign up to contribute to your 401K for however much the company matches. I get 3% from the company when I contribute 6%. Ergo, I put in 6%.
(3) Set up two online bank accounts. One's the house fund, the other's the emergency fund. Make your contributions automatic. I don't particularly want a house yet (grad school is more important right now) but it takes time to save up a down payment. I figured, $20/week is so minimal, only 1 night's dinner and/or cocktails, so I can give that up no matter where I work or how little I earn. I've got $2400 saved and that's been painless.
Your emergency fund is like insurance; charge yourself $100/mo "insurance" and you'll have an ample fund in no time. Mine got depleted when I moved, so I've posted all overtime, odd-job income & found money since December. It's back up to $3000 now.
(4) Once I had a couple thousand in cash, I opened a Roth IRA. Then, I made future contributions automatic. Our pay schedule changed last year from semi-monthly to bi-weekly, and I had to adjust my contributions. The new pay schedule made it look like I "lost" $150/mo, but then had a really rockin' June & December wherein I got a 3rd check. I dropped my IRA contributions to $250/mo, and send an additional $500 in each of the two months when I get a 3rd check.
(5) Moved money out of a taxable investment account into a 529 plan, so it can grow for grad school free of taxes.
(6) Got a no-fee rewards credit card. I've got $15000 in available credit at 7.9% interest. Those cards might bridge the gap between federal loans & the higher-rate MBA loans, so I'm keeping my credit in tip-top shape.
(7) Had a heart-to-heat with my parents a couple years ago...if I'm going to pay for grad school, buy my first house, buy my next new-to-me car, and do it all before I'm 30...that if they want a wedding, they're paying for it. Otherwise, I'm eloping.

[Dus10]

Contrary to popular belief, weddings don't need to cost a whole lot. We spent about $2000 on our wedding, not including the honeymoon. That included her dress, invitations, $200 for the church, and food (we had the reception in the church... they had a separate area for that).

[Matt]

Fund the retirement accounts first. Even though retirement is a long way away, you're hampered by hard limits on the amount you can contribute to those accounts every year. And if you don't start young, you won't get a chance to catch up until you're in your 50s, and even then the extra "catch-up" allowances aren't nearly big enough to make up for early non-contribution.

Saving for other things will be done in accounts that aren't tax-advantaged, which means that you can save as much as you want to in them, every year. If you under-save in the buy-a-house fund at the beginning of your career, you can make it up by over-saving in that fund a few years down the road when you're making way more money than you will right out of college. It'll cost more, but unlike with the retirement accounts, it'll be possible.

For what it's worth, until you've fully funded both a Roth IRA and a traditional one, I wouldn't worry about what _percentage_ of your income you're saving. Do that, and then put as much as you can into a high-yield savings account or a regular (non-IRA) investment account for general savings. Don't worry if, for the first few years of your professional career, there's not as much of the latter as the former...unlike with your IRAs, you can make up the difference later on when you're making way more money.

[CIWOOD]

I am 58 years old. I teach financial planning at a university. My life experience has taught me that stuff happens!!! My advice to all my students is to fund a large emergency fund first. If you can, fund a retirement at the same time but the emergency fund is most important. Then when stuff happens, you are not required to cash out your retirement funds. Your emergency fund protects your retirement fund, allows you to choose larger insurance deductibles, protects you from using credit cards for emergencies, encourages you to rollover rather than spend, etc...
In short, an emergency fund is the cornerstone of your financial plan and it should be liquid at all times.

[FMF]

Thanks, everyone. Lots of great stuff in here.

[tinyhands]

I'll go one bit further than everyone else who left really good suggestions above: Open a brokerage account. Often, if you have more than one account at the same institution, they will consider the sum of your accounts and waive or reduce the fees.

In addition to doing all the great stuff like saving for retirement and low/no-risk short term savings, I submit that a young investor needs to play with a bit of "mad money" with the flexibility to make a few mistakes. Even seasoned investors still believe that they can regularly pick individual stocks and time the market. The sooner a young investor learns these lessons (i.e. you can't and you can't) the better off you'll be in the long run. Some lessons can only be learned the hard way.

I'm not advocating putting all of your short(er)-term savings into the mad money pot, as that will depend on your budget. But EVENTUALLY you're going to want to have some market investments, so you might as well get some first-hand knowledge.

[Jim]

I think it's important to get the saver's tax break your first full year out of college. To do that plan on not spending but putting aside $2000 that year in a qualified plan. Qualified plan basically means an ira.

After you do your taxes it turns out you get a little bit subsidized by the gov't.