Savings Allocation - The Magic Formula

​One of the most common questions I answer is, “Where should I be saving my excess cash flow (the money left over at the end of the month)?" There is no easy answer as every situation is different, and the “magic formula” varies for everyone. However, a few basic principles may get you started in the right direction. What follows is my “magic formula”, applicable to most, but not all situations. 

​To discover your “magic formula,” start by setting up your equation.  I make this recommendation on repeat because of the importance of having a vision or an end goal. Write out your financial goals. What are you hoping to achieve? What are the must-have’s in your life? List these items in order of priority. Prioritizing this list will be important when considering how to allocate your savings.

---

The Magic Formula
 
Step 1) Maximize Your Company Match
Step 2) Build Emergency Savings and Pay Down Debt
Step 3) Health Savings Account (HSA)
Step 4) A Minimum Retirement Savings Contribution
Step 5) Goal or Short Term Savings
Step 6) Maximize Retirement Savings
 
Step 1) Maximize Your Company Match on your Retirement Plan
 
First, find out how much your company will match to your retirement plan. You may find that your spouse’s employer will offer a better matching contribution. If you have limited resources to contribute to retirement plans, it is important to make sure you are contributing to the plan that best maximizes your match.  
 
Step 2) Build Emergency Savings and Pay Down Debt
 
In some cases, this may be a better “Step 1”. This would be the case when you have limited resources to dedicate to saving / debt reduction, and you have a significant amount of high interest debts that you are falling behind on making payments towards.
 
Paying off debt should be a high priority because consumer debt (such as credit cards) have very high interest rates that are hard to pay down. Also, a healthy emergency fund will allow you not to take out high interest consumer debt when unexpected expenses occur. See this article when considering what to have set aside in an emergency fund.
 
Step 3) Health Savings Account (HSA)
 
This is the curve ball that many people do not consider. If you qualify to open an HSA either through your employer or on your own, it is a great long term investment vehicle, even if you are not using it for health expenses. I’ve dedicated an entire blog post to covering the benefits and common questions for this unicorn investment vehicle.
 
Step 4) A Minimum Retirement Savings Contribution
 
Based on your retirement goals, you should set a minimum percentage of your salary aside for your retirement contribution (after you complete steps 1-3). If you are working with a financial planner they should be able to help you decide a good minimum amount to set aside to reach your retirement goals, or you can find many financial or retirement calculators online that can help you come up with a number.
 
You need to find the best retirement vehicle through which to maximize your retirement savings. Many times, you can contribute a large amount without limitation through a company sponsored retirement plan like a 401(k), but even with those plans, you choose between a ROTH contribution or a Traditional Deductible contribution (or even a non-deductible contribution if you are needing to set aside a large amount of retirement savings).
 
If you do not have an employer retirement plan, depending on income limitations, you may be able to make contributions to IRAs and ROTH IRAs. If you are a business owner, there are several options based on the size of your business that you can use for retirement savings like a SEP IRA , SIMPLE IRA, or Solo-401k. It is important to find the optimal retirement vehicle for you and your family because of the exponential impact it may have on your future financial health.
 
Step 5) Goal or Short Term Savings
 
When you are contributing the minimum retirement savings needed to reach your intended goal, you can begin saving for other goals. Depending on the goal, you may want to open a specific tax-advantaged account. For example, if you are saving for a child’s college expenses, you may benefit from opening a 529 account in your child’s name.
 
You also need to consider your investment allocation for these accounts. If you are setting aside money for a down payment on a home that you will use in a year or two, you should invest less aggressively than you would in a longer term investment such as your retirement savings.
 
Step 6) Maximize Retirement Savings
 
Finally, if you have set aside the money that you need for short-term savings goals, you can supercharge your retirement savings by putting the rest of your excess cashflow to work in tax advantaged retirement accounts – completing step 4. If you have set aside enough for a comfortable retirement, this optimization of retirement accounts would allow for more money left for heirs or a more comfortable retirement.
 
 An additional consideration for step 6 would be to enjoy your excess cashflow now in a variety of ways that would  bring joy to your life. Saving the most money that you can over the span of your life as an end in itself cannot bring you or others joy.  My next three blog posts will be a series on the topic of joy and money. If this is a topic that would interest you, you can subscribe to our blog, here. 

Enjoyed this post? Check out these pages...