If you’ve ever wondered if a penny saved today will really be worth a lot more than a penny saved tomorrow, then take a look at this simple math:
- If you put $1 away at age 20, that dollar would be worth $21 by age 65, assuming an average 7% return over the years.
- If you wait until 30 to invest that same $1, it will be worth $10.68. Start at 40 and you will have $5.43.
- Wait until you turn 50 to invest that same $1 and you’ll get a measly $2.76.
So a dollar invested at age 20 is nearly twice as productive as a dollar invested at 30, and 7.5 times as powerful as a buck that gets put to work at age 50!
Hopefully, you have already started saving and if you haven’t, then the time to start is today. Every day that you wait is costing you serious money.
Keep in mind that you need to have a plan to maximize your return. A great blueprint for optimizing your savings is the Hierarchy of Investment Savings, which outlines where to put your money and in what order.
Hierarchy of Investment Savings: From Top to Bottom
Level 1: Emergency Cash Savings
At the very top of your hierarchy or pyramid of investment, savings should be your emergency cash savings. The amount of emergency cash on hand should be able to cover 3-6 months of fixed expenses and should be held in a money market account, a high-interest savings account, or in other very liquid investments. Use this money only for true emergencies, such as job loss or catastrophic medical costs.
When comparing high yield savings accounts, be sure to check the initial deposit requirements, minimum balance requirements to earn interest and the monthly fees.
Level 2: Short-Term Cash
Your next level is for short-term cash which should cover expenses coming due in 1-3 years. This should not be confused with emergency savings; this money should be used if you have a known large expense coming up in the next 12 to 18 months, such as a down payment on a house or a new roof. It doesn’t make sense to have your emergency fund wiped out due to a planned financial event, even if it’s a year or year and a half away.
If you have a set timeline for when you'll need to draw on short-term cash, consider certificates of deposit as a savings option. CDs can offer higher yields than regular savings accounts, though withdrawing from them ahead of their maturity date may trigger a penalty.
Level 3: Match Your Employer’s 401(k) Contributions
Now it’s time to match your employer contributions. You’ll want to contribute what your employer is willing to match for free to your 401(k). If you're unsure of what the minimum contribution is to qualify for the full match, your human resources department or plan administrator should be able to help.
Level 4: Roth IRA
Next, start funding- and try to fully fund- a Roth IRA. Contributions are made with after-tax dollars and can be withdrawn at any time. Just be sure to understand how much you can take out without incurring a penalty. Once you reach 59 ½, all withdrawals are tax-free. Additionally, unlike a traditional IRA that requires minimum withdrawals at age 72, there is no mandatory distribution age with a Roth IRA.
Your ability to make Roth IRA contributions hinges on your income and filing status. If you can't contribute to a Roth IRA, you may consider a traditional IRA instead.
Level 5: Max Out Your 401(k)
After funding your IRA, go back and max out your 401(k) if possible. If you can't afford to make the full maximum yearly contribution, consider how you can increase your contribution rate over time. For example, you may be able to incrementally increase contributions automatically each year. If that increase coincides with a pay raise, you may not even miss the extra money coming out of your paychecks.
Level 6: Taxable investments
If you have done all of the above and still have money to save, you can put those funds in a brokerage account. Whether you manage your money or have someone else manage it, be sure that you are in a well-balanced diversified portfolio that will earn dividends, interest, and distributions.
When comparing online brokerage accounts, look at the range of investment options available as well as the minimum investment requirements and fees. If you don't have a lot of money to invest, you may want to stick with low-cost, tax-efficient exchange-traded funds to stretch your money further.
Money held in a brokerage account isn't treated the same as money held in a 401(k) or IRA for tax purposes. Your investments are subject to capital gains when you sell them, which has to be reported when you file your taxes each year.