When people refer to saving, they are typically talking about multiple things while using the same term. It’s wise to separate out the different types of saving funds and reasons for saving. So, in this post we’ll clarify the different savings funds and discuss the percentages or amounts of money that need to go into them each month.
Types of Savings Funds
- Emergency Fund
- Retirement Fund
- Sinking Fund
The Emergency Fund is covered in more detail in this post. For the purposes of the Emergency Fund in light of other savings, start with getting at least 1-2 months of expenses saved up BEFORE aggressively contributing to your Retirement Fund and the Sinking Fund.
Now, to clarify, over time you should continue to contribute to your Emergency Fund until it’s fully funded with 3 to 6 months-worth of expenses. However, you don’t have to have the Emergency Fund at 100% to save in these other funds. So, aggressively build up your Emergency Fund until it’s sufficient for right now, then start saving 10% to retirement, and calculate (formula is below) how much you’ll need to save for the Sinking Fund. As you get some momentum going, you’ll be contributing to all 3 funds and all 3 will continue growing. As you get pay-raises, bonuses, or other additional income through side-hustles or overtime, add that money to whichever fund needs it the most.
Retirement Savings Fund
The retirement fund is the most important saving you will do! One day, you won’t be working. How are you going to live, maintain your quality of life, travel, see your kids, etc.? It will be very difficult to exist merely off social security or government aid. Those are not good retirement plans!! You must save for your own retirement.
I always hear Dave Ramsey in the back of my head saying,
“Live like no one else [now], so that later you can live like no one else!”
That makes so much sense. We all know people around us that spend all of their money and say they don’t have any left to save. That’s the opposite of how to do this saving thing right! A survey from 2017 found that 78% of working Americans live paycheck to paycheck! This even includes some people making over $100,000 per year!! If you are one of them, and odds are you are, read the budgeting posts and start living frugal! It may seem counter-intuitive, but saving is the best way to spend!
Back to retirement accounts, when we say retirement fund, or account, we’re really talking about a tax privileged savings or investment fund. This means that the money that you contribute to this account is either your pre-tax income (for a Traditional IRA or 401k) or post-tax income (Roth IRA/401k) that is intended by the government to not be used by you until retirement age, or 59.5 for these specific funds. The tax privileged part is key – you can either go for tax-free growth and no taxes when you withdraw the money to use after the age of 59.5, such as with a Roth IRA/401k. Or, you can use pre-tax income and it grows tax-free until you withdraw it (you’ll pay income tax on it once), also after the age of 59.5 years old. Some of these tax privileged retirement accounts are your employer sponsored 401k and associated match (hopefully!), Traditional or Roth IRA (Individual Retirement Arrangements), SEP or SIMPLE IRAs through your work, or for military and federal employees there is the Thrift Savings Plan.
This is the most important savings fund you have. Start paying yourself first by automatically contributing a minimum of 10% of your monthly income (I recommend gross income, but net income is fine, just save!) into a tax privileged retirement account (such as the ones listed above). This savings rate is the first one you set when you make your budget. Figure out your income, then set this 10% contribution, and then see what other expenses you have and those are secondary to retirement! Prioritize retirement!
Now, be aware that this money will be set aside and not be usable (in most situations) until you’re 59.5 years old, so plan wisely! (There are times you can “borrow” against your retirement savings, but there’s penalties and you take a tax hit if you fail to pay it back! We’ll cover this in more detail in future retirement account posts. So, use the Sinking fund (below) to save for purchases as well!)
Save aggressively for retirement, but don’t over-extend yourself here and go into debt on other things because you didn’t plan well. Slowly increase your savings contribution from 10% to 15% or higher over time. As you become used to saving, it won’t even feel like you have less money in your checking account. Plus, this money will grow exponentially with wise investing (future topic!) in the stock market, but that’s an entire post and more on its own! Just remember to KEEP IT SIMPLE!
The Sinking Fund is a less-commonly known fund in which you save in advance for expected future purchases that are bigger than what you can absorb with a regular monthly paycheck. This is NOT an Emergency Fund, that is a separate fund for actual emergencies. The Sinking Fund is for purchases that you know you will make at some point in the future.
Basically, a sinking fund is making a loan payment to yourself in advance of the purchase INSTEAD of taking out a loan to buy something and then paying interest to someone else! Sinking funds are one of the most important funds you can set up and contribute to! They save you money in multiple ways: things are cheaper because you’re not paying interest on top of the cost of your purchase, you have more bargaining power if you have the money, you avoid getting scammed by “financing” or getting stuck with monthly payments that are low but end up costing you well over the actual price of what you bought, just to name a few of the benefits!
Now here’s one catch; it does take up time to build up this level of savings. These are typically for larger purchases, such as cars, furniture, vacations, gifts, or other miscellaneous purchases that you know that you’ll make in the next 1-5 years. This fund is about planning for the future and comes after funding your Emergency Fund and your Retirement.
The Sinking Fund Formula
For example, you know right now that you’ll need a newer car at some point in the future, and you should have a fairly good idea about how long your current car will last. What you do is, ask yourself how much you want to spend on your next car in XX number of years and divide that total amount you’ll spend on the car by the number of months that you assume you still have until you need to buy the car. That will give you a monthly “payment” that you’ll start making to yourself in order to purchase the newer car with cash. This will save you a car payment with thousands of dollars of interest! Here’s what it looks like for me:
In 3 years I’m going to be moving back to the U.S. I am assuming that my wife and I will buy a mini-SUV or SUV and that we’ll spend around $15-$20,000 on it. I have 36 months to save. So,
$20,000 / 36 months = $555 per month that needs to go into our “2020 Car Fund”
Now, $555 every month may seem like a lot of money, but the average car payment is currently ~$480 per month, so I’m not too far off. Again, I’m essentially making payments to myself without interest, which means I’m able to buy more car for the same amount of money! This is smart, we should all do it!
Now, look forward 3-5 years and project what purchases you may make: cars, furniture, vacations, a move, etc.? Start calculating how much you may be wanting to spend using the formula I used for the car above. Add all these numbers together and this is how much money you will need to contribute to a savings account each month to make these purchases.
Now, when you do this it can become a pretty large number, especially if your income isn’t that high! You’ll need to be honest with yourself about your ability to afford certain things you want and reprioritize towards what you need. Doing this helps you buy what you can afford, NOT what you can afford the monthly payment on, which is a completely different amount! (Hint: it’s always higher, they’ll get more of your hard-earned money!!)
Finally, with Sinking Funds, since this is money you know you’ll use in the relatively short-term, it shouldn’t be invested in the stock market. You’ll need to consider keeping this money in either a regular bank savings account (poor option due to low interest), a money market account (low return, but low volatility and very low chance of losing money), or the best two options are a high interest savings account or a rewards checking account, similar to your Emergency Fund.
If you’ve read the previous budgeting posts, by this time you should have a budget and an idea of where you’ve been spending your money. That information helps guide you towards how much money you can and should be saving for those expenses. If you’re unsure, start by tracking your spending, budgeting, set up your Emergency Fund, and then begin saving in these funds!
Here’s your priorities: First, focus on the Emergency Fund until it’s funded at a basic, 1-2 months of expenses level, second, save aggressively second for retirement (which is really first, once your Emergency Fund is at a decent level), and finally, pay yourself for future expected purchases in your Sinking Fund! These three, key funds will make spending money significantly less stressful and more fun because you’ll not have any of the guilt of spending money you don’t have.
Finally, consider your debt, if you you can “afford the payment” then you can afford to pay yourself – but it’s hard if you’re already in debt to save for future purchases when you’re still paying off your previous debt. That’s the biggest issue with debt – it steals your income and decreases your saving and spending potential! So, resolve to do better from today on, get out of debt ASAP, start saving for future purchases to avoid debt, and you’ll be well on your way to financial independence!
- Do you currently have any savings for future purchases? If so, how much? (also, great job!)
- Do you currently have any consumer debt? (i.e., credit card balances, car loans, financed furniture/tables/equipment,etc.) If so, what is the total of your monthly payments? Calculate how much you are spending on interest and you’ll know how much more you could have bought had you paid yourself first in a Sinking Fund PRIOR to borrowing the money!
- What expenses do you expect to have in the next 3-5 years?
- How long do you have until you anticipate having to make the next purchase?
Saving is one of the funnest parts of finance!! And it only gets better when you start to see those pools of money grow, so best of luck!