Birthdays, taxes and surprises are the only sure things in life. Here's a savings plan that will help get you ready for the inevitable "holy trinity."
I'm currently reading "The Money Book for Freelancers" by Joseph D'Agnese and Denise Kiernan. It's a great book, and if you work for yourself, you should definitely check it out. While a lot of the advice is specific to the self-employed, the heart of their money system is good for everyone.
The "holy trinity of savings"
The authors advocate a system of savings based on three core principles: saving for retirement, saving for emergencies, and saving for tax day. They call these goals the "holy trinity of savings."
It's a popular and largely true cliche that nothing in life is guaranteed except death and taxes. It's also common advice to "expect the unexpected." The beauty of this particular savings system is that it helps you prepare for the inevitable: your next tax day, your living expenses through the end of your life, and all the unexpected events in between.
According to the authors, your goal should be to save as much as 20 to 30 percent of your income overall. If you're self-employed, go for the higher number. If your employer is already managing your payroll taxes, 20 percent should be sufficient.
Retirement savings means money to help put food on your table and keep a roof over your head when your working years are done. If you work for a large company or institution, your employer probably contributes in some way to your retirement. You may qualify for a pension plan. If you're getting employer-paid matching contributions to a 401(k) account, this is great; it's like free money.
For example, let's say your employer matches up to 5 percent of your salary in retirement contributions. You contribute 5 percent of your pre-tax income to your 401(k). You'll get an immediate 100 percent return on those dollars.
In addition to building up your 401(k) or IRA savings, you may want to put some of your retirement investments into FDIC-insured high interest savings accounts or CDs. This is especially useful as you get closer to retirement, when your goals should be shifting from building wealth to protecting what you have. A CD ladder can be a great way to take advantage of the highest available interest rates without risking your capital in the stock market.
Your retirement savings should get 10 percent of your income, more if you're starting late. Again, if your employer is matching your contributions, you can leverage your portion to meet that percentage. Just be sure you know what you'll need for retirement, and that your investments are on track with those needs.
To my thinking, your emergency fund is the first one of these priorities you should focus on. It's the only one you certainly have to do on your own. Whether you're self-employed or working for a major corporation, your emergency fund is your responsibility. It's also the account you'll need soonest. Retirement looms in the future, but an emergency car repair or a medical catastrophe could happen tomorrow.
To be prepared for sudden changes in your financial weather, you want to have a solid emergency fund. This should have about six months of living expenses in it, available relatively quickly in cash. But keep it far enough out of reach that you can't snag it for an impulse buy. Shop around to be sure you get the best bank rates for this account.
Building an emergency fund takes patience and discipline. Obviously, you can't put six months' worth of your salary away overnight. You'll want to set up a dedicated bank account to hold this money, preferably a high-interest savings account at an online bank. Money market accounts can also be great options for an emergency fund.
How much should you save? In the "holy trinity" system, this account gets 5 percent of your income. Once it's fully funded with six months of living expenses, you can stop contributing to it and roll that money into your retirement accounts instead.
Most of us pay most of our taxes through our employers, so we don't need to save a part of each paycheck for them ourselves. You'll want to anticipate the tax payments your employer doesn't manage for you, though. That includes excise taxes on your car, property taxes if they aren't rolled into your mortgage payments, and any other local tax bills you receive. If these are relatively small expenses, note them on your budget. If they're large, you may want to set up a dedicated savings account for them.
If you are self-employed, it's imperative that you put money aside for taxes each time you get paid. Otherwise you'll be facing a mountainous tax bill come April 15.
Just do it
The most important thing with this approach, like any approach, is that you just do it. Being disciplined and consistent with your savings will get you where you need to be.