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Everyone knows it's wise to save money for a rainy day. Of course, actually saving money is a little easier said than done. But a common question people frequently ask is: How much money should I be saving?
How Much You Should Aim to Save Each Month
Ideally, you should save as much money as you can each month. But there is no set amount that works for everyone, because everyone has different incomes and expenses. However, several rules of thumb can help guide you when you're figuring out your savings strategy. One is the 50-30-20 rule. Here's how it works:
- Of your monthly after-tax income, you should aim to put 50% of it toward your necessities. That includes housing, food and monthly bills like your cell phone, utilities and student loans.
- After that, you can spend 30% of your income on your "wants." These can vary depending on your priorities, but they may include travel, clothes or entertainment. This is the stuff you can live without but that enhances your life.
- Finally, aim to put 20% of your income into savings. This can include money you're setting aside for retirement, money you're putting into an emergency savings account, or cash you're saving toward a specific goal, like a down payment on a house.
If this breakdown is a stretch for you based on your income, you can alter it based on your situation and needs. For example, you may need to cut your wants to 15% or 20%, especially if your needs cost more than 50% of your income. But even if you can't get to 20% in savings when you start your savings journey, try to earmark at least some part of your income to savings, even if it's only 5%.
This strategy doesn't just focus on your after-tax income, however. If your employer allows you to set aside money in a 401(k) retirement savings account, do everything you can to take advantage of it. These funds are pre-tax and go directly into your retirement account—helping you reduce your tax burden and save for retirement. For example, if you make $75,000 a year but direct $5,000 each year into your 401(k), you will be taxed on $70,000 rather than the higher amount. What's more, many employers offer a 401(k) match. So if you put a certain percentage of your paycheck into a 401(k), your employer may offer to match it (usually up to a certain percentage). Not taking advantage of this is like leaving free money on the table.
How Should You Direct Your Savings?
Once you've allotted a certain amount of your after-tax income to savings each month, figure out a plan to prioritize it. These days, it's very easy to open a free online savings account at an attractive interest rate. Consider earmarking a separate account for each of your goals.
The first thing you should focus your savings on is building an emergency fund. Experts suggest saving anywhere between three and six months' worth of expenses in this fund. Because it's an emergency fund, calculate your expenses based on the absolute necessities you must pay each month, like your rent or mortgage, groceries and utility bills. You can exclude your wants—this is the bare minimum you will need to get by.
Once you have built up at least three months of living expenses in your emergency fund, next focus on earmarking your extra savings toward paying off high interest debt, like credit cards. This type of debt can cost you a lot of money in the long run, so the faster you pay it off, the more money you will save and the better your credit scores will be.
If you have an emergency fund and don't carry any high interest debt, direct your savings to your long-term goals, like saving for a house. And even if you are already putting pre-tax dollars into a 401(k), it's crucial that you direct some of your savings into retirement. You may consider putting half of your savings toward retirement, and the other half toward your big goals.
Saving Strategies for Success
Temptation can often get in the way of our goals. If you wait to save after you've already spent your paycheck on bills and wants, you may end up saving nothing at all. That's why the best way to save is to automate as much as possible.
Some employers will allow you to direct deposit your paycheck into more than one bank account. If that's possible, take advantage of it. Direct your employer to put the 10% or 20% you want to save into a savings account, while the rest of your pay is deposited into your checking account. You won't be able to access the savings funds as easily as the checking funds since by law, you're only allowed six withdrawal or transfer transactions each month before your bank can take action, such as charging you fees or converting your account into a checking account. Automating savings will also trick your mind into making do with what's in your checking account. This is known as paying yourself first, and it's a time-tested behavioral economics technique for saving.
If your employer won't deposit funds into more than one account, you can still pay yourself first. Set up automatic deductions to a savings account that take place the same day your paycheck hits your checking account. That way, the savings money won't linger in your checking account for long. Automation is the key—it removes or at least reduces temptation to spend the extra funds.
Once you've started saving a portion of your paycheck, the best way to increase your savings is to do it little by little. If you try to jump from saving 10% of your paycheck to 20%, you will probably feel that change drastically. Of course, if you can do it, go for it. But another strategy is to slowly get yourself used to saving more by increasing your savings by a small amount, like 1%, every quarter or every year. And if you receive an annual raise, consider directing a part or all of the extra funds to your savings—before you get used to having the extra money.