The first bit of financial advice you probably received in your life was to save as much money as possible for a rainy day. While that's a good rule of thumb, some people take the penny-pinching so far that they end up missing out on fun activities. Worse, by leaving everything locked up in a savings account, they may be depriving themselves of the opportunity to earn more money.
Here's a useful guide to help you determine how much money you should save for emergencies, and some suggestions on where else you may want to put some of your cash.
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How big should my emergency fund be?
Opinions vary depending on who you talk to, but most experts agree that a good rule of thumb is to save at least three to six months' worth of living expenses in case you find yourself out of work for an extended period of time. Living expenses include your mortgage or rent payment, transportation expenses, utility bills, insurance premiums, and some money for groceries.
These are your day-to-day necessities that you can't live without. They do not include extras like your morning coffee, your Netflix subscription, or your gym membership. If you consider those to be essentials, factor them into your budget, as well.
Add up the total cost of these items to determine your living expenses for one month. Then multiply that number by three. In an ideal world, you would have an emergency fund that holds at least that much cash.
If you have extra money left over, you may want to save an additional three months' worth of living expenses. This will give you an extra cushion in case you end up out of work for longer than you expected or if other unexpected costs (home repairs, medical bills, etc.) arise during this time.
But if you've already got that much money stashed away, you're probably not doing yourself any favors by continuing to add to your emergency fund. Money in savings accounts is currently accruing 1% or less in interest, on average. While we are in a rising interest rate environment, that isn't a guarantee that your bank is going to increase your interest rate. Meanwhile, inflation rates vary widely, but they've been averaging around 2% year over year for the last decade. So if you think your account value is increasing over time, it's actually decreasing in value by about 1% per year.
Where else should I put my savings?
Though riskier than leaving your money in a savings account, investing your money usually leads to a much bigger return. A good place to begin is with retirement accounts. The sooner you begin contributing, the more compound interest can grow your investments so that you have a comfortable nest egg when you're ready to retire.
If your workplace offers a 401(k), you can contribute up to $18,500 in 2018. Individuals 50 and over can contribute as much as $24,500. This should be one of your first stops if you're looking for a place to put your extra savings, especially if your employer matches part of your contributions. Many will match $0.50 for every dollar you put in, and that coupled with years of compound interest, could help your retirement savings to grow quickly.
To put this in perspective, let's say you contributed the maximum $18,500 this year. Your employer matches 50% of that, bumping your total up to $27,750. Assuming an 8% interest rate, in 30 years, that $27,750 will have grown into $279,238.73. And if you add more money next year, that total will climb even higher. By comparison, if you left that $18,500 in a savings account, it may or may not grow any faster than the current standard of 1% per year. That only adds up to about $24,935.20 after 30 years. Keep in mind that inflation is unpredictable, but often outstrips the typical savings account APY, so that amount will likely be worth less in 30 years than it is worth today.
If your employer doesn't offer a 401(k) or you've already maxed it out, then open an individual retirement account (IRA). Contribution limits for these plans are much lower than on a 401(k). You can contribute $5,500 in 2018 if you're under age 50 or $6,500 if you're over 50.
You're doing this on your own, so your employer won't be matching any contributions. The advantage of IRAs is that they have low or no annual fees and you have more options when it comes to choosing your investments. Compound interest works the same way as with a 401(k) and contributing early can pay big dividends when you're ready to retire.
Retirement accounts should be your first choice for investment since you can get tax breaks for your contributions and reap the benefits of compound interest. But if you've maxed out your retirement savings or you want to be able to take your money out at any time without being penalized, consider opening a regular, taxable brokerage account, as well.
There aren't any tax breaks for money in a brokerage account, but you have complete freedom to choose what you want to invest in. And in the unlikely event that your emergency fund isn't enough to cover an unexpected expense, you can pull the extra money from your brokerage account to cover the extra costs.
Smart investing requires a thorough understanding of the stock market and the stocks you're buying, plus a little bit of practice. But done right, you can grow your savings at a rate that far outstrips the measly 1% you'd get from leaving it safely in your savings account.
