This week I received a question from Sally P. She says:
I’m 32 years old, self-employed, and earn about $400,000 per year. I’ve saved $100,000 to buy a home but want to wait until I’ve saved a total of $200,000 to put down on a condo. The money is sitting in a high yield savings account for now. I don’t have a retirement account and am wondering if I should fund one in addition to putting money aside for a condo. If so, how much should I invest and what type of account is best?
When Should You Start Saving for Retirement?
First off, Sally gets a big pat on the back for earning so much at a young age. But then I’m going to slap her on the wrist for not setting up and funding a retirement account by now! You should begin investing for your future as soon as you start earning income from your first job.
Sally’s doing a good job saving, but she could benefit from implementing some structure into her financial life. Here are five financial goals that you should accomplish in the following order, no matter if you earn $40,000 or $400,000 per year:
Financial Goal #1: Create an Emergency Fund
The following excerpt is from chapter 2 of my award-winning book, Money Girl’s Smart Moves to Grow Rich:
… having an emergency fund should definitely be one of your first financial goals. You could get into real trouble without one. None of us knows what the future holds when it comes to our income, our economy, or our health. It’s vital that we hope for the best, but plan for the worst. If you lost a portion or all of your income, you still have living expenses to pay. Unemployment benefits can help you survive a layoff, but that income is only temporary and isn’t likely to cover all your expenses.
How much money you should set aside in an emergency fund varies depending on your personal situation. But I recommend that you keep at least three to six months’ worth of living expenses in a safe place, like an FDIC-insured savings or money market deposit account. Your emergency money should never be invested, because that exposes it to some amount of risk, nor should it be co-mingled with other accounts. And never, ever dip into your cash reserves for anything other than a dire emergency.
Financial Goal #2: Get Adequate Insurance
An important part of being prepared for the unknown is being adequately insured. Many people get into financial trouble in the first place because they don’t have enough of the right kinds of insurance. As your net worth grows, you have more assets and income to protect from unexpected events. Without enough insurance,—such as health, disability, life, auto, homeowners, renters, and long term care—a catastrophic event could wipe out everything you’ve worked so hard to earn.
Financial Goal #3: Pay Down High-Interest Debt
Once you have an emergency fund in place and have adequate insurance, your next financial priority should be to pay down any high interest debt, like credit cards and payday loans. If you have excess cash above and beyond your emergency fund, use it to pay off expensive debt so you save the interest expense.
However, you should not pay off a debt early if it has a relatively low interest rate or comes with a tax deduction, like a mortgage, home equity line of credit, or student loan. Instead, you should use your money to earn a higher rate of return so you accumulate wealth for your future.
Financial Goal #4: Invest for Retirement
The next step is to start saving for retirement as aggressively as possible. A good rule of thumb is to invest at least 10% of your gross income in a retirement account, such as a workplace plan, an Individual Retirement Arrangement (IRA), or an account for the self-employed. If you can afford it, invest 15% or more. Increase the percentage you contribute every year until it hurts! When you’re sitting on a massive retirement nest egg down the road, you’ll be glad you did.
Financial Goal #5: Save for Other Goals
After you set up a retirement account and are making contributions on a consistent basis, then you can use your extra money to save for other goals like buying a home, funding a child’s education, or taking a vacation.
How to Save for Retirement If You’re Self-Employed
For 2011, Sally can only save $5,000 in a traditional IRA—but she can also put away much more in a retirement account for the self-employed. Use the IRS Retirement Plans Comparison Table to learn more about different types of retirement accounts that are available for businesses and self-employed individuals, such as a SEP-IRA, SIMPLE IRA, and 401(k).