How much should you keep in savings?

Let's talk about your Magic Number...

When planning your finances, specificity is important. Knowing what you are saving for is extremely helpful when determining what is an appropriate investment.

For most of us, building up an emergency reserves is the first place to start. This is where we're going to talk about your Magic Number.

Let's talk about that emergency savings

There are a lot of general recommendations out there, but I'm going to talk you through how to come up with a strategy that fits for you.

I'm also going to talk about "backup" options that you can count on if you can't save enough in your emergency savings.

So how much should I have?

A general rule of thumb is that you should have 3-6 months of either your income or expenses in easily accessible cash.

Let's break this down a bit...

First, do you save up your Income, or Expenses?

I say, start with the smaller number, usually your expenses.

Income

Expenses

What does it cost you to survive if you were to lose your job or income for a month?

Typically this will be:

Mortgage / Rent
Food
Gas
Insurances
Utilities
Any other necessary expenses

Let's say all of this adds up to $3,000.

Great, your Magic Number is $9,000 - $18,000.

Notes: This article is written more for High Cash Flow Savers. IE, people who are saving consistently and generously towards their goals.

Ultimately, your Magic Number is 3-6 months of your expenses, OR, the amount you need to keep in cash to Feel Safe.

What I really want to encourage is for you to save up until your Magic Number, AND THEN STOP!

Okay, I don't really mean stop saving...

What I mean is, save purposefully.

To explain this, I'm going to briefly bring back the concept of the three types of accounts you can save in.

Pre-Tax - you pay taxes LATER

(the larger dollar)

Post-Tax - you pay taxes NOW

(the smaller dollar)

Taxable - you pay taxes LATER

(only on gains)

This is where your savings is.

Why is this important?

I see a lot of people who have $30-$100k in savings.

Often times, it's been there for years.

They keep adding to it because they don't know what to do with it!

This is critical because you are losing out on an immense opportunity to save smarter!

Meet Joe Savesalot

Joe has a stable job.
Joe is saving in his company 401k with a $70,000 balance.
Joe's monthly expenses are $3,000
Joe has built up his savings to $50,000
Joe also has a Roth IRA of roughly $15,000.

In our very first meeting, I (tactlessly) tell Joe, "Hey, you have too much in savings. Let's cut that down to $9,000 and invest $41,000 into the stock market."

Joe's response.

Try #2

Okay Joe, let's first talk about the money you already have, and how accessible it is.

Taxable

Checking

Savings

Taxable Investment Accounts

Joe, if you had an unexpected event where you couldn't work, you have FULL and IMMEDIATE access to all of these accounts.

Post-Tax

Roth IRA

Roth 401k

You can access your CONTRIBUTIONS to your Roth IRA at any time.

Your Roth 401k accessability is up to your employer.

Pre-Tax

401k

403b

IRA's

You normally have access to 50% of the VESTED value, or $50,000 (which ever is less) through a Loan from your 401k or 403b.

Your IRA funds are mostly inaccessable until 59 1/2 years old.

Context check- If Joe has a stable job, he may be able to lean more towards the Lower End of the savings range, $9k - $18k.

Chances are, if he's built up $50k in savings, this has happened over years. Years with no unexpected emergencies.

Some caveats:

If your job is relatively stable, I normally recommend people keeping the Lower End of the savings range in a savings account.

I encourage you NOT to think of a savings account as something that "makes money". A savings account simply keeps money safe and accessible for you.

In this scenario, I would likely recommend that Joe keep $9,000 in his savings account and invest the remaining $41,000 into a taxable investment account.

Since Joe's Magic Number is $9,000, AND he already has that much in savings, I'm going to recommend that Joe save all excess cash into either his 401k or the taxable account.

Now Joe has:

Pre-Tax - $70,000 in 401k

Post-Tax - $15,000 in Roth

Taxable - $9,000 in Savings & $41,000 in a Taxable Investment Account

Emotional Sidebar - Often times, we have a certain savings number that we need to "feel safe." As in, " I don't feel comfortable with less than $50,000 in the bank."

We also tend to think of the worst case scenario. As in, I need that $50,000 in case:

The furnace breaks
My car breaks down
We lose a job
Have an unexpected medical expense...

In reality, it is not likely that all of these will happen at the same time. More than likely, any "emergency" will happen over a matter of weeks or months.

Meaning you have time to react and plan.

So what does that mean for me?

Let's say you lose your job AND the furnace goes out at the same time.

Well... You have three months of expenses, $9,000 in savings ($3,000 x3).

So, practically speaking, this money will slowly be spent over 3 months. This gives you time to process, plan and adjust your finances accordingly.

But the furnace replacement is another $10,000, I don't have that in savings!

That's okay, you have options...

Pre-Tax - $70,000 in 401k

Option 3) You could potentially take a loan for up to $35,000 at a low interest rate (usually 3-6%)

Post-Tax - $15,000 in Roth

Option 2) You could withdraw your CONTRIBUTIONS to your Roth penalty free.

Taxable - $9,000 in Savings & $41,000 in a Taxable Investment Account

Option 1) You can look at liquidating part of the $41,000 to pay for the furnace. You'll simply owe taxes on any gains.

Option 4) You could buy the furnace on a credit card or other credit. This will buy you more time to work out the logistics of how to pay for the furnace.

Let's sum this all up:

It's important to understand the Opportunity Cost you are giving up by keeping an excess amount in savings.
- Low savings return vs. higher expected returns by investing.

I encourage you to honestly think of the reality of how likely your "worst case scenario" is to happen as you picture it in your head.

You should weigh what is more important to you:
- Having higher expected returns by investing some of your savings in exchange for slightly more work getting funds in an emergency.
- Having lower expected returns by keeping excess savings in exchange for simplicity of getting funds in an emergency.

My recommendation:

I normally recommend people invest excess funds into a taxable account. A taxable investment account is an EXTREMELY powerful investment tool long term. Learn more here.

Your worst case scenario has a low likelihood of happening.

I don't see any problem with "kicking the can down the road" a bit and buying yourself time to make a smarter financial decision.

If you'd like to talk more about your Magic Number, but don't know how to get started feel free to schedule a phone call. We're happy to help...

We're a different kind of financial firm than you may be used to.