A Money Girl podcast listener named Heather says, “I work for a nonprofit and contribute 4% to my 403(b)—but I’m also trying to get out of debt. Would it be better for me to stop my retirement contributions until I pay off my debt or to continue investing at the same time?”
Thanks for this great question, Heather! It's critical to save for retirement and to pay off debt. But with only so much money to go around, knowing where to focus your attention can be tricky.
In this post, I'll answer Heather's question and give you a five-step guide to follow when you're not sure how to manage or allocate your money. You'll come away with a clear path to prioritize your precious financial resources so you can build wealth faster.
1. Evaluate your savings
I receive many questions from podcast listeners and readers about paying off debt. There's a lot of confusion about which debts to tackle first, how aggressive to be, and ways to balance paying off debt and saving.
Before you spend too much time agonizing over the details, take a step back, and evaluate your savings. Do you have a cash reserve? How much?
Building some amount of emergency savings should be your number one financial priority. Creating a cash reserve must come before paying down debt or investing, so you're protected from a financial emergency.
Savings needs vary
The amount of emergency savings you need varies depending on your lifestyle and financial situation. You probably need a more substantial financial cushion if you:
- work in an unstable industry
- are self-employed
- are the sole breadwinner for a large family
A single person with no dependents and plenty of job opportunities wouldn't require as much emergency cash.
Ideally, you should accumulate a minimum of three to six months’ worth of living expenses. Another good rule of thumb is to save at least 10% of your annual gross income. For instance, if you earn $50,000, make a goal to accumulate and maintain a $5,000 emergency fund.
If you’re starting with zero savings, you could begin with a small goal, such as saving 1% or 2% of your income each year. Or you could start with a small target like $500 or $1,000 and increase it each year until you have a healthy cushion.
If you try to accomplish other financial goals before accumulating a cash reserve, you’re putting the cart before the horse. So, evaluate how much savings you have, how much you need, and create a plan to bridge the gap.
A common mistake to avoid is investing your emergency savings or thinking you could tap your retirement fund. Your emergency fund should be in a safe, high-yield, FDIC-insured savings account. Don’t worry if your savings earn little or no interest. The purpose is for your emergency money to be accessible and liquid in the short term. If you invest it, the value could shrink to nothing the moment you desperately need it.