The Savings Hierarchy
April is Financial Literacy Month so I'm talking about some general personal finance topics that might be of interest to you and your students. Today I'm writing about the savings hierarchy: What savings accounts should you have, and what goes into each one?
The savings hierarchy fits within the overall hierarchy of financial needs. You've seen these types of pyramids everywhere; here is one for personal finance:
(Thanks to Visual Capitalist)
The bottom layer of the financial needs pyramid is cash flow and basic needs: housing, food, transportation, healthcare and other nondiscretionary needs.
The next step after basic needs is your safety net: enough liquid savings to get you through an emergency. For a family, 3-6 months' expenses is a good amount to have in emergency savings; young people who have less fixed expenses and more flexibility might be able to get by with a little less. We recommend using high-yield savings accounts such as those from Marcus, Ally, Barclays Online and others, both because they earn slightly higher interest rates than traditional bank savings accounts and because it's helpful to have a little separation between your savings account and your spending accounts.
Next comes wealth accumulation: saving for the long-term, especially retirement. This means not just increasing savings but reducing consumer debt and focusing your finances on the future-- what do you want to do with your time on this earth-- not the past-- paying off debt or dealing with the consequences of past decisions.
Wealth accumulation leads to financial freedom. After all, wealth is really more about time than money: being able to choose how you spend your time, whether it's work or pleasure. Financial freedom allows you to plan for your children's college educations, take vacations or even sabbaticals, and to start to plan for risks that might jeopardize your financial freedom.
Finally, your legacy comes into play. What mark do you want to leave on the world? Do you have assets-- personal or business-- that you'd like to plan for?
In practical terms for families planning for college, here are some rules of thumb:
If you don't have emergency savings, or a means to get 3-6 months' expenses quickly, that is your #1 priority and needs to be addressed first.
If you're not maxing out retirement savings, make sure you're doing at least enough to get an employer match (if offered) before saving for other priorities.
If you're somewhere between the full employer match and maxing out retirement-- $20,500 this year for those under 50 or $27,000 for those over 50-- then your annual college savings should not be more than 10% of your annual retirement savings. If you want to save more for college, save more for retirement first and bump up your savings rate for both over time.
Only when you're maxing out retirement should you think about maxing out college savings. In doing so, start by targeting your state's annual tax deductible amount, since in most cases saving at that rate will put you in good shape to have a lot of affordable college choices.
Most important in all of this is that the four points above are rules of thumb: ways of thinking about things. Your situation may have nuances that aren't accounted for in these basics-- a large pension, for example. The hierarchy of savings, however, is a rule, not a rule of thumb. Emergency, then retirement, then college.
