Facebook Question: I just got out of college, should I focus on saving a year's worth of cash reserves or investing in my 401(k)?
December 2010
Question: I just got out of college. I got a job as an engineer for a major oil company, making $100,000. I have been following your monthly newsletter. As much as I agree with your advice, I am a little confused. As far as I gather, you recommend people save at least one year’s worth of spending in cash reserves. I also frequently see you saying invest in a diversified portfolio like that of EMAP, and to invest in a 401(k) as much as you can. Which of these should I focus on first? I don’t owe on credit cards, but one year’s worth of spending is a lot of cash, and your EMAP requires a minimum of $50,000 to open an account.
Ric: Congratulations on your new job! You’re off to a great start, and I’m very impressed that you are getting an early start to planning for your financial future.
You are asking the right question, for it is important that you follow my advice in the correct order to give you the best opportunity to help you achieve your financial goals.
Begin by participating in your company retirement plan, and do so to the maximum that you are allowed. Notice that we do not say to limit your contributions to the amount contributed by your employer.
This is an important distinction, as some employers match 3% of your salary. If you contributed only to that extent, you would be investing only $3,000 of your paycheck in your case. But you’re allowed to contribute as much as $16,500 (those 50 or older can contribute an additional $5,500). Clearly, the more you contribute, the more you’ll have in retirement — and that’s the point. So contribute the maximum you’re permitted.
(People who cannot afford to do this should contribute as much as they feel they can afford, and then they should increase their contributions slowly, perhaps with each salary increase. Pretty soon, they’ll find themselves saving the maximum too!)
After you’ve done this, you’re ready to move to the next step: Pay off any credit card debt you have. Chapter 49 of the new fourth edition of The Truth About Money explains how to do this. Sometimes people find it strange that we recommend you pay off the credit cards after you start funding your retirement plan, but our reason is simple: If you don’t start saving for retirement until after you pay off your debt, you’ll probably never start saving for retirement — for the simple reason that most people always carry debt of some kind.
Since you don’t have credit card debt, you can skip this step, and thus you can begin to accumulate cash reserves right away. As you noted, we recommend that you have 12 to 24 months’ worth of essential spending saved in a savings account or short-term certificate of deposit. Accumulating this much cash may seem like a daunting task, but it’s easier than you think: Just save a portion of your income each month until you reach this target. It’s important, for you might lose your job or incur a major expense unexpectedly. Having substantial cash in reserve will help you get through any such problems. If you skip this step, you risk having to liquidate investments during an emergency — and Murphy’s Law suggests that the emergency will occur at the same time the market is down, forcing you to sell at low prices. We want you to avoid this risk, and that’s why having lots of money in reserves is the smart approach.
After you have taken these steps, you’ll be ready to begin accumulating money that you can then invest in a diversified investment portfolio (such as EMAP) outside of your employer’s retirement plan.
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