Lauren

The plan

1. Create a budget.

Lauren’s first steps should be to establish a realistic monthly budget and to track expenses every month against that target. She does not spend frivolously and is disciplined about only spending what she has. However, to maximize savings opportunities we recommend that Lauren utilize a budget and track expenses each month so that any excess can be applied toward savings. Getting a firm handle on both income and expenses will also come in handy as the payments on her home equity line of credit increase.

Lauren




The challenge:

She says short on college and retirement savings. We say need to budget and build an emergency account.

The plan: Create a budget to make room for more savings.

Follow-up: Still no budget, but more savings and confidence.

2. Beef up emergency savings. While Lauren’s goals revolve around saving for her retirement and her two children’s college educations, her first priority is to rebuild an adequate emergency savings fund. An adequate cushion is at least three months’ worth of expenses, and for households with one primary wage earner, a sum equal to six months’ worth of expenses.

Do this by immediately discontinuing the extra $100 that is being applied to the mortgage each month. Add that $100 to the $150 currently contributed to savings each month. This will boost Lauren’s savings cushion by $250 monthly. Keep up this monthly contribution to the emergency savings account for the next six months. For even better results, open a high-yielding money market or savings account, where the returns are high enough to outpace inflation. This is important to preserve the buying power of the emergency savings fund.

Why should she stop putting an extra $100 per month against her mortgage and put it into a savings account? There are several reasons. Lauren has a low, fixed-rate mortgage and there are other priorities for that extra payment. Putting money against her mortgage means the money isn’t readily accessible if she needs it. Case in point: Lauren has turned to a home equity line of credit to finance home repairs, paying interest to borrow against those earlier prepayments. The solution is to put the $100 into a liquid emergency fund where she can get to it without penalty if needed.

Lauren also has a substantial amount of home equity that accounts for the majority of her net worth. This is not uncommon, particularly after the housing boom of recent years, but it isn’t desirable to have too much wealth concentrated in any one asset. In the interest of diversification, there are better uses for that extra money even after her emergency savings account has been replenished.

Lauren should plow $250 per month — and more if she can — into the savings account for a period of six months. After six months of contributions, and no withdrawals, Lauren can then begin working toward longer-range goals. She will continue contributing $125 monthly to her emergency savings, but she can simultaneously pursue her objectives with the remaining $125 per month.

3. Set up a Roth IRA. Lauren’s priority should be retirement savings over college savings. No one gives grants, scholarships or loans for retirement expenses, but all are options when the kids head off to school.  

The step toward boosting retirement savings is to open a Roth IRA. Contribute the other $125 per month to a Roth IRA, taking the opportunity to raise this contribution whenever possible (pay raises or other windfalls). Lauren should continue contributing to her employer-sponsored retirement plan, maximizing the employer match. Lauren can contribute $4,000 to a Roth IRA for 2006 (the deadline is April 17). And since Lauren turns 50 in 2007, she can contribute a maximum of $5,000. This amount will seem out-of-reach, but a worthy goal is to raise her contributions until she can contribute the limit.

Retirement strategies. In her workplace retirement plan, Lauren has wisely chosen a life cycle mutual fund targeted for a projected retirement date of 2025. This fund is tailored to investors retiring around 2025 and will grow more conservative as that date approaches. Lauren plans to work full time until age 70, which will be in 2027. She may wish to make a similar choice for her existing Traditional IRA as it is currently invested in a mutual fund with a noticeably more conservative investment mix than the target retirement fund. When she opens a Roth IRA, she should consider taking a slightly more aggressive stance, say target retirement for 2030 (when she will be 73) or target retirement for 2035 (when she will be 78). Why? Because a Roth IRA allows for tax-free withdrawals in retirement and because withdrawals are not required, this should be the last of her retirement assets to be tapped for expenses. 

Keys to success
  • Live on a budget to set boundaries on spending and to cultivate savings.
  • Avoid high-cost debt or strive to eliminate it quickly.
  • Create adequate emergency savings through automatic payroll deposits.
  • Invest savings in a high-yield savings or money market account.
  • Participate in an employer-sponsored retirement plan.
  • Maximize tax-favored investment opportunities for retirement and college savings.
  • Contribute to a Roth IRA as it permits tax-free withdrawals in retirement.
  • Consider a 529 plan for funding college as withdrawals for college expenses are tax-free.

Lauren’s ace-in-the-hole is the substantial home equity she has accumulated. This is a nice boost to a retirement nest egg if she should ever choose to downsize to a smaller home, either prior to or during retirement. Once retired, Lauren could use a reverse mortgage if her financial assets were being depleted and she found herself in need of cash.

For the sake of conservative planning, Lauren should think of a reverse mortgage as a last resort. It is better to save more than needed rather than less, knowing that there is a margin of safety in the event that she lives longer than anticipated, retirement expenses are more than expected, or an illness derails her intention to work until age 70.

College funds. For any responsibility on the children’s future college expenses that she may incur, consider opening 529 college savings accounts for each of the kids. 529 plans allow for tax-free withdrawals to pay for higher education costs. Plans are offered through all 50 states and the District of Columbia. You are free to invest in the plan of any state, but some states offer residents the ability to deduct contributions from state income taxes. The State of Pennsylvania offers 529 plans through Upromise Investments and The Vanguard Group that have low minimum investments and modest expenses, plus the contributions are deductible from Pennsylvania state income tax. Lauren will retain control of the money, with each child listed as a beneficiary. This is a real selling point to parents as it eliminates any worry that their children could one day spend the money on cars and clothes, instead of college.

Since this is the first year that Lauren will be filing under single tax status, it is worthwhile to consult a tax professional well in advance of the April tax filing deadline. This is also another reason for an adequately funded emergency savings account as any liability for taxes, should one be incurred, would come from this account.

Now what?

Lauren will follow these suggestions as best she can. We will check back with her in six months to check her progress toward her financial goals. Good luck, Lauren. You can do it!

The plan in 4 steps
1) Establish a realistic monthly budget.
  • Keep track of all expenses for a month to set budget.
  • Stay focused on daily spending. Track it all.

Tools: Use this work sheet to create a budget.

2) Build an adequate emergency savings account.
  • Stop the extra payment against the mortgage.
  • Add the $100 from mortgage to savings account monthly.
  • Continue to contribute $150 to savings each month.
  • Keep this fund in a high-yielding savings or money market account
  • Follow this plan of stashing $250 monthly for six months.

Tip:

Pros and cons of paying extra on a mortgage

3) Build up retirement savings in the most tax-advantaged ways.
  • Continue to contribute to employer-sponsored retirement plan, maximizing the employer match.
  • Once emergency fund is adequate, open a Roth IRA.
  • Contribute half of regularly scheduled savings ($125) to Roth monthly.
  • Put other half of savings into the emergency fund.

Tip:

Tax advantages of IRAs

4) Consider college savings plans.
  • Investigate opportunities for creating 529 accounts for each son.

Tip: Ins and outs of investing in 529s

This report was prepared by Bankrate Senior Financial Analyst, Greg McBride, CFA.

What’s your experience with budgeting? Are you struggling? Successful? Share your story.

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