With record high inflation and rising interest rates, an economic recession has been the subject of many conversations lately. Now with two consecutive quarters of a drop in GDP (gross domestic product)—the benchmark many economists use to gauge a recession—the possibility of a serious economic downturn isn’t just fodder for conversation anymore. It’s time to get serious about protecting your finances for a recession. Here’s how you can make sure you’re prepared.
Build Up Your Emergency Fund
It’s widely recommended to have enough savings to cover three to six months of living expenses. The specific amount will depend on your circumstances. For instance, in today’s uncertain economy, you might feel it worthwhile to aim for more than six months. It might seem daunting, but don’t undervalue the effectiveness of small contributions on a regular basis. You can also think about automating your savings contributions for a set-it-and-forget-it approach. Whichever way you go about it, consistent contributions to an emergency fund help to build positive saving habits that will carry into the future.
Pay Down Credit Card Debt
Focus on paying down any high-interest debt. Not only will this help you be more prepared should you get laid off during a recession, but credit card APRs are rising in response to the Federal Reserve’s rate hikes. Knocking out debt could free up critical breathing room in your budget that you could use to boost your emergency fund.
Identify Ways to Reduce Expenses
Start looking at all the ways you spend money, and identify ways you can scale back on discretionary spending (services or items that aren’t necessities—vacations, dining out, cable, spa treatments, etc.). Typically, the guidance is to spend no more than 30 percent of your net income on discretionary purchases. Think about creating a monthly budget in order to stick to this guideline and ensure you’re not overspending.
Stay Invested
It’s tempting when the market is as volatile as it’s been recently to think about cutting back on 401(k) contributions or selling stock investments. Keep in mind, however, that you’re investing for the long term. Stocks rise and fall all the time, and history has proven that bull markets (rising market conditions) last longer than bear markets (falling market conditions).
Rebalance Your Portfolio
While you want to stay invested for the duration of a recession, you might consider rebalancing your investments. Depending on your age, risk tolerance, and investment goals, it may make sense to shift more investments into growth funds, which could potentially experience greater gains when the market rebounds. Be sure to keep in mind that money needed in the short term should not be allocated to these funds as they are high risk.
The Federal Reserve reports that 26% of working Americans have no retirement savings. And among the working Americans who have retirement investment funds, 45% feel that their savings projections fall short of their long-term goals. If you’re a late retirement investor, it’s still possible to build a solid nest egg by the time you retire. The tips below will help you make up for lost time and get back on track.
Estimate How Much You’ll Need
A general guideline for retirement savings is to have 10 times your income saved if you plan to retire at age 67. For example, if your annual salary is $50,000 per year, you should aim to have $500,000 saved by the time you turn 67 years old. However, you should adjust this number based on your individual retirement goals. Do you plan to travel extensively in retirement, or do you want to downsize and live frugally? Increase or decrease your estimate based on these goals.
Start Saving
One of the easiest ways to start saving for retirement is through an employer-sponsored plan, such as a 401(k) or 402(b). These plans are even more valuable if your company offers matching contributions. If you don’t have access to an employer-sponsored retirement plan, think about opening a traditional or Roth IRA.
Traditional IRAs: Contributions are tax-deductible, but withdrawals in retirement are taxed.
Roth IRAs: Contributions are not tax-deductible, but withdrawals in retirement are tax-free.
Small business owners and self-employed individuals can also look into retirement plans in the form of SEPs and Simple IRAs.
Pay Down Debt
Debt is holding you back financially, so create a plan to pay off credit card debt, car loans, and other high-interest debt. If your mortgage is fairly new, you might also consider making extra mortgage payments in order to pay down some of your principal. However, if you’re in the later stage of a mortgage, and your payments are mainly covering the principal, it might be more beneficial to invest in retirement rather than putting that money toward your mortgage.
Pay Yourself by Automating Investments
Regular, automatic investments can help close your savings gap between now and retirement. While it might seem smart to be sure you’re covering essential expenses with each paycheck before investing, chances are—unless you’re budgeting faithfully—more of your paycheck is going to impulsive and discretionary purchases than you realize. Get ahead of the game by allocating a portion of your paycheck to be automatically and directly deposited to your retirement account.
Start Cutting Costs Now
It is never too early to get organized and prepare for retirement, no matter how close or far off your golden years are. However, if you’re on the closer-to-retirement end of this spectrum, now is the time to start cutting costs in a meaningful way. Start by minimizing expenses and stashing the extra cash away in savings. In addition to cutting debt, find ways to save on everyday bills and costs. These savings can add up and offer some breathing room once you’re no longer receiving a regular paycheck.
Use Catch-Up Contributions
American workers ages 50 and older are qualified to contribute an additional $6,500 in catch-up contributions to their 401(k) per year, increasing the maximum contribution to a 401(k) to $27,000 per year, or $2,250 per month. This is a lofty monthly goal, and might not be possible for many workers, but aim to contribute as much as you possibly can in order to get you that much closer to your retirement goal. Even if you are just beginning to save at 50 years old, by funding your 401(k) up to the maximum amount—assuming an 8.7% annual return and considering compounded interest—it’s still possible to save $1 million by the time you retire.
Setting goals is a necessary start to achieving a financially secure future, but sticking to those goals is another hurdle altogether. Unexpected expenses, the costs of day-to-day life, and failure to track spending all have the potential to derail any roadmap we may initiate. Read on for actionable strategies to help you stay on track to reach your financial goals.
Be Clear About Your Objectives
Most of us have heard that every dollar should have a name, which means that when it comes to saving, you need to be clear on your objectives. What are you saving for? It could be a down payment on a house, a child’s education, retirement, a dream vacation, etc. Many of us save for a combination of objectives, so it’s also important to be crystal clear on the reasons behind your financial goals. Knowing your “why”—for any goal in life—will create intrinsic motivation. The goal becomes a priority despite whatever external forces are at play.
Establish Small, Attainable Goals
Many financial goals are lofty, whether paying off student debt or saving for retirement or anything in between. They take diligence, consistent monitoring, and a solid framework to reach. In other words, financial goals require micromanagement. If your goal is to save $5,000 for an emergency fund, write down the steps you plan to take to achieve this goal, then put them into action and monitor them constantly. Some of these steps could include, for example, reframing your budget to account for the emergency fund, setting up automated weekly deposits into your savings account, and finding a money managing app that works for you.
Compartmentalize
In order to meet a specific goal, think about dedicating a separate account for it. You can even set up automatic direct deposits so you’re not tempted to use the money for something else. Be sure to label this account with a name that reflects your goal, such as “Early Retirement”. This can be applied to any financial goal. In fact, you may have several different accounts allocated to different goals.
Break Down Big Goals into Quarterly Milestones
Once you compartmentalize your goals, think of your bigger goals in terms of quarterly increments. If you want to save $20,000 in two years for a down payment on a house, rather than focusing on the daunting path ahead, make a plan to allocate a certain amount each month, then review the account every quarter. In this case you would need to save roughly $834 per month. When you see that you’re saving $2,502 per quarter, the end goal of $20,000 in two years is undeniably within reach.
Build a Flexible Budget
In order to reach financial goals like the $20,000 down payment example above, you need to keep spending in check. When you know how much money is coming in and leaving your account on a monthly basis, you can better determine how much you can allocate to different goals. When you create your budget, keep in mind that it should be realistic yet flexible so you can make smart adjustments as needed.
Save Your Raise
When saving for financial goals, aim to save at least half of any raise, bonus, or unexpected funds. Better yet, save it all. As tempting as it can be to splurge on a big purchase, you’ll be happier in the long run when you refrain from impulsivity in favor of staying the course to meet your future goals.
If you’re in the market for a new house, you might be wondering if you can tap into your workplace 401(k) to cover the down payment. The short answer is yes, but there are definite disadvantages in doing so. Let’s take a look at some of the pros and cons to this approach.
Benefits of Borrowing from a 401(k) to Make a Down Payment on a House
You’re borrowing from yourself rather than another lender, which means you might not be losing as much money on interest payments as you would if you acquire the funds through other means, like taking out a larger home loan to cover your down payment costs.
The loan approval is typically hassle-free. Provided your workplace plan allows for loans, and you do indeed have sufficient funds in your 401(k), your credit score and other financial credentials shouldn’t impact your ability to borrow against it.
The process is typically quick. Every plan is different and works on its own timeframe, but once you’ve decided to borrow from your 401(k), it’s usually just a matter of filling out a few forms to gain quick access to the funds.
More money for a down payment may equal more options. Borrowing against your 401(k) plan will allow for a larger down payment, which will allow for wider options when it comes to mortgage lenders. It could also help you qualify for a better interest rate as well as help you dodge Private Mortgage Insurance (PMI).
A Note on PMI
PMI is customarily required when you have a conventional loan and make a down payment of less than 20 percent of the home’s purchase price. The most common way to pay for PMI is a monthly premium that is added to your mortgage payment. Because it protects the lender and not the borrower, many home owners want to avoid this added expense, but some choose to see it as just another expense of owning a home.
Disadvantages of Borrowing from a 401(k)
You are diminishing your retirement savings, both in its immediate drop in balance and its future growth potential. Most likely, the return on investment (ROI) you would gain by keeping your money invested would be greater than the ROI from the interest you pay yourself (or the appreciation on your house).
Your budget will take a hit. You are required to repay the 401(k) loan, which means that a portion of your future paychecks will go toward repayment. That means less money at your disposal for other expenses, such as homeownership costs.
You will be on a repayment deadline. Borrowers typically get five years to repay a 401(k) loan. Depending on the size of your loan, you could potentially face large monthly payments in order to meet the repayment deadline.
Inability to repay the loan will result in penalties. Your loan will be treated as a withdrawal if you are unable to pay it back in full by the deadline, which means that you will owe income taxes on it. You will also be subject to a 10% penalty associated with early withdrawals unless you were older than 59 ½ when you took the money out.
Beware of the cost of leaving your job before the loan is paid. If you quit your job or experience a layoff, the entire loan amount will need to be paid by the due date for filing taxes that year. This could result in a need to repay the loan quickly in order to avoid penalties.
The beginning of a new year has long been associated with starting from a blank slate and setting new goals for the year ahead. While 2020 taught us that plans and goals can quickly veer off course through no fault of our own, maybe 2021 can teach us the value of planning anyway—even in the face of the unknown. The financial tasks set forth below will help you pay down debts, save money, and better prepare you for whatever 2021 has in store.
File Your Tax Return ASAP
Not only does filing early help stave off refund-hungry thieves, but, generally, the sooner you file the sooner you get your refund. If you’re planning on owing the IRS, it’s better to know early and make arrangements for payment.
Given the unemployment plunge of 2020, keep in mind that unemployment checks are typically taxable, so if you received extended jobless benefits, be prepared to face a potentially greater-than-expected tax bill.
Check Your Withholding
You can use an online income tax calculator to estimate how much you’ll owe in federal taxes. Use your prepared 2020 tax return and your first pay stub from 2021 to check that you’re on track with tax withholding. If not, the calculator can help work out adjustments to your paycheck, and you can contact your employer if you need to make changes.
If you’re a business owner, you may need to make estimated quarterly payments. Tax professionals can help you work out amounts and details.
Get Organized
There’s no time like the present to organize your financial life. All those paper receipts and statements scattered on desktops or tossed into random drawers? Corral them into labeled file folders, baskets, or envelopes. If you want to shed the paper clutter all together, go digital with an accounting software like QuickBooks. A digital snapshot of your finances will help you gain a better grasp for where you are financially before setting new goals.
Commit to Saving in a Realistic Way
Instead of just thinking about saving, commit to establishing a habit of saving by striving for a concrete goal. Set the amount and time frame for your goal, then come up with actionable steps on how you’re going to reach it. For instance, set up an automatic draft from checking into savings, take on a side hustle, and/or comb through your budget to see where extra funds could be found. In order to set yourself up for success from the get-go, be sure to be realistic. A goal of $100,000 in five years might be realistic for some people, while beginning with a goal to save $50 a month will be more on par for others.
Create a Budget
First, look back over bank and credit card statements from last year to help identify spending patterns and areas of improvement. Next, set a budget. Think of your budget as a roadmap of how you’ll save and spend your money, starting with essentials, such as mortgage, food, utilities, and healthcare; then move to recreation and savings. Keep in mind that your budget has movable parts, meaning life circumstances can change, even month to month.
Start an Emergency Fund
An emergency fund is exactly what it sounds like—funds set aside for an unexpected cost like car or home repairs. At the minimum you should aim for $1,000 to be put into an emergency fund, and try to work your way to saving three months’ worth of income.
Spend Your Medical FSA Early Rather than Later
If you have an employer-provided flexible spending account, spending it as early in the year has possible has a few advantages, including:
Acquiring medical expenses early in the year can help you meet insurance deductibles, so the rest of your health care can cost less.
If you leave your job at any point during the year, you can spend the full amount you had planned to contribute—up to $2,750—and aren’t required to finish making the full FSA contribution.
You mitigate the risk of not using the full amount by the deadline and potentially losing money.
Consult a Financial Advisor
Contrary to popular belief, you don’t have to be a millionaire to seek professional guidance from a financial advisor. Whether you’re looking for a one-time consultation or on-going advice, someone in the know can help set you on the path for long-term planning.
