My roommate recently got a promotion and a raise (congrats again, roomie!). And over brunch this past weekend, she asked me for advice on what to do with her new monthly surplus. The first thing I suggested was that she should put an X amount of dollars into her savings account every paycheck. Saving money is always the easiest when you first get a raise or any type of windfall because you’re already used to living without that extra cash.
Our conversation eventually turned into talking about the three different “cups” we could put our money in. I literally used 3 different cups on our table to explain.
The Savings Cup
The first cup is the savings cup, which is your savings account. This is the first cup you should consider putting any extra money in because everyone needs an emergency fund. Emergency funds should typically cover 3-6 months worth of expenses.
The Retirement Cup
The next cup is the retirement cup. This is your 401ks and IRAs. The reason why this cup is second most important is because of all the tax benefits it offers. All the dividends you receive from your investments in these cups are going to be tax deferred (aka you don’t pay taxes until later when you take the money out during retirement). And if you’re using a Roth 401k or Roth IRA, you have the added bonus of not having to pay any taxes when you withdrawal from the account.
The Investment Cup
The third and final cup is the investment cup, which is your personal investment account at Schwab, TD Ameritrade, Fidelity, etc. You often hear people say they put their “play money” in here. It’s not because the “account” is inherently more risky (a common misconception). It’s because people like to try their luck in finding the next “Apple stock” with this account. But you could technically do the same thing in your 401k and IRA because they’re all just accounts; they hold your money and YOU decide what to invest in. So why is this the 3rd cup if it’s almost like a retirement account? It’s because it offers the least amount of tax benefits. When your investments pay you dividends each year, you have to report it on your tax return, increasing the amount of taxes you’ll have to pay.