There are a lot of large expenses in life. Before the “Just Married” is washed off the car, the average married couple has dreams of multiple children, annual vacations, and homeownership in addition to (hopefully) contributing to and investing their Roth accounts. They also find that they have small starting salaries and student loan payments. Planning for these expenses can be challenging.
Take for example the dream of becoming a parent.
Baby Center has a “First-Year Baby Costs Calculator” which has average expenses, both ongoing and one-time, which you may experience and allows you to toggle on or off each expense. With its default settings, it suggests the first year will cost $10,158 and that the ongoing costs are $8,100 of that number. Removing the cost of regular childcare and formula and adding in college savings makes those numbers drop to $5,520 and $3,462 respectively, but also might incur the loss of all or part of one-spouse’s salary.
If you are going to have to live off only one spouse’s salary in the future, you should live off of only that salary now. All known expenses should come out of the salary that you know you will continue after your child arrives. Otherwise, when the salary goes away, it will be painful to reduce the lifestyle to which you’ve grown accustomed.
In the meantime, use the second salary to develop an emergency fund and retirement savings. Don’t earmark it for expenses, just save it. The peace of mind that your future self will experience knowing that you have an emergency fund and retirement savings is worth the minor inconvenience of having to start living off your permanent salary now.
Another budgeting trick is to allocate your budget in dollar amounts, rather than percentages. Then when you receive a raise you won’t automatically spend more. Instead you will automatically save more. This technique is built into our recommendation of how to automate your savings. Keeping your lifestyle low and your savings high is how you earn financial freedom.
The one-time baby expenses ($2,058 in our example) are simple: take the expenses divide by the number of months you have to save. If you plan on having babies in two years given these numbers, you should save $85.75 per month for the next two years.
For ongoing expenses though, if you were to save using the same formula, you’d have a savings plan that enabled spending $3,462 every two years. But because you need these expenses annually, that means that eventually your budget will fall behind your needs.
Instead, you should live like you have those expenses now, saving the full amount that later you will need to spend. That means saving an additional $288.50 per month.
This both gets you ahead of your costs, providing you a cushion should you ever need it, and sets your standard of living low enough that you won’t have to take a cut to your lifestyle when the new expenses arrive. Lifestyle cuts can be a painful process that most families are not able to follow through and implement well. Much of the wisdom of long term financial planning is trying to avoid a painful reduction in your standard of living.
Now that you have calculated how much you need to save, the next question is where you should save this money.
There is a lot of chance for generating wealth via the stock market, but its volatility makes it a poor place to save for fast-approaching expenses. When an all-stock portfolio is burdened with withdrawals, if the volatile market dips during the year you need the money, you have to take the money out while it is down. Then, that portion of your portfolio misses the recovery and your chance of meeting longer term goals is hurt by your immediate withdrawals.
There is an optimum allocation between stocks and bonds for any given withdrawal rate. A general rule though is that you should have your bond allocation large enough to cover five years of withdrawals.
Therefore the money for any family expenditure which will be needed in the next five years is best kept in stable investments such as bonds. And since individual bonds have a higher bid-ask spread and lose a percentage of their value buying or selling them, it is better to invest in a bond fund which you will be able to easily sell.
The farther away the expenditure, the more easily you could risk the uncertainty of stock market returns. Although a baby fund needed in two years is better in bonds, a homeownership fund not needed for seven years is better kept in stocks.
Saving $1,000 a year with no interest for five or ten years will only result in $5,000 or $10,000. But saved and invested in the stock market earning 8% a year would result in $6,336 or $15,645. The extra money earned from appreciation in the markets could help you buy a home or pay for college that much sooner.
Some super saver families invest even their emergency fund and short term savings accounts in the stock market. At an 8% annual return, even saving $1,000 a year will grow to $2,246 at the end of two years. This can be a good but dangerous bet. The danger is that you will need the money after the markets have gone down. For some families, this may not be a problem.
If you have other savings which you can use or you are able to delay your purchase without detriment, then you might be able to risk keeping all your savings in the more volatile stock markets.
However, if that situation would be catastrophic for your family, then it is better to keep your short term financial needs in the stability of bond investments.
Planning for future expenditures is a critical part of financial planning. You owe it to your future self to avoid being broke, in debt, or lacking the money to meet your goals.
Some sacrifices may need to be made on the journey to financial freedom, but you’ll be happier if you make those sacrifices consciously and intentionally.
Photo used here under Flickr Creative Commons.