What to do with the surplus cash?
So you are now in the habit of paying yourself first. The next question is what to do with the money. Before you dive right into funding your investment account, there are a few things you should take care of first.
Get rid of consumer debt
Before you begin fueling any funds, you should highly consider paying off your debt first. If you have any consumer loans or credit cards with high interest rates. You should be using all of your excess cash to pay these cards/loans off.
Read my full article on consumer debt here.
Your Emergency Fund
The first fund you need to create is your emergency, or rainy day fund. This fund of money will protect you if you are temporarily out of work or some other life emergency occurs. Generally this fund should amount to 3-6 months of expenses. In most cases, this money is best kept in a CD. Having this money placed in a CD give you a slightly higher interest rate than a savings account but more importantly will reduce the likelihood of you breaking it for impulse purchases. However a CD is easy enough to break if you get into some financial trouble and need the funds.
Your Retirement Fund
The next fund you should create is your retirement fund. I would recommend starting with an IRA account. In your IRA, you can invest in both traditional and alternative investments – and you can even use this account to save toward your first home. The IRS allows a single individual to use up to $10,000 and married couples up to $20,000 of their IRA money towards the purchase of their first home. You can contribute up to $5,500 a year into an IRA each year. Depending on your tax bracket you may want to use a Roth IRA or a Traditional IRA, more on those another time. If possible, your retirement fund should not be funded by the same dollars as your investment account.
Finally Your Investment Fund
This is where 10% or more of of your income should be allocated once you have funded your emergency account.
I would recommend opening up a savings account or CD at another financial institution, separate from the one you handle your normal banking activities. Also, do not get a debit card. This will again prevent you from the temptation of spending this money on impulse or unnecessary purchases.
Each pay period this account will grow larger and larger. Once you have a sizable amount of money in the account, you can make an investment. At this point your money will be working for you to create more money. This newly created money will come in the form of interest, dividends, rent payments, and so on. You can then take the new money and reinvest it along side the original money (principal) to create even more money. Repeat the process.