As a passive investor, you are in an enviable position. Unlike the rest of the rat race, you can earn money without having to work for it. However, you have to manage your financial resources carefully if you want them to last. Rather than investing all of your funds right away, you should make sure that some of your monthly income goes into your savings account instead. The amount depends on your expenses and how much you already have put aside in your savings account.
What Does Your Emergency Fund Look Like?
An estimated one out of four 20-year-old adults will become disabled before they turn 67. Other than long-term disabilities, a car repair, job loss, medical expense or home repair may become necessary at any time. These unexpected expenses require capital, so savvy investors always set aside an emergency fund before they focus on wealth building.
In general, financial experts recommend that you start building an emergency fund before you invest your surplus cash. You can put your emergency fund into a high-yield savings account. This kind of account has zero risks, but it still earns more money than a typical savings account. Unlike the stock market, a high-yield savings account is insured by the Federal Deposit Insurance Corporation (FDIC). Because of this, your account balance will not change because of market fluctuations.
Financial experts normally recommend that you save three to six months of expenses in your savings account. If your income fluctuates significantly, you may need to save more money. Likewise, you may want to put aside more income if your job is insecure.
- Three months of expenses: This amount works for couples who have secure employment and two incomes.
- Six months of expenses: Couples need six months of income if they are both employed, but their jobs are not secure. If one partner is not working, this is also a good choice.
- One year of expenses: If you are a single person and have an insecure income, you should save a year of expenses.
You can also use your high-yield savings account for short-term goals like saving for a major vacation or an upcoming wedding. Once your emergency fund is full, you can use your surplus cash for your investments. Through passive investing, you can start growing your wealth.
How Much Should You Save or Invest Each Month as a Passive Investor?
If you think you will need the cash within the next five years, you should store it in a savings account or another liquid asset. Short-term savings must be accessible, so they should not be invested in the stock market, real estate or illiquid investments. If you do not have an emergency fund, you should put half of your savings into a savings account and half into your retirement account until your savings can cover three to six months of your expenses. To be extra secure, you may want to save even more.
Once you have an emergency fund set up, you can start putting all of your surplus cash into retirement accounts and other investment accounts. A high-yield savings account only earns an interest rate of 1 to 2 percent. You cannot put all of your financial funds in a savings account because they would never grow enough to fund your early retirement.
Max Out Your Retirement Accounts
If you are eligible for a 401(k) match from your employer, you should at least contribute enough to your 401(k) to max out your employer’s contribution. At many workplaces, employers will match your contributions up to 4 to 6 percent of your salary. With 401(k) matching contributions, you are basically getting free money from your boss. If you take advantage of this option, you will be able to quit your job and retire early. Best of all, your employer will be the one paying for your early retirement.
In general, you want to contribute enough funds to max out your employer’s contribution. The only exception is if you are struggling to pay your bills. Even when you are just starting your emergency fund, you can still do a 50-50 split between your savings account and your 401(k).
If you do not have a 401(k) account through your employer, you should set up an individual retirement account (IRA) or Roth IRA. Ideally, you should max out your retirement contributions each year because these accounts carry tax advantages. If you are 50 years old or older, you are also allowed to save an extra $1,000 each year as a catch-up contribution.
Pay Debts That Have a High-Interest Rate
Once your emergency fund has been set up, you should also pay off any debts that have a high-interest rate. In general, debts have a high-interest rate if the interest rate is at least 10 percent. Since it is difficult to find investments that consistently pay more than 10 percent a year, you will end up doing financially better if you pay off debts that have a high-interest rate first.
When Is Investing Better Than Saving?
If you want to develop passive income or become independently wealthy, you need to invest more money. No one has ever become truly wealthy by just earning a paycheck. Instead, most affluent households gained their wealth through investments. To decide if you should focus on your investment accounts or your savings accounts, read on.
- You no longer have high-interest debts. Many people begin their careers with car loans, mortgages and student loans. While low-interest debt is fine, you should be wary of high-interest debts like credit cards. If your credit cards charge an interest rate of 20 percent, you will get a higher return from paying off your credit cards than you would through a typical investment. Once your high-interest debts are gone, you can focus entirely on investments and wealth building.
- Your emergency fund is full. You need to have money set aside for a rainy day. While you only need three to six months of living expenses if you have a secure job, you should save more if you are single or self-employed. Once your emergency fund is complete, you can devote your income to passive investing.
- Your long-term goals require a significant amount of cash. If you plan on needing the money within five years, you should put it into a savings account or an extremely liquid investment. For long-term expenses like retirement and college funds, you should put your cash into an investment account instead.
Savings Accounts Versus Checking Accounts
A savings account pays a better interest rate than a checking account, but it also has certain limitations. Because savings accounts are made for deposits, you are generally given just six withdrawals a month. If you use more withdrawals than that, you will end up having to pay a fee.
Your savings account is where you can put your emergency fund. If you are saving for large purchases like a vacation, you can also put those funds in your savings account. As a general rule, your savings account is for money that you do not currently need for your everyday purchases.
While a checking account does not pay as much in interest, it is designed to handle more transactions each month. Because of this, you should fund your everyday expenses through your checking account. Your mortgage payment, utilities, grocery funds and other expenses should be in this account. If you do not have enough money in your checking account, you will end up having to pay overdraft fees. To prevent this from happening, you should put a buffer in your account just in case you spend more than you expected.
Focus on Passive Investing and Retirement Planning
As a general rule, you should always save an emergency fund before you begin real estate investments or other passive investments. The only exception to this rule is your 401(k) account. Because your employer only contributes matching funds if you contribute to your 401(k) as well, you should start saving for retirement right away. In most cases, you can put half of your savings in your 401(k) and the other half in your emergency fund until your emergency fund is full.
Once your emergency fund is full, you should focus on maxing out your retirement contributions, Then, you can move on to different passive investment sources. Depending on your unique situation, you may want to try generating passive income through some of the following methods.
- Invest in stocks and bonds.
- Bring in rental income.
- Sell digital downloads on sites like Etsy.
- Use peer-to-peer lending.
- Sell information products like Udemy and Coursera courses.
- Buy real estate investment trusts (REITs).
- Earn money through affiliate marketing.
- Bring in income from a blog.
- Sell stock photos or books online.
- Buy a storage center or laundromat.
- Buy annuities.
As a passive investor, you know what it takes to save money and prepare for your future. Whether you are focused on wealth building or retiring early, the right investing strategies can help. Once you have saved an emergency fund and contributed to your retirement account, you can immediately start putting aside money in your investment accounts and passive income strategies.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.