When thinking about how to manage money, the waterfall can serve as a great metaphor.
Start at the top of the waterfall with your “checking” account. The checking account is a life use account. This simply means it is not for investments but for use with everyday expenses. A checking account is not the best place to store large amounts of money and it is not appropriate for saving or investments. The average daily balance in your checking account should not exceed more than one or two months of annual income.
After your checking account, ideally you should have an “emergency reserve” account. Your emergency reserve should be enough to cover three to six months of household expenses. Your “emergency reserve” dollars should be stored in a savings or money market account that is easily accessible but (hopefully) earns more interest than a typical checking account. These dollars are for the sole purpose of covering for unexpected, life altering events that may impact your regular income (i.e. a job loss).
After you have allocated funds to your emergency account the cascade continues as you are now ready to invest for retirement. A good rule of thumb (depending on your age) is to invest 15% of your income in retirement savings. Once you have allocated 15% into your retirement accounts, the waterfall continues to short term savings.
Short-term savings are used for larger purchases planned before retirement (a down payment on a house, a vacation, a car, etc.). These goals require patience and that your previous financial allocations have been met. A simple way to know how much to save is to divide the cost of the purchase by the number or months you have to save before the planned purchase
Finally, after you have paid your monthly expenses, filled your emergency reserve account with the proper amount, set aside 15% of your income for retirement (depending on your age), and allocated for your short term goals, you can invest in the rest! These investments, which come at the bottom of the money management waterfall, allow you to utilize your wealth to accomplish other goals: save for college expenses, leave money to heirs, increase your lifestyle at retirement, etc. These goals are typically long term in nature.
Talk to your financial professional about how you might set up the financial waterfall system to ensure you are getting the most out of your money, while ensuring your current and future financial stability.