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Automatic savings and investment plans: The full breakdown

At a glance:

  • What are automatic savings and investment plans?

  • When to use automatic savings or investment plans

  • How to set up an automatic savings or investment program

  • Where you can put your money

  • Automatic investment plans and retirement

  • Summary of automatic savings and investment plans

  • Practical ideas you can start with today

Do you often wonder at the end of every month where your money goes? Do you wish you could stash away some money so you weren't caught short every month? It's not an uncommon situation.

Savings usually takes a back seat to paying current bills and meeting expenses, so at that point, we're generally financially tapped out. But some people have found that they can build up savings by setting up an automatic savings plan that does this work for them before their paychecks are spent elsewhere.

Let's look at automatic savings and investment plans in more detail: what they are, how they work, how to set them up, and what investments are most suitable for them. With a little preliminary work, you can build wealth more quickly and easily by setting up automatic payment plans.

What are automatic savings and investment plans?

An automatic savings or investment plan is a plan that deposits money into one account from an existing account on a regular basis. It goes by other names, such as automatic withdrawal plan and automatic deduction plan.

Generally, you choose the same date each month or week to have a set amount of money removed from your savings or checking account and deposited into the target account. The minimum allowed is usually $25, though it varies. In order to avoid overdraft charges from your bank or credit union, you must make sure you have enough in your account on the day that money is scheduled for withdrawal.

Ideal for saving

You can use automatic savings and investment plans to put money into any savings or investment accounts you may have. Saving accounts you may want to regularly add money to include a bank or credit union savings account, a bank money market account or an investment money market account.

They work for investing, too

Although you can use automatic plans to put money into other savings accounts that you may have, you can also use them to put money into an investment account, such as a mutual fund or stock, in which case the money taken out will be used to buy shares at the current market price. When you use an automatic investment account in this way, it works in a similar fashion to dollar cost averaging.

Some advantages of automatic plans

The advantage of an automatic plan is that it does the work of saving for you. Once it is established, you will begin building up funds without consciously deciding to do so. Another advantage is that it can circumvent the emotional difficulty of continuing to invest when there are losses in your portfolio; yet another is that, when stock or mutual fund prices are down, you are buying them at a more advantageous price, all done automatically.

(Graphic: Hannah Smart)
(Graphic: Hannah Smart)

When to use automatic savings or investment plans

Why are they created?

Automatic plans are usually created for a specific purpose. Retirement is one, saving for a child's or grandchild's college education is another. Some people use them to build a source of funds for emergencies. Others want to save for homes, cars, vacations, or other large purchases and want an easy way to let funds accumulate.

Although an automatic plan will reduce the amount of money you have left to spend on other things, it tends to become a motivator to start budgeting. Automatic savings and investment plans are useful wealth building tools that can help you adjust your savings and spending patterns. They enforce a useful discipline, as it is harder to dip into money just sitting in your checking account because there is less of it.

Can you afford one?

Can you afford an automatic savings plan? If you're not sure, track your spending for a month to see where waste and unneeded pennies are going. You may find budgeting a helpful tool. Many people find that they can scrape up an extra $25 or more when they try hard enough. If you get a wage increase or a tax refund, you've got an instant source of money.

You can also change your federal and state tax withholdings to increase your take-home pay (but remember that changing your withholdings too low can result in penalties being charged by the government). Finally, paying off debts more quickly will leave you with a little extra to invest. If none of these ideas work, there's also the option of a part-time job on the side or starting a consulting or freelance business out of your home, if only for a while.

An example

Consider an example where you invest $100 at the beginning of every month for 35 years with a 6% interest rate. The actual amount invested over time is $42,000, while the earnings (before taxes) come to just over $101,000, bringing your hypothetical total to over $143,000. Not bad for putting your investing on automatic pilot.

A 6% interest rate is very high and can be unrealistic at times for savings accounts. However, interest rates do rise and fall over the years, and this illustration shows the power of saving and compounding over many years.

How to set up an automatic savings or investment program

Setting up an automatic plan starts with checking a box on the account application into which you want funds deposited. You will choose a day each month or week to have withdrawals made from an existing account (savings or checking) and deposited into your destination account. You can set the amount you want withdrawn, and you can make changes later on as you see fit.

Direct deposit

If your employer offers direct deposit of your paychecks, you can set up an automated withdrawal, where a portion of each deposit goes directly into a savings or other account instead of your checking account. This option allows funds to accumulate before you can spend them on anything else.

Investment accounts

Many stock and mutual fund accounts offer an automatic investment feature. Setting up an automatic plan involves checking a box on the account application. These funds will go to purchase additional shares. Savings bonds can also be purchased in this way, though via a direct deposit plan that holds them as a source of funds until you have enough to purchase an actual savings bond.

After you have chosen this feature, you must provide relevant information about the account that will be debited, such as the account number, routing number, and name of the institution from which the funds will be withdrawn.

If you have online access to your bank or investment accounts, you will usually be able to log in and set up a plan or change its features. Many banks and financial services companies allow you to make such transactions over the phone or in person at a nearby branch, if there is one in your city.

Automated transfers between accounts

If you have both a savings and a checking account at the same institution, you may have the option of setting up automated transfers from one account to the other.

Other accounts

There are other sources for automatic withdrawals. The federal government encourages consumers receiving Social Security payments to get their payments via direct deposit, and many states offer child support recipients direct deposit as well.

Where you can put your money

Generally, any financial services institution that offers savings or investment accounts will offer an automatic investment plan. Savings accounts, checking accounts, stocks, mutual funds, certificates of deposit (CDs) that permit the periodic addition of funds, known as add-on deposits, and savings bonds fit this description.

Your choice of investments is based on purpose

Which investment you choose to have your money deposited in will depend on your intended purpose for those funds. The more risky an investment is, the greater the chance of loss. Therefore, if you are saving up for a short-term purchase, such as a computer within the next year, and you don't want to risk losing your money, you may find it best to choose a savings account or certificate of deposit. Money market deposit accounts can offer even higher returns provided that your balance meets a certain minimum.

Another way to use automatic investment plans is to obtain a higher rate of interest for your savings. If the bank or credit union where you have your checking account doesn't offer very high rates on a savings account or a money market savings account, you can use an automatic savings plan to transfer money from your checking account to a savings or money market account offering a higher interest rate.

Money market

One of the more conservative options is a money market deposit account, which typically offers higher interest or dividend rates than savings accounts. It is common for these accounts to restrict the number of deposits and withdrawals that are made each month.

If you're looking to earn even higher rates, consider investment money market mutual funds, which aren't insured by federal deposit insurance, but seek to keep their value at a stable $1 a share. You can find investment money market mutual funds at mutual fund companies or brokerage firms.

Growth investments

Growth-oriented investments that carry the potential for higher returns along with higher levels of risk can also be used for short term goals, but there is a higher risk that their value will drop.

However, investments with higher return potential, such as many stocks and mutual funds, and sometimes real estate, are commonly used for long-term savings because market ups and down generally smooth out over the long term, providing more growth than more conservative investments. These long-term investments are popular with retirement plans and college savings plans.

Low risk for the long term

If you are saving up for the long term and you dislike risk, a low-risk account such as a savings account or certificate of deposit may be appropriate. If you are comfortable with higher levels of risk and want your account to grow at a potentially faster rate, investments like stocks and mutual funds may be a better option.

Automatic investment plans and retirement

Retirement plans are very popular choices for automatic investment programs because they can help the retirement savings build up over the course of many years, often decades. Many investors find that they sleep better at night because the burden of remembering to keep adding to their accounts is taken care of for them through automatic withdrawals.

The potential steady buildup of money, especially if compounded, should provide a noticeable growth in retirement wealth. In addition, many employers provide matching funds for employer-sponsored retirement plans, hopefully increasing the chances that savings grow even faster.

You can build retirement plan funds through automatic investment plans via a sponsored retirement plan such as a 401(k), 403(b), or 457 plan, or on your own with a traditional or Roth individual retirement account (IRA). Regardless of how you deploy your automatic investment program, remember that they do not assure a profit or protect against loss.

Popular investment vehicles

If your investment strategy involves seeking maximum growth, you may benefit from investments with higher risk profiles, because risk and return are generally correlated (though exceptions do occur). Over the course of years or decades, the ups and downs in the market can smooth out and may result in a lot of growth. Investments commonly used in retirement accounts include stocks, bonds and mutual funds.

Some investors like to invest in real estate, either in individual properties that they can rent out and receive income from or via real estate investment trusts where a large company invests in many real estate properties and passes on the returns to investors.

Review the risks of investing to help you determine which investments are appropriate for you.

An illustration of the potential power of time

The chart below shows how a tax-deferred, compounded retirement account can grow with about $416 deposited each month (for a total of $5,000 per year). Even if you didn't start saving until later in life, it is possible to build up a respectable amount of savings, courtesy of compounding and long-term growth.

Use them in the reverse manner in retirement

Automatic plans are also available for withdrawing money periodically from a retirement account once you retire and need to spend those funds. In this case, it works in the reverse manner — funds are taken out of the retirement account and automatically deposited into a target account, such as a checking account or money market fund.

Summary of automatic savings and investment plans

When you put your savings and investing on automatic, you can save yourself a lot of thought, time and effort. It's important to review your automatic plan periodically to make sure you are happy with the amount withdrawn and the date of withdrawal. You may find it helpful to make the withdrawal date a few days after payday so that you have adequate funds available, and to ensure you don't spend the money on other things.

Practical ideas you can start with today

  • Set up an automatic savings plan(s) at my financial institution.

  • Set up an automatic investing plan for my retirement account(s).

  • Calculate how much I will need to save for retirement.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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