Living Below Your Means, part 3

If you are already living on less than your household income, you're on your way to building financial security for your family. You already know that you can't save anything if it's all getting spent, but maybe you're not quite sure what to do with the extra piling up. Consider this column a quick primer on dealing with the excess you're working so hard to amass.

Just like with cutting expenses, start with the basics. Building up your savings and investments is a step-by-step strategy. Just like a house, start at the bottom with solid footing for the steps which follow.

First, build up an emergency fund. Into every family, a little rain must fall. Hopefully, it's of the "The car dropped the transmission" variety rather than health-related emergencies or job losses. Whatever the storm which might befall you, though, having a cushion of savings lessens your potential worry.

General advice is to save approximately three to six month's worth of living expenses in liquid form. A money market account with check-writing capability provides this. Having this buffer fund allows you to focus your concerns on fixing the problem, rather than wondering if you can afford to fix it.

Once you've got that kind of cash as a backup, you can begin considering other means of saving and investing.

The first kind of investment you will probably want to consider is to make the most of any tax-deferred investment opportunities. This money is generally set aside for retirement. Once you put it into a tax-deferred vehicle, you can't get it out before age 59--without paying a hefty penalty.

There are some exceptions, such as using it for a down payment on a first house or education expenses. That's what makes this a great way to save for your children's education. On the other hand, don't forget that you're responsible for your future security also.

The place to start is anywhere that matches funds. If your work or your spouse's work has a 401(k)-type plan, take advantage of it. If you're self-employed, your options are a SEP-IRA, or SEP-401(k). You should also fund a Roth IRA if you're eligible (this can be used for education, and differs in its tax deferrment). These kinds of accounts won't work for all your investment needs, since there are restrictions when you want to get at your money.

You're going to need more available investments. Generally, these are in taxable accounts. If you're new at this money stuff, take a deep breath. This money will go into the stock market.

Over time, nothing else matches the returns you can make by putting your money to work in this way. Unless you're a genius at this (and you wouldn't be reading at this point if you are) this chunk of money should probably be invested in index funds as their tax efficiency is quite good, and their returns are above average.

You also need to think about protecting yourself. Life insurance, adequate health insurance, auto insurance, disability insurance, and possibly long-term care insurance, if you're old enough. If caring for elderly parents might be in your future, consider talking with them about long-term insurance. No sense building up savings if they could be wiped out with a single major hospitalization.

This may sound daunting if you've never thought about investing in stocks or using a mutual fund. Talking with a financial professional might help you make some decisions, but use care here. Many "investment advisors" make their money by gathering commissions on funds and stocks they sell. If you choose a "fee-only" advisor, you can be assured that he or she only makes their money by the services they provide. To insure that you're getting as nearly unbiased opinions as possible, you can consider paying them an hourly rate, like an attorney.

No matter where you start, starting is the key. Even if you're only setting aside a fraction of your income to begin with, compounding interest will work for you. Watching your savings and investments grow is a great incentive to save more.

Living Below Your Means, Part One: Knowledge gives you power over money

Living Below Your Means, Part Two: The envelope, please