For those in the early stages on their path to financial freedom
It is essential to have a plan for those things in life that are important. Most people believe financial freedom is important enough to warrant a plan but unfortunately, not enough people spend the time to get help or develop a plan. Our hope here is to help build a framework for those in the early planning stages.
Let’s start with what would be fantastic goals before retirement:
- Homeownership with no mortgage
- No consumer debt
- An investment portfolio sufficient in size and structure to meet your income needs for the remainder of your lifetime
Although this can sound like a far-fetched dream to many, these are very attainable goals – regardless of how much money you make. Just like any big goal, breaking it down into small, manageable steps will help show you how this is not only achievable, but the process can be enjoyable.
Let’s start with the three things that are most important to achieving financial freedom:
- Live below your means
- Avoid debt
- Embrace the power of compound interest
The plan below assumes you are early in your career and do not have loads of debt. If you are up to your eyeballs in debt, addressing this needs to be a priority. You may need to start with a Dave Ramsey Financial Peace University class where you will learn to eliminate debt with “gazelle intensity” using his “debt snowball” technique.
1. Live Below Your Means
The number one most important step to attaining financial freedom is to live below your means; aka, spend less than you earn; aka, pay yourself first.
Mastering this first step will set the course for financial independence. Regardless of your income, it is a good practice to replace instant gratification with delayed gratification and to learn to live on at most 80% of what you make without taking on debt. There are people at every income level who have mastered this, and many who have failed. Income level does not matter.
Introducing The 15/5 Savings Plan
The 15/5 Savings Plan aims at saving 15% of income for retirement and 5% for short-term savings, for a total of 20% of your income. Here is a great set-up for saving/investing 20% of your income (in order):
- Invest in your 401k plan (or equivalent) up to the amount of any company match.
- Emergency Fund: Contribute to this account until you have reached an appropriate balance. Short of a detailed calculation, 6-months of living expenses is a good target. A smaller amount like 3-months is OK when you are young, as long as you regularly evaluate and increase the amount as you age. This fund should be held in a money market savings account.
- Short-Term Savings: Once your emergency fund has reached the target size, continue to put away 5% of your income into the short-term savings account to pay cash for major purchases like a car or down payment on a house. This fund should be in a money market account and can be combined with your emergency fund as long as you maintain a minimum “emergency fund” level.
- After you have your emergency fund funded, and after the 5% into your short-term savings, split the remaining (of your initial 20% to save) evenly into the following buckets:
- Health Savings Account – the most tax advantaged “bucket” available
- Roth IRA or Roth 401K
- Taxable Investment Account
- If/when you hit the maximum on the HSA and Roth IRA or Roth 401k, divert those dollars to the remaining bucket(s). If you are a super-saver or have a high income and max your HSA and Roth option, there is no maximum on what you can contribute to your taxable investment account so fill it up.
Here’s an example at $50,000 of annual income:
- 401k: 3% of income = $1,500
- Emergency Fund: 17% or $8,500 until target is reached
After emergency fund reaches target, your split would look like this:
- 401k: 3% of income = $1,500
- Short-Term Savings: 5% or $2,500
- Health Savings Account (HSA)*: (12%/3) = 4% or $2,000 (make sure to invest in this account)
- Roth IRA or 401k: (12%/3) = 4% or $2,000
- Taxable Investment Account**: (12%/3) = 4% or $2,000
*If you do not have an HSA, split the money evenly between the other two buckets: 12%/2=6% or $3,000 each into Roth and taxable investment account.
**A taxable investment account is a non-IRA investment account
Forming the discipline to follow this plan will put you in great shape financially but like most things in life, “controlled” flexibility is also important. For example, in your early years, you may opt to save more than 20% of your money and delay some of the buckets while you save for your 20% house down payment. Make it a priority to always take advantage of any company matches that your employer offers.
2. Avoid Consumer Debt
Americans use far too much debt to fund lifestyles above their income levels. On the surface, this strategy can appear to work well until a bump in the road changes everything. Facing an interruption in income when debt levels are high can be the kiss of death for personal finances. Even if there is no interruption in income, living debt-free is a key ingredient to obtaining financial independence. Some people view this as a near impossible goal but if you save and work your way up to bigger, better, and newer, the journey can be fun.
Paying cash for items such as cars, boats and expensive vacations will make you think twice before pulling the trigger. You may decide you don’t need to drive a brand new $50,000 car and maybe you’d rather keep $25,000 in the bank and drive a nice used car that cost $25,000. People who don’t borrow to spend tend to be more thoughtful about large purchases.
If you currently have a car payment, once your car is paid off, continue making your car payment into your short-term savings account with the goal of paying cash for your next car. You may need to step down a notch or purchase a car that is not quite as new but when you purchase the car it will be 100% yours, and you will not miss making a car payment.
One item worth noting here is that even if you choose a debt-free lifestyle, you will still most likely need to take out a mortgage. To qualify for a mortgage, it helps to have an established credit history which can take a little intentional planning. We will dig into this a bit deeper in a future post.
3. Embrace the Power of Compound Interest
Albert Einstein is said to have called compound interest the eighth wonder of the world. This money-earning-money phenomenon can only be realized if you have money invested. The best way to do this is by investing in the stock market - not in savings accounts, annuities, gold, crypto, life insurance, or certificates of deposit.
Here is a simple way to invest your accounts in the stock market. This portfolio may lack “sophistication”, but it will get you started in a portfolio that will probably outpace most of your friends. Make sure you select low-cost index mutual funds.
70% Total Market Index Fund
30% Total International Index Fund
That’s it - two mutual funds is all you need to get started when you are young. These two funds will give you exposure to thousands of different companies (stocks) and eliminate many of the risks associated with being underdiversified. If you are later in your career, adding a bond index fund will help dampen stock market risk.
To fully realize the compound interest benefits, you need to stay invested in good times and in bad. You also need to stick with contributing during good times and bad. Don’t forget that when the market drops, everything you purchase is on sale. When you look back years later, you’ll wish you had purchased more.
A plan without action is just wishful thinking. The best way we have found to implement a savings plan that you can stick with is to automate the process. Contributing to a 401k through payroll deduction is a great example. The key point is to make sure you are contributing enough, and to the appropriate investment “bucket” or account.
Start by splitting your income so that at most 80% goes into your checking account to cover your everyday expenses (yes, you may need to adjust your lifestyle). Most employers will allow you to split your paycheck between two accounts. The remaining 20% (or 20% minus whatever you’re contributing to your 401k) should go into a separate savings account. From there, you can have funds moved automatically to fund different investment accounts. Just split your annual target by 12 and have the money automatically moved each month.
You don’t need to, and probably shouldn’t, go through a broker to get your investment accounts set up. You can go directly to Schwab or Fidelity online to open an account and they will walk you through the process.
Avoid 401k loans. Borrowing from a 401k (or equivalent) is a very expensive form of borrowing. You borrow before-tax dollars and pay back with after-tax dollars. When you finally withdraw from this account later in life, you will be taxed AGAIN on the money you paid back. Double taxation is never good.
Never carry a balance on a credit card. Pay your card in full each month – on time.
Avoid the urge to keep up with the spending of your broke friends. If it appears your friends or neighbors are spending beyond their income, they may be borrowing to finance this lifestyle. Sometimes hanging out with the right friends can go a long way toward your financial happiness.
Be suspicious of financial salespeople. They like to sell active mutual funds with high fees and sales loads, life insurance as an investment, annuities, and trading programs. They can be very convincing, but their goal is to separate you from your money.
Be conscious of subscription payments. The opposite of automating saving and investing is to have money automatically deducted from your accounts. Think twice before signing up for these subscriptions or memberships, and regularly review any automatic charges.
Do not gamble. Avoid online betting, casinos, and lottery tickets. The odds are not in your favor and the urge to “get back to even” or “strike it rich” has destroyed too many lives.
Don’t blow “windfall” money. At some point in your life, you will receive a windfall from a bonus, inheritance, large gift, etc. A strategic way to employ these funds would be to take 10% to spend on fun, 30% to pay down debt, 30% to put toward retirement (invest long-term) and 30% toward short-term savings.
Be mindful of lifestyle creep. When you receive a raise, a good practice is to live on 2/3 of the increase and bank/invest 1/3. Getting a handle on this “marginal propensity to consume” early in life will help ensure that your spending doesn’t get ahead of your earning.
There you have it - Financial Planning 101. There are many ways to tweak this plan and it will not be 100% perfect for everyone. We’re aware that all situations are different, but the main tenets here will benefit just about everyone at every age and income level. This is not something to put off so if you think you are behind today, please don’t delay. Your future self will thank you for the effort you put in now.
More to come in Financial Planning 201.