There is an alarming statistic that speaks volumes about the financial health of the average American consumer: savings rates (as a percentage of disposable income) is close to 0%, while consumer credit is at an all time high.
This guide is intended to help you understand the basics of money management and how to set up your accounts so that you can start building wealth.
We will not delve deep into any financial vehicle, but rather take a look at the big picture, to give you a framework to start building your own personal finance strategy.
As a disclaimer, let me state that I am not a financial adviser. The strategy I am describing has worked for me, but your situation may be different. If you have any questions please consult with your tax and accounting professional or a certified financial planner.
Saturday, September 13, 2008
Introduction
How to Use This Guide
To start, we will assume that you are an employee who gets paid a salary. We will use the following analogy: your salary is a stream of water that will flow through different buckets, which are connected by pipes.
Each container is intended to hold portions of your money. Some of them will hold them briefly and others for a long time. The five buckets we have identified, which are also the sections of this guide, are the following:
- Retirement Bucket #1: Contributing to a 401(K) Plan
- Parking Bucket: Using a Free Checking Account
- Short Term Bucket: Building a Safety Fund for “Rainy Days”
- Retirement Bucket #2: Contributing to a Roth IRA
- Long Term Bucket: Saving and Investing for Growth
You can refer to the chart above at any moment when reading this guide.
Retirement Bucket #1: Contributing to a 401(K) Plan
Once you are paid your salary, the money should flow to the Retirement Bucket #1. This means that, if your employer offers a 401 (K) plan, you are going to contribute a portion of your salary to that plan.
Your contribution to a 401(K) plan is deducted from your paycheck before taxes and invested at your direction in any of the investment options (stocks, mutual funds, etc.) offered by the plan.
Your 401 (K) funds will grow tax free until you start withdrawing them. You can withdraw funds from your 401 (K) without paying a 10% penalty after you turn 59 ½.
Another great feature of 401 (K) plans is that employers usually match your contribution, partially or in full.
Let’s say that you make $50,000 / year and you contribute $15,500 (the maximum allowed in 2008) with your employer matching 50%. This means that you will get $7,750 free money from your employer, and the $23,300 (your contribution plus your employer’s match) will grow tax free year over year.
For more information on how 401(K) plans work visit these links:
How does a 401(K) plan work?
All about 401 (K) by The Motley Fool
Parking Bucket: Using a Free Checking Account
After you contribute to your 401K, part of your salary will go to pay for social security and income taxes, and whatever is left will be your take home pay (see the two pipes that come out of the first bucket in our sketch).
Your take home pay should be deposited in a free (no fee) checking account (you can google “free checking account” to find banks that offer them).
From that account you will pay for all your expenses (rent, gas, food, credit card bills, etc.) either by check or automatic payment (I try to put all my expenses on auto payment; one of the most important goals of a sound financial strategy is to simplify your life).
Hopefully, after you make all your payments you will have some money left. If you don’t, or if you have too little money left, you are either making too little money, spending too much, or both.
This is the time to start keeping a budget of your expenses. You can find many good budget spreadsheets here .
Use any of those budget sheets to religiously write down your monthly expenses and see where you can make cuts. Some areas where you usually can save money are:
• Gym subscriptions that you don’t use
• Magazine subscriptions (cancel them and read the magazines online for free).
• Pack lunch instead of eating out every day
• Plan your routes carefully so you don’t waste gas wandering around
• Don’t go out to clubs or restaurants every weekend
• Cut and use grocery coupons
• Etc.
After three or four months of monitoring your budget carefully you will have a good idea of where you can cut costs. If this is still not enough, get a part time time job to supplement your income.
For more on making a budget, follow some of these links:
How to make your first budget
How to make a budget and stick to it
How to make a budget that works
After all your expenses are paid, move whatever money is left to your Short Term Bucket.
Short Term Bucket: Building a Safety Fund for “Rainy Days”
Your Short Term Fund is the first place you should put your extra money after you have paid all your expenses.
The time horizon for a short term fund varies widely depending on who is giving the advice, but in my opinion this fund must contain enough money to live comfortably for six months without working (in the event you get laid off), plus money for medium to large expenses you plan to incur in the next five years: a down payment for a house or a new car, a trip you want to take, a wedding, a new roof, car repairs, etc.
Let’s say that you need $3,000 per month for living expenses, plus you will buy a new car in two years and need to save for the down payment. You may also need to fix your roof or want to take a trip to Europe. These are all short term expenses. You will need to save 6 x $3K = $18K for six months living expenses plus all your other short term expenses.
Other than the six months living expenses, which you must try to accumulate as soon as possible, you can set up a savings schedule for other expenses depending on when do you expect them to happen.
Since this is money that you will need in the short term, it shouldn’t be invested in risky, long term vehicles like stocks or mutual funds. The best options are:
- Savings Accounts: Internet savings accounts (like ING or Emigrant direct) usually pay better than regular bank savings accounts.
- CDs (certificates of deposit): these pay better than savings accounts but they tie your money for a specific period of time (3, 6, 12 months or more). One thing you can do to mitigate this is to invest your short term fund in different CDs, with different maturity dates, so all the money is not tied up at the same time.
- Money Market Deposit Accounts: These accounts offer a rate close to that of regular savings accounts but limit the amount of transactions you can make in any given month.
60 second guide to short term savings
High yield savings accounts for short term savings
Retirement Bucket #2: Contributing to a Roth IRA
If you have already paid all your expenses and built your Short Term Fund, you can take advantage of the Roth IRA.
A Roth IRA is a financial vehicle that lets you invest up to $5,000 per year (2008 limit) in after-tax money, so that it can grow tax free until you are allowed to withdraw it without penalties (at age 59 ½). Since you open a Roth IRA with after tax money, you won’t pay taxes again when you withdraw your money.
The advantages of a Roth IRA are evident: your money will grow tax free and you withdraw it tax free once you're allowed to do so.
There are many other requirements and limitations regarding Roth IRA’s, as well as other advantages. If you want to learn more about Roth IRA’s you can visit the following links:
Why you need a Roth IRA
Top 10 Roth IRA questions
Long Term Bucket: Saving and Investing for Growth
You have already maximized your 401 (K), paid all your taxes and expenses, built your short term fund and taken advantage of the Roth IRA. If you still have money left, congratulations! This is when the real growth and wealth building begins.
You can now deposit all your extra money in a brokerage account. You can open a brokerage account in a financial institution like Fidelity, Charles Schwab, Etrade, etc.
Your money will be deposited in a money market mutual fund account, which will earn interest. From there, you can buy or sell stocks, bonds and mutual funds. You can do so online or by calling the financial institution.
Stocks are a more risky option, since you depend only on one company to get a good return. The price of a stock will depend on the expectations of future profits.
With mutual funds your money is divided and invested in many different companies and financial vehicles, so that there is less risk. The possibility of losing all your money with a mutual fund is very low, as are your chances of getting an unusually large return.
If you don’t have a lot of financial experience or time to follow up on your investments, you can invest your money in index funds (for example, the Vanguard 500 index fund mimics the S&P index).
Index mutual funds are cheaper to manage than regular, actively managed mutual funds. As surprising as this may sound, over 85% of actively managed (expensive) mutual funds fail to beat the market.
Bonds are a safer alternative, although the returns are usually lower. A bond is basically a promise a company or financial institution makes, to pay you interest on your money for a certain period of time, after which they will return your principal (the amount you invested) to you.
For more on brokerage accounts and investing for the long term you can read the following links:
What is a brokerage account?
All about mutual funds
Where to invest your money
The Warren Buffet way to invest
For more good information, you can visit the links in our "Resources" section on the sidebar.
