What should I do with my money?

Or, alternatively, How do I save money and achieve financial health?

In concept, making and saving money is simple. You acquire money through some method, then simply save more money than you spend.

budget2
Money goes in, money goes out

The difficult part is controlling your mind to do so. Humans by nature are not wired to think over such a long time horizon – we are not so far removed from the days of hunter-gatherers living life with potential death around every corner. Saving large amounts of money requires a long-term perspective many humans are not used to – and why would they be? We rarely teach our youth or adults to do so seriously with regards to personal finance.

I’m here to give you a hand with that. I must include a disclaimer that I am not a fiduciary nor a financial expert, but I do understand basic arithmetic quite well, and I promise you I want to help your finances. We’re going to follow a seven step plan here, which closely follows a flowchart from our good friends at /r/personalfinance. It’s designed to give you a feasible path to retirement – if you don’t want/plan to retire, you can of course feel free to invest your money in taxable accounts and adjust accordingly. There will be very slight adjustments, but the general principles are the same. We want to decrease your expenses (including taxes!) and get your income working for you. If you follow the plan and everything goes smoothly, you should be able to settle into a nice retirement with plenty of money in savings and stocks.

Let’s get started!

Step 0: Pre-planning: evaluate the state of your finances

The difficult part about saving for most people is finding the money to save. Your paycheck comes in for the month, you have overdue bills to pay that take a chunk out immediately, a huge portion for housing, and dinner that night… Sound familiar?

If you don’t know where your money is going, it’s impossible to save it. It’s like trying to capture water with a leaky bucket; you put a good amount of water in it, look away, and by the time you look down again, it’s all gone! We need to track where this water is going before we even try to save any of it. In other words, we’re going to re-arrange your budget given how you currently spend your money to make sure it’s going to the areas it must go to first, then work on budgeting later once we’re funneling the money correctly. In terms of the bucket analogy, we’re going to take some of the water that you capture and make sure you get a chance to drink from it first before it gets leaking, then later we’ll slow the leaking and plug the holes. The advantage of this approach is that you should not have to drastically change the money you spend on food, rent, and other essentials, which is typically a large roadblock to sudden budget changes. Unless, of course, these three together already cause you to outspend your income, which is another problem altogether, and which we will tackle in a separate post.

In 1943, psychologist Abraham Maslow proposed a theory of a hierarchy of needs as followed by human beings. The first need, physiological, includes: air, water, food, sleep, clothing, and shelter. Of course, one need not be a psychologist to realize these are critical, you understand this rather intuitively. As such, we have to address these things before anything else.

Maslow's Hierarchy of Needs
Maslow’s Hierarchy of Needs

Take a look at your paycheck. It will be easiest if we do this by the month (so if you’re paid bi-weekly or bi-monthly, scale the amount accordingly). Follow step by step and portion out money according to how much each steps currently costs you right now. If you use debit and/or credit cards, your providers all have options to download expenses as Excel spreadsheets which can be viewed with Microsoft’s viewer for free. If you are cash. If you can’t do either, just approximate an amount and come back to it later

If done properly, we should find ourselves with some sum of money once we get to about Step 3, which we can use to tackle debt as aggressively as you feel comfortable doing. If you are fortunate enough to have minimal or no debt, you can of course fast-forward through less relevant sections.

0A. Housing

You need to put a roof over your (and your family’s) head. If you don’t have a place you can go back to at the end of the day, detox, and sleep without worry for your (and your possessions’) safety, your life will suffer immensely, let alone your finances. Get a space which you can call yours, rent, buy, even an RV, but you need to have it. Budget money for your apartment or your house before anything else.

0B. Food

Food goes in, body makes energy. No food, no energy. You must get food into your stomach. This is a very close second to your housing bills. Figure out how much you are spending per month on food, whether it be groceries or restaurants, and budget this amount out of your paycheck accordingly. We can (and will) work on honing a budget and cutting food costs later. The key part to this step is to not overspend the amount that you already find yourself spending regularly.

Nota bene: If your situation is so desperate that it’s a choice between making rent or starving for the next month with made rent, find a way to get food in your belly first – the energy needs are more immediate and you can always find a friend’s place to crash at for a very short period.

0C. Essentials/Utilities

A modern dwelling is no better than a dry roof without the necessary utilities: electricity, water, heat. Other essentials such as toiletries and sanitation items come right after. We portion out some money to make sure your housing continues to function properly.

0D. Income Earning-Related Expenses

You need to make money somehow, and chances are, there are expenses related to doing so (car/bus/train, perhaps internet access or a telephone, etc.). It’s necessary to ensure those are covered for at this step so you can actually acquire income to do the rest of these steps. We portion out some money here.

0E. Healthcare

The healthcare system in the United States is exorbitantly and needlessly expensive, and it sucks. These are facts, though we can certainly have a lively debate about the magnitude in which it sucks. That, however is a discussion for another time.

And that being said, hospitals here are excellent, and you do not want to be without access to one at semi-reasonable cost should you or someone in your family have some kind of accident that requires one. In almost every case, it is better to have healthcare. The government wants you to have healthcare coverage (at least, generally speaking, and at least the Democrats do), and as such, offers subsidies for those in lower income brackets to acquire cheaper healthcare. Hopefully your employer covers much of it, but if they don’t or their plan is poor, you should look to acquire coverage through your state. Budget enough money to pay for your healthcare bills. The thousands or even tens and hundreds of thousands of dollars you may need to pay in the worst case scenario could be crippling to your life.

0F. Minimum Payments

I will soon show you if it has not been impressed upon you already how bad carrying debt with interest is (note that cases of 0% APR are the rare exception).

Interest is great when it works for you; it allows your money to grow with no further effort. However, this works the other way around too; if you have debt with terms of interest on it, that debt will continue to grow and grow even as you eat, sleep, and breathe. Once we’ve accounted for absolute necessities as listed above, we must make minimum payments to keep any debt you have from snowballing out of control. If your debt is already out of control, that’s ok – we’ll tackle it bit by bit. The first step to handling any debt though (other than necessities listed in previous sub steps), is to make your minimum payments. It will keep your interest rates from growing further and becoming entirely unmanageable.

You may have heard a myth that a good faith effort is enough to keep your creditors from enacting late payment penalties. This is not true: if you contact them in advance, perhaps if your credit score and record are generally good, you may be able to get extra time or a one-time courtesy waive, but otherwise, your financial wellness will suffer immensely if you do not make your minimum payments. You need to make them.

If you have the terms of your creditors available, collect them and set them all down in front of you, then sort them by those that have the greatest gain in APY for missed payments. Budget money for paying them off in that order, one at a time. By making our minimum payments, we will avoid giving your creditors permission to take some very nasty actions, such as charging you a late fee, reporting the late payment to credit bureaus, or raising your interest rate to the highest penalty rate.

Step 1: Establishing an Emergency Fund and Safety Net

One of the most difficult parts of saving and paying off debt for many is the simple fact that you are living paycheck to paycheck. Life is difficult, and you should not be ashamed of doing so, but there is a better way, and it can be done by making slow, but steady adjustments to your spending and saving habits. A critical step to doing so is establishing an emergency fund. An emergency fund is a general, all purpose fund meant to cover any kind of an emergency that may come up. Having an emergency fund allows you to cover moderate to huge unexpected expenses, such as a car accident, damaged house door, an family emergency, ER room visit, etc. without having to tap into your precious paycheck.

Once we establish an emergency fund, we can pay off your other bills and make sure your life remains normal knowing you have a float in case of trouble.

1A. Emergency Fund

Note that if it would reassure you more to have your emergency fund on hand, you can switch the place of 0F: Minimum Payments with this sub step, 1A: Emergency Fund.

Making an emergency fund is procedurally simple. Store away the desired amount in a safe, easily accessible place until you have enough, then forget it’s there until you need it. You can take your time with this over several months if need be. A checking or savings account is recommended rather than trying to store it under your pillow or something. If you do not have a bank account yet, I recommend either a larger bank like Chase, Citibank, Bank of America, etc. if you have the liquid funds or other qualifications available to avoid paying their monthly fees; their wide network and many physical locations will make things easier on you. A local credit union is also an excellent option if you can’t avoid these fees, or if you just prefer to avoid the big banks. Tellers at a physical location will help you set up an account (all you have to do is bring ID) – nowadays you can also do it yourself online quite easily as well.

A good baseline is $1000, or one month’s expenses, whichever is greater. Once you have the emergency fund set up, continue your daily business as usual, knowing you have at least one month’s expenses in your back pocket if anything happens.

An other option for storing your emergency fund if you’re willing to put in a little more legwork are an Netspend card, or an online high yield savings account (HYSA) like Ally, Discover, American Express, or Marcus. Netspend is a debit card linked to an FDIC-insured savings account with an APY of 5.00%, a very nice, safe account for you to sock your money away and accrue some extra interest in. Online HYSAs are simply online bank accounts that do not offer brick-and-mortar locations, but in exchange offer higher yield rates, currently around 1.50% APY; not as high as Netspend, but fairly straightforward to set up and will also provide you with some small gains. A guide on HYSAs is available here. A guide detailing Netspend cards will soon for you to do more research and decide if you feel comfortable pursuing such an option will soon follow.

1B. Non-Essential Bills

Note that while I say non-essential bills, that by no means implies these are not important. Essentialness is defined as relative to bare-bones minimum for survival and making income. At this point, we want to pay off these bills to make sure your day-to-day life can function reasonably smoothly.

At this point, you should still have at least a little bit of money left in your budget unless you work a minimum wage job. If this is not the case, it is highly likely you have an income problem rather than a budgeting problem, unless you are living in property too expensive for you to afford, or eating out too much for your income level. We can take a look at some alternatives below to ease the adjustment you’ll have to make, but we need to make our focus increasing your income level, which I address in a separate post here.

If your phone bill is too expensive, consider a pre-paid phone or a flip phone. If internet is too expensive, call and write your representatives to bug them to improve internet access and pricing in the area (the internet service provider field is a known oligopoly), then cancel your plan and make more use of the public library (an excellent resource in general, by the way), or a local coffee shop like Starbucks or Peet’s. If cable is too expensive (it is), switch to streaming if you need your entertainment fix, or make use of the ample free streaming and/or video sites online. There are many creative ways to make use of modern technology to provide alternatives for these services. I would argue internet access is the only one of such bills that is a must currently.

Step 2: Getting Free Money From Your Boss

If you’ve been around media or you read newspapers, or you’ve heard anything about retirement, you’ve probably heard of this thing called for a 401(k), even if you don’t know what it is or does. In simple terms, the 401(k) is a tax-deferred retirement savings plan that enables you to save up to $18,500 a year (as of 2018) in an retirement account, with an additional $6,000 contributable if you are over the age of 50. Money from this account is tax-deferred, meaning you do not have to pay taxes on those earnings until later; the money is literally subtracted from your W2 wages field, so this 401(k) money doesn’t even show up on the income lines on your 1040 when you file taxes. The advantage of tax-deferred savings is that unlike taxable or Roth retirement accounts, you can put more money into your retirement account where it can grow tax-free, taking advantage of compounding interest to grow rapidly over the years. It is highly likely that you will retire in a lower tax bracket than when you were working, which means that you avoid paying taxes at a higher marginal rate when you contribute to your retirement accounts, then can pay taxes at a much lower marginal rate once you withdraw in your retirement.

Note: There is also a Roth option for the 401(k). This is generally not recommend, for reasons I will break down in a separate post another time. If you follow this guide and save your money properly, the traditional 401(k) should make you more money every time.

traditional-retirement-accounts
Money goes in tax free, grows tax free, then is finally taxed only when you withdraw (image courtesy of Mad Fientist)

Contributions to a 401(k) plan can only be made through employee payroll deduction, meaning that in exchange for seeing slightly less money in your paycheck up front, when you retire, you will suddenly have anywhere from an extra thousand to millions of dollars to fund your retirement years. A contribution of just $200 per month at a 7% annual rate of return contributed from age 30 to 65 ($81.6K in total) would lead to an extra $344,218 at retirement!

Tax-Deferred vs. Taxable Savings
The power of tax-deferred savings

Nonprofits offer 403(b) plans, local/state employees, 457(b) or 401(a) plans, federal employees, the TSP (Thrift Savings Plan); these all have differences, but for our current purposes, they are functionally the same thing: tax-deferred retirement plans. Contribute the same as you would to a 401(k). You can read all about this in my post on retirement plans (to come later). Any point henceforth where I mention a 401(k), I am referring to all such retirement plans unless I explicitly state otherwise.

Eligibility for a 401(k) plan varies by the employer, but typically if you currently receive any benefits from your employer, you are likely eligible for such a plan if they offer one at all, though in some cases there is a six to twelve month waiting period after hiring before eligibility vests. Enrollment is simple, and just requires filling out a form or two. Your company’s HR rep should be able to walk you through the process.

Now, plans will have certain investment options, and I will have a separate investment post to come, in which I will detail fund selection and how to tailor it – advice there will supersede whatever is listed here in terms of fund recommendations. For now though, just take 110-your age, and put that percentage into a 1) “Total Stock Market Index Fund”, 2) if that is not available, look for a S&P 500 Index Fund, 3) if that is not available (unlikely), look for anything with the label “Large Cap” or “Large Mixed”. Alternatively, if there is a target date fund option which has a year that appears close to your retirement date, you can just throw everything there and forget about it. Opt for Vanguard, Fidelity, or Charles Schwab funds if your provider has them. I’ll detail some of the reasoning behind this later.

Now, while the 401(k) is fantastic, it by itself technically doesn’t give you free money. Where the magic happens is from your employer’s end. Your employer is able to contribute up to $53,000 per year (as of 2018) to your 401(k) account, and this is typically done through what is called a “match,” which is meant to incentivize you to contribute to your retirement fund. For every dollar you put into your retirement account, your employer will contribute a certain matching amount. Typically this amount is 50¢ for every employee dollar contribution, but can be more or less. This money is tax-free going in, and you only pay taxes upon withdrawal. There is of course a limit to your company’s generosity, usually ranging anywhere from 3-6% or so, though of course this will vary by the company. There is also almost always some form of a vesting period for this employer contribution of some years (2-4 years is typical), to serve as incentive to remain at the company.

So because your employer gives you immediate returns of ~25-100% on your contributions, I strongly urge you to contribute up to the amount needed to maximize the employer match, but not a penny more (for now). Nowhere else will you get such enormous guaranteed returns on your money; this even beats paying off very high interest debt. We will re-visit filling out the rest of your 401(k) later.

401k_Matching_Effect
The drastic effect of employer matching combined with compound interest over the years (courtesy of MyMoneyDesign)

In short, by contributing to your retirement, something you should be doing anyway, your company will give you free money, money that is not taxed when you file at the end of the year, and will grow tax-deferred until you eventually take it out in retirement, taxed at a much lower rate. This is why it is generally recommended that even if you don’t contribute anything else to any retirement accounts, you should contribute at least up to the full 401(k) match to get the free money from your employer.

Step 3: Becoming Debt-Free

Debt freaking sucks. It really does. Having debt in and of itself is not a bad thing; what is bad is the astronomically high interest rates that banks, credit card issuers, and other leasers typically write into the terms of your lease. The problem is that you will rarely be given loans with terms considered favorable for you. Practically, most debt you acquire that is not a home mortgage, a well-shopped student loan, or a 0 APR% promotional rate credit card is highly likely to have huge interest rates. If you do not pay off debt with interest and allow it to grow, compound interest will cause it to rapidly get out of control and dominate your entire financial situation. With the high interest rates that accompany most debt, it is critical to pay off the debt (refinancing as needed) as soon as possible.

3A. High Interest Debt

High interest debt is the biggest demon in any financial situation imaginable. For these purposes, we will define it as an interest rate of >10.0% APR. If you have any high interest debt, I strongly urge you to pay it off at this point as soon as possible. You will find your free money and net worth rapidly improve as you remove the albatross of high interest debt from your financial situation.

There are two typical approaches to this, named the “Avalanche” and the “Snowball” methods.

The Avalanche method targets the debt with the highest interest rate first and pays it all off as soon as possible, then targeting the next highest interest rate and repeating, and so on and so forth. By hitting the higher interest rates, you efficiently clear out your debt in large chunks, in turn minimizing added interest, which frees up even more money to pay off the rest of the debt, until eventually all that money going to debt is suddenly freed up, and you free as well.

The Snowball method does the opposite, starting with the smallest (and therefore easiest to pay off) debt first, ignoring interest rate. Once the smallest debt is paid off, that interest is off the books, freeing up more money to target the next smallest debt, and so on and so forth until you get to the largest debts, by which point you should have more money freed up from not having to pay off the smaller debts and their interest, and finally knock out the biggest snowballs to leave you debt-free. Psychologically the snowball method generally tends to be easier. One of the hardest parts about handling debt is that many little bills pile up, on doctor’s bills, money borrowed from friends or family, store credit cards, etc. Clearing out all the small debts is empowering, and leaves you free to tackle the large debts like a car loan, student loan, or large credit card balance with renewed focus.

Note that in both cases, we have already tackled minimum payments in sub step 0F.

How To Pay Down Debt
Tackling debt by the avalanche vs. by the snowball (from American Consumer Credit Counseling)

Generally, I recommend the Avalanche method, but I’m a stickler for hard numbers. Mathematically speaking, it’s preferable to nail the biggest anchors, which are the debts that grow the fastest and sink the hardest. Of course, you should evaluate the merits of each approach and how they fit your personal situation. If you want, you can use a bit of a hybrid approach where if you have debts similar in interest rate (say ~1% within each other), but the lower interest rate is significantly smaller in amount, you could opt to knock that one out first if it makes it easier on you. However, ultimately it’s largely irrelevant which method you choose as long as it works. There’s no point in picking an approach if it doesn’t do what it’s intended to do: get you to pay your debt off. The most important thing is actually to make sure you’re making at least the minimum payment, but if you’re following this guide, you should have already done that!

Whatever you opt for, buckle down and knock out that high interest debt!

3B. Expanded Emergency Fund

At this point, it is ideal to expand your emergency fund. The same reasoning and process applies as discussed in 1A: Emergency Fund, but we want to expand this to cover more months’ worth of living expenses now. Generally the recommendation is three to six months’ worth, up to eight if you’re particularly cautious. Having a month’s expenses is fantastic (and a must), but we want to ensure you can provide for your family, or in the event that you lose income sources. These are unlikely to occur, but hey, that’s why we call it an emergency fund!

The approach is the same as previously: simply fill up your savings account of choice until you have your desired amount of emergency funds saved. I personally have a little over a year’s worth liquid, but I’m quite risk averse when it comes to having liquid funds.

3C. Medium Interest Debt

Medium interest debt (defined as ~4-5%, mortgage excluded) presents a more complicated situation, as the opportunity cost of paying off medium interest debt versus investing in the stock market is generally negative, meaning you should benefit more from investing in the stock market compared to paying off debt in the long run, especially in a bull market like the one we’re currently in (as of mid-2018).

If it is a strong bull market like the one we are in currently (Q2 2018), and the rest of your finances are in good shape, you can consider putting off paying off some of this debt to invest in some broad market index funds, opting to simply make minimum payments as usual. This will vary from case to case and is more a question of personal preference.

Your approach should be the same as in 3A: High Interest Debt, evaluate and pick either the Snowball or the Avalanche method and get whacking away at the debt.

Step 4: Planning For Your Future, Part 1

Saving for retirement sounds fairly daunting, but the basics of it are simple, and frankly, if you follow my short plan outlined below, you won’t need to know the meat of it until decades later when you start trying to plan out required minimum distributions, tax optimal withdrawals, and your desired withdrawal rate. Ready? Here it is.

Open a retirement account at your brokerage of choice (I recommend Vanguard, Charles Schwab, or Fidelity). Place all your allotted retirement savings in a target date fund with the target year closest to your anticipated retirement.

That’s it!

The alternative if you don’t want to do this is to do the equivalent manually, where you split your investment roughly one third each among a total stock market fund (VTSAX/SWTSX/FSTVX), an international stock market fund (VTIAX/SWISX/FTIPX), and a total bond market fund (VBTLX/SWAX/FSITX). The percentage of each should change as you age to give you more exposure to bonds, and less to equities (stocks). The advantage of doing it this way is that you have finer control over this percentage, and can thus overweight or underweight more to US or international stocks or bonds if you so choose to. The downside is that it’s more trouble to rebalance and manage over the years, whereas the target date fund will automatically adjust the ratio for you over the years. From hereon forward, if I talk about a stock/bond split, you can ignore this if your money is all just in a target date index fund.

Now, if we really want to get dirty with it and start dabbling around with ETFs, sector funds, and even individual holdings, we can also do that, but with retirement funds, I recommend playing it safer. A target date or three-fund portfolio is simple, easy, and safe.

You might ask a few questions at this point. I will address all of them in detail in my separate post on saving for retirement. Here’s the Cliff Notes version:

  1. The traditional US retirement system was meant to be a “three-legged stool” of a pension, Social Security, and your own personal savings.
  2. Unless you work for a government (and even then they are on their way out), pensions are going the way of the dodo; many are also fairly meager
  3. Social Security continues to run into funding issues, and while it’s at no danger of dying soon, projections suggest it will need to be phased out to a large extent within several scores (that’s a unit for 20 years; thanks, Lincoln). It’s also not meant to provide for your entire retirement like so many Americans seem to believe. Finally, keep in mind SS takes from your own earnings, so if you had time periods without employment, that’s less SS money in retirement.
  4. As a result of 2 & 3, personal savings, tax-advantaged or not, takes on a much more important role since we’re looking at a one-legged “stool” scenario.
  5. It is therefore critical to save your retirement funds in such a way that they can grow sufficiently and outpace inflation, even in retirement. In other words, you must invest in the stock market (or win the lottery). Savings accounts and CDs will leave you woefully underfunded at a time when you should be enjoying your Mai Thais, traveling, and enjoying time with your hobbies and grandchildren.

The simple math behind this is that averaged over a long period of time (say, 20+ years), the inflation-adjusted average per year. This means that if you put your money in a total stock market index fund and counterbalance with an appropriate amount of bonds for your age relative to retirement age, you should be looking at an approximate doubling of your principal every ten years or so, ensuring ample growth. The key point here is that this is over the long haul; the market can certainly have a terrible year or a few (see: Great Depression, Dot Com Crash, ’08 Recession, etc.), but over the long haul, the overall market will always go up. Even in the worst of the world’s depressions, the market always recovers and goes on to smash previous highs. If the market does not go up, we’re looking at a doomsday scenario with scorched earth, bomb shelters, and emergency food reserves where you’ve got bigger concerns like how to keep your family fed and safe. As long as you don’t jump ship, your money will be fine.

Once youget your money into your retirement account(s), the rest is procedurally easy for you. You just wait until your retirement, checking every year or half year to rebalance your fund ratio if you didn’t opt to use target funds, and enjoy your retirement when the day/year comes, pulling out the hundreds of thousands to millions of dollars you should have in your account(s)!

4A. Invest in your IRA

Individual Retirement Accounts, or IRAs, can be a little tricky to understand at first if you haven’t done a deeper dive into the Leviathan that is the US tax code. The quick version is that an IRA is a retirement account entirely separate of your employer’s (e.g. 401(k), 403(b), 457(a), etc.) to which an individual can contribute up to $5,500 per year (as of 2018). Like the 401(k), an additional catch-up contribution of $1,000 is allowed if you are past the age of 50.

Unless you run your own business or work for an employer who has opted for a SIMPLE IRA plan rather than a 401(k), you have two options for an IRA: the Traditional and the Roth. The Traditional allows you to deduct the amount you contribute from your income when you file taxes that year, as long as you make below a certain income level ($73,000 adjusted income for singles as of 2018). In other words, money you contribute to your Traditional IRA is not taxed. This of course means that that money can then grow tax free as well. However, when you withdraw that money, it is then taxed, principal, gains, and all. This is typically known as a tax-deferred account or a tax-free contribution account, the same as a Traditional retirement plan like the 401(k).

traditional-retirement-accounts
As with the 401(k), money goes in and grows tax free, then is taxed when you withdraw (courtesy of Mad Fientist)

The Roth, on the other hand, is sort of the inverse: it’s treated as normal taxed income, but once it’s placed in your Roth IRA account, grows tax free, and can be withdrawn at the time of retirement (with a few exceptions permitting earlier) principal and interest free. When you withdraw it, the taxable amount is listed as zero on your income taxes. This is typically known as a tax-deferred account, sometimes also called “tax-free“.

Roth Retirement Account Taxation
Unlike the Traditional 401(k) and IRA, you pay taxes on your contribution to the Roth IRA going into the account, but your earnings then grow tax free. (courtesy of Mad Fientist)

The maximization math for this is a little more complicated than is suited for this already-jumbo post, so I will discuss it separately in my retirement accounts post. Suffice to say the simplified version: if you expect that you will be making less annual income during your retirement than your current income, opt for the Traditional IRA (and 401(k)). Otherwise, you are expecting that you will be making more annual income during your retirement than your current income, in which case you should opt for the Roth IRA.

Once you’ve made your decision, the set-up is the easy part.

  1. Go to a branch/the website of the brokerage of your choice and open up the according IRA (i.e. Traditional or Roth)
  2. Deposit money at the pace you desire up to the $5,500 annual limit (You have from January of the calendar year to the following April (Tax Day) of the tax year, so actually ~15.5 months)
  3. Put your money in target date funds or total stock market index funds (see above)
  4. Forget you have money in that account until it comes time to rebalance every year
  5. Salivate over your retirement!

4B. Large Upcoming Necessary Expense(s)

So by this point you should have:

  • stockpiled a multi-month emergency fund that can provide for you and your family in case of all kinds of emergencies, from mild to major
  • paid off all your non-mortgage debt, both high interest and moderate to low interest!
  • managed to save some solid amount of tax-benefitted retirement savings in your 401(k) and IRA

Pat yourself on the back! These are impressive and important accomplishments.

At this point, we want to take a breather to see if you’re coming up on any kind of large necessary purchase, such as a car, a professional certification, fronting a large bill to be reimbursed later by work, or even the dreaded college tuition (for yourself or maybe your children). If so, budget the necessary amount and just stick it in a checking or savings account (such as the high yield savings accounts or options suggested in 1A: Emergency Fund) until your money is needed.

Step 5: Planning For Your Future, Part 2

At this point, you’re already in fairly great shape. Most Americans cannot cover even a $1000 emergency if need be, live paycheck to paycheck, have notable amounts of debt, and contribute less than 5% of their income toward retirement each year. If you’re following this guide, none of these should now apply to you. Congratulations! That’s a huge step!

But we’re not quite finished. This is what I contest may actually be the most difficult part of all: keeping your retirement contributions high enough to ensure a worry-free, stressless retirement. Maxing your IRA contribution of $5,500 annually is fantastic and will definitely be a huge boon toward your retirement. However, unless you start saving this money extremely early in your career, it is unlikely you will quite meet what your retirement funding goal is unless you get incredibly lucky with the stock market timing.

Therefore, it is here that I recommend that you top off your 401(k) fully. The magic standard we want to hit is 15%. 15% of your pre-tax income being contributed toward your retirement every year will allow you to reach a comfortable retirement if it is invested properly and you do not try to withdraw it early. 15% can seem rather daunting, especially if you live paycheck to paycheck, but with the foundations we’ve set up previously, particularly the emergency fund, it should be attainable. A little bit of your money toward your 401(k) and IRA with every paycheck, and you’ll soon find quite an impressive stash saved up for piña coladas in Hawaii.

If you are already hitting 15%, skip to Step 6.

5A. Continue to fill your 401(k)/retirement account

As previously discussed in Step 4: Planning For Your Future, Part 1, younger generations are in a scenario where retirement needs to be funded from personal retirement accounts (401(k)/employer plans + IRA), with a modest contribution from Social Security savings. We’ve already gotten off to a good start by putting money into your IRA and getting an employer match. Now we want to make sure you’re getting enough money into these accounts that you’ll be sure to be able to retire.

The 401(k) can be filled up to $18,500 per year (as of 2018). Your goal should be to increase your contributions/contribution rate toward your 401(k) until you hit 15%.

If you are self-employed, contribute to your choice of an individual 401(k), an SEP-IRA, or a SIMPLE IRA until you hit 15%. If you are not self-employed, and you do not have access to a tax-deferred retirement plan, this is unfortunate, but contribute to a taxable account as necessary to reach this goal.

Step 6: Some Advanced Tactics and a Taste of FI(RE)

If you’ve made it this far, you should be very pleased with yourself. At this point you are doing better than the vast majority of Americans, and now have yourself positioned to not only enjoy retirement, but to spend money discretionarily on entertainment, and also save up excess money for whatever occasion you desire.

This is actually probably the most boring part of all. The ugly secret to getting rich is that there are just about no safe ways to do it quickly, and the safe ways take a while. If you do as I’ve stated above and continue to shovel money into the stock market (rebalancing as your risk, of course), using tax-advantaged accounts where possible, at some point, you will become wealthy, and not only have enough to retire on, but with some luck, even retire early. With a lot of luck and aggressive saving, you may be able to retire very early.

In this section, I outline a few more easily accessible methods for tax-advantaged savings, and offer a few suggestions looking forward. At this point your money should be considered entirely discretionary, and it is wholly up to you whether you want to treat yourself a bit and live easier, or continue to save aggressively to buffer your future.

6A. The Health Savings Account (HSA) – last of the retirement trifecta

Did you know that it is healthcare, and not housing, that is the highest expense of most retirees? This means that the vast majority of your retirement savings will go toward paying off high healthcare bills – because of the way America runs its healthcare, your healthcare skyrockets when not provided by your employer, which you obviously don’t have because you’ll be retired.

The Health Savings Account is an incredibly powerful tax-free (truly tax free!) option available to Americans, and has very few requirements.

  1. Be enrolled in only a high-deductible health plan (HDHP) (i.e. all healthcare plans you are enrolled in must be HDHPs); defined as $1,350/2,700 (solo/family) for 2018.
  2. You aren’t enrolled in Medicare
  3. You can’t be claimed as a dependent on someone else’s tax return

That’s it. It’s almost painfully easy to qualify.

So what’s the upside, you ask? Well, the upside is $3,450/6,900 you can stash away in a savings or brokerage account entirely tax free, so long as withdrawals from the HSA are taken to pay for a healthcare-related cost. The definition of “healthcare”-related is surprisingly rather broad, allowing for not only typical healthcare costs, but also health-related costs like dentist and orthodontist visits and over-the-counter drugs.

tax-free-investing
Unlike either Traditional or Roth accounts, you never pay taxes on HSA money as long it’s withdrawn for qualifying health-related expenses! (courtesy of Mad Fientist)

The real power comes in that there is no statute of limitations on HSAs, which means that you can pay yourself back for expenses incurred decades later. Therefore if you can pay for expenses out of pocket/from taxable money and you save the receipts, you have a stash of money you can withdraw from your HSA at any time, but until you need it, it is sitting in your HSA growing tax free. It’s basically a juiced up retirement savings account.

The HSA is not for everyone, as the requirement that you must have an HDHP almost always necessitates that you will be covered by a plan that offers less coverage compared to a high premium, high/full coverage plan, so if somebody in your family has particular health issues. HDHPs, and in turn, HSAs, are best utilized by those mostly in good health who do not suffer from a chronic illness. I would especially recommend it for young adults in good health, who in most circumstances should not need to make use of a high premium plan’s expansive coverage.

6B. The 529 and the Coverdell ESA

If you do not have children/never plan to have children, or do not plan to help them pay for their college expenses, skip this section.

With all the attention drawn toward college as of late, it is only right that the government has made available tax-advantaged methods to save for college. There are two main types of specialized college savings plans: 529’s, and the Coverdell ESA (Educational Savings Account; may be referred to as just an ESA or just a Coverdell).

Within these 529s are the traditional savings plan, and the prepaid tuition plan. The former works like any normal savings account, with the added bonus that any gains can be withdrawn tax-free, so long as they are used for college-related expenses. The latter is essentially a plan where you pre-pay tuition up front at an in-state public school in exchange for locked tuition at the current in-state rate, that is, your child’s future tuition will have tuition covered so long as it is at an in-state rate (i.e. if you move away, you will be charged out-of-state rates upon matriculation). Note that room and board are not covered, as well as private schools. Also, many states have been cancelling their pre-paid plans, as they have not been able to obtain high enough returns to keep up with spiking tuition rates, and have since returned money (plus meager interest) to parents now left scrambling – there are currently only 16 states with intact prepayment plans at my last check.

529 plans are rather interesting in that they are directly offered through states, and with a few exceptions, you are not limited to contributing to your home state’s 529. There are many great 529 plans out there: some that are highly recommended are CA, NV, NY, IL, OH, ME. In some states, 529 contributions (to any 529, not just your state of residence’s) are partially or even fully deductible! The government wants your kids to go to college and are willing to help you do it. As always, look for passive index funds rather than actively managed funds to save money on typically high fees.

Coverdell ESAs, on the other hand, have slightly different terms compared to 529s:

  • Coverdells have lower contributions limits, at $2,000/year/child
  • Coverdells can allow almost any investment (stocks, bonds, mutual funds, & more) that an IRA can, while 529 plans are limited to state selection
  • Coverdells must be disbursed on qualifying expenses by the time the beneficiary is 30 years old to avoid taxes and penalties, whereas the 529 has no age limit

Both 529s and ESAs also allow you to designate a new beneficiary easily with no incurred taxes or penalties so long as the new beneficiary is a family member of the past beneficiary, so if plans change, you can “hand it off” to, say, a nephew or another child.

It is of note that 529’s have recently been changed to allow for payment of private school (i.e. K-12) tuition (ESAs already did), so if you plan to put your child through private school, it may still be worth it even if they don’t plan to go to college or you don’t plan to help them with college.

These accounts do have implications toward a family’s Expected Family Contribution (EFC), but I will save those for a separate post. Suffice to say that you are generally still much better off opting for the 529 rather than a standard taxable account if this money is being saved exclusively for college.

6C-1. FI(RE): A Fork in the Road

Here’s where I introduce you to a concept called “Financial Independence (Retire Early)”. With the advent of the newer and newer technologies and a shrinking world, it has become more known that one can actually retire early (early defined as before the retirement age of 67 the US government uses) on savings.

This builds on the math that I have discussed previously above. To put it simply, based on your projected annual expenses in retirement, there is an amount of money that, if you can save it up, allows you to withdraw these allotted expenses every year, and continue to have money remaining. This withdrawal rate is ~4% of your total savings, therefore you need ~$25 in savings for every $1 you want to be able to withdraw perpetually at the time you start withdrawing. If you can save up this amount, you will be able to retire early, so long as your projected annual expenses do not suddenly spike up for an extended period. This is incredible: essentially you never have to work ever again so long as your withdrawal rate does not outpace the growth rate of your money. This means you can do whatever you want. Wake up at 10 and hit the golf range with your buds? Done. Float your partner’s new entrepreneurial venture? Done. Spontaneously take a vacation to the other side of the globe? Done.

Note that FI is not so much about actually retiring early as it is about having the financial freedom to do whatever you want to do, without fear of poor job performance or stresses of frustrating co-workers/clients/collaborators affecting your ability to pay rent. We’ve already made a great step toward that by building an appropriate emergency fund. If you want to continue working, you certainly can, but FI gives you the flexibility to do whatever you want to do with yourself if you didn’t have to work. If you want to continue working, you absolutely can. Work part-time from home for a modest pay decrease so you can spend more time with your family? No problem. Work part time focusing on your less-profitable hobby? No problem. Venture into a brand new field? No problem. You can see how liberating this can be.

To do it is fairly straightforward procedurally, if difficult mentally. Continue to fill your tax-advantaged accounts (401(k), IRA, HSA) until all are maximized ($27,450 annually for an individual, $35,450 if older than 50). If you are fortunate enough to have access to an employer-sponsored account that allows for after-tax contributions, you should take advantage of the Mega Backdoor Roth IRA, which allows you to contribute to the employer contribution limit of $54,000 annually that then grows tax-free in your Roth IRA.

Now, if you still have money leftover in your budget, make sure your emergency fund is adequately filled, determine a savings rate you feel comfortable with, and contribute the according amount to a taxable brokerage account, with the portfolio balanced as stated in previous sections (broad market, international, and bond index funds). Sit back and count the years until you can FIRE!

6C-2. Immediate Goals?

Not everybody may necessarily want to retire early, and that’s fine. If that’s the case, surely you want to do something with all money you’ve earned with your hard work!

If you have more immediate large goals (such as a down payment, a car, wedding expenses, a big vacation, etc.), you would want to start saving up for it here. A more conservative mix of stocks and bonds than long-term savings should be used – I would approximate your time horizon to be ~3-5 years.

If you have no such upcoming goals, and your money is sitting around, I would open up a HYSA (see above) if you haven’t yet, and store a little bit of extra liquid money in there to smooth over your monthly bills. At this point, I would find a savings rate that feels comfortable for you, put the according saving amount in a, surprise surprise, total stock market index fund, and bonds as rated appropriate for your desired risk, and allow yourself the rest of your paychecks to use freely at your discretion. Of course you can adjust over time if you feel that savings rate is either too loose or too tight on your monthly finances.

That’s it! Now live like a royal family and enjoy your life.

 

Questions? Comments? Concerns? Please share below; I would love to discuss!

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