Over the years, I’ve helped hundreds (maybe over a thousand) of people with their personal financial planning. And I can tell you that there are five basic things you want to do to never have a serious financial problem the rest of your life.
1. Get out of debt and stay out of debt.
There is good debt and there is bad debt. There’s only one kind of good debt — the kind that’s going to make you money. Carefully considered business debt can be good debt. Investment debt can be good debt in certain instances. Mortgage debt can be good debt if you work to pay off a mortgage as soon as you can.
Almost all other debt is bad debt. Consumer debt like automobile loans, loans to buy appliances and furniture, loans to buy boats, motorcycles and the like — they’re all bad. And credit card debt is terrible debt.
The big problem with debt is that you have the magical power of compound interest working against you rather than for you. The average American has $8,000 in credit card debt. If that’s you and you’re making the minimum payment, it will take you 26 years and 8 months to pay what you owe. And you will end up paying $11,423 in interest.
I hope you enjoyed whatever you bought for that $8,000 because it will be the most expensive $8,000 you ever spent.
2. Save 10% of your gross income by using the 60/20/20 rule.
And the only way to do it is to pay yourself first. Let’s say that your gross income is $5,000 a month. The first $500 automatically goes into savings and investments. Set up an automatic deduction plan where you don’t even see it. It automatically goes into a savings account. Saving is not an option. So consider it a necessary expense just as you would food, utilities and a mortgage payment.
The 60/20/20 rule means that 60% of what you save is allocated to long-term investments. 20% is allocated to an emergency fund. And 20% is allocated for “emotional spending.” Long-term investments are critical for achieving financial freedom.
An emergency fund is important for…well…emergencies. Traditional financial planning says that you should have about six months living expenses set aside for emergencies — those “unexpected” things that happen like a loss of a job, or unplanned medical expenses, or major repairs.
Emotional spending is defined as spending for things you want, but don’t necessarily need — vacations, a new TV, down payment on a second home, and all the “stuff” people like to accumulate. An emotional spending account is important because that’s what makes saving money fun. And you want to have fun doing this.
So here’s an example of how this could work…
We will use as an example a gross income of $5,000 a month. Let’s say at first you can only save 2% . (Remember you’re also paying off your debt at the same time. You’re going to eventually be saving 10% of your income. But you have to start somewhere, even if it’s only 1% or 2%.)
So you’re saving $100 a month (2% of $5,000). Here’s how $100 would be allocated according to the 60/20/20 rule…
$60 into a long-term investment account like a 401(k) account, a Roth IRA, etc.
$20 into an emergency savings account like a money market fund
$20 into an emotional spending account. This portion could also be put into a liquid account like a money market fund. However, if it’s for a longer-term goal, you may want to put it into a certificate of deposit or a bond mutual fund to get a higher rate of return. If you put it in the same account that you have for emergencies, make sure you know how much of that account is for emergencies and how much is for emotional spending.
As you increase the amount you are saving you will increase the amount going into the three categories. The allocation stays the same until you have about six months of savings in your emergency savings account.
Then you could change the allocation to 80/0/20. In other words, 80% allocated to long-term investments and 20% allocated to emotional spending. You no longer need to save for emergencies because you’ve reached your goal in funding that account.
Simple but powerful.
3. Buy a house and pay off the mortgage.
The advantage of home ownership has been well documented. The idea of paying off a mortgage early is more controversial. Some would say that if you have a 6% mortgage and you can earn more than that by investing the difference, you shouldn’t pay off the mortgage.
I disagree. First of all, whatever you can earn over and above the 6% is not guaranteed. Paying off the mortgage is guaranteed. Let’s say you have a $180,000 30-year mortgage at a 6% interest rate. If you make the minimum payment of $1,079 a month on that loan for 30 years, the real cost of that mortgage will be $388,508. Not nearly as bad as credit card debt, but not nearly as good as having money work for you.
Also, there is a psychological factor that goes way beyond dollars and cents. It’s a wonderful feeling to own a home free and clear. So pay it off.
4. If you’re eligible, open a Roth IRA account.
The Roth IRA is the simplest, easiest, most effective tax-free savings plan imaginable. Not only do your earnings accrue on a tax-free basis, but withdrawals are free of taxes as well.
If you’re confused about the myriad of retirement plans that you have to choose from, let me make it easy for you. The Roth IRA is probably going to be your best bet, hands down. It’s more flexible than a 401(k) or a traditional IRA and it will probably allow you to accumulate more money for retirement.
I can think of one exception where the 401(k) may be better. If your employer matches your contributions, you probably want to contribute to a 401(k). But contribute to it only to the point that your employer matches your contribution. Beyond that, put your money in a Roth IRA. And even if your employer matches your 401(k) contribution, it is usually the case that you have to stay with the company for a certain number of years before you actually own your account. If you don’t plan to be there that long, then opt for the Roth IRA.
For 2006, the contribution limit to a Roth IRA is $4,000 if you’re under age 50 and $5,000 if you’re 50 over. However, there are proposals before Congress to raise that limitation or remove the limitation altogether.
If you’re single and your adjusted gross income is higher than $95,000, or $150,000 if you’re married, the amount you can contribute to a Roth IRA begins to decrease. It reaches zero for incomes of $110,000 for single people and $160,000 for those who are married. But there are proposals to remove the ceiling, making all Americans eligible.
The big attraction to the Roth IRA is the tax break it gives you. If you contribute to a 401(k) or a traditional IRA, you get a tax deduction in the year of your contribution, which reduces your taxes for that year. And you won’t pay taxes on interest, dividends, or capital gains while you’re working. But you will pay taxes when you go to withdraw the money at retirement.
With a Roth, you don’t get the tax reduction on contributions, but after that it’s completely tax-free. You never pay taxes on interest, dividends, or capital gains — not while it’s growing, not when you make withdrawals. Never. That’s a huge benefit.
Also there are no distribution requirements with a Roth. Remember that a 401(k) account and a traditional IRA are just tax-deferred, not tax-free. The government wants its money when you make withdrawals. So you are required to start making withdrawals at age 70 1/2. But since Roth IRAs are tax-free, the government doesn’t care how long you let it grow. So if you don’t need the money you can just keep letting your account grow, free of taxes, for as long as you want.
Withdrawals from a traditional IRA or an employer-sponsored retirement plan before the age of 59 1/2 could lead to taxes and penalties. That may not be true with a Roth IRA. You can withdraw the money that you contributed at any time without penalty. However, the earnings on your contribution may be subject to tax and penalties. So a Roth also has an advantage over other retirement plans if you plan to retire early since you can first remove your contributions without tax or penalty.
If you appreciate the tremendous advantages of tax-free savings and investing, the Roth IRA is hard to beat.
5. Learn to invest like the best.
Maximize the return on your investments by buying a partial interest (shares) in good businesses when you can buy them at a bargain price. That means you want to buy shares of businesses that have a high return on capital when the shares are selling at a high earnings yield. And that’s what this site is all about.
Other than making sure your insurance needs are taken care of, that’s it. Do the above five things well and you’re not likely to ever have a significant financial problem.
Larry Holmes
