Not only did we get hit with the Polar Vertex at the start of the year, but as we see every year, New Years ushered in the people making new years resolutions. Almost anyone that makes a resolution falls into three categories: they want to lose weight, improve their finances, or stop smoking. It's great that people want to better themselves however by now almost 75% of the people who have made resolutions have already given up on them.
We are going to focus on the popular resolution of improving your finances and what three basic areas to focus on to achieve improvement.
Contribute to a retirement account
There are two benefits that you get when you save for your retirement. The first is that you will build up assets so that one day you can stop working. Social Security is nice, but not enough to live on. Pensions are being cut at both the private and public levels. What you sock away during your working years is what will be used to build your income stream once you start working. There are three things that will determine how much money you will accumulate. When you start saving, how much you save, and what returns you see on your investment. Surprisingly when you start saving is a huge factor to how much money you will have
The second reason for contributing to a retirement account is the tax benefit. If you contribute to a 401k, Traditional or SEP IRA, or Profit Sharing Plan, you are able to deduct your contributions. That means if you earn $100,000 in salary this year and are in a 25% tax bracket you would have to pay $25,000 in taxes. If you contribute $5,000 to your retirement plan when it comes time to pay taxes, you would pay on $95,000 and not $100,000. Your tax on $95,000 if you fall into that same 25% tax bracket would be $23,750. If you contribute more or are in a higher tax bracket the savings by contributing is even greater. The other tax benefit you see in a retirement account is that you are allowed to defer paying tax every year on any gains in the account. If you saved money in a bank or regular investment account, every year you will receive a statement showing how much interest, dividends and/or capital gains the account earned. You then have to include that in your tax return. In a retirement account you are allowed to reinvest the interest, dividends, and gains back into the account to grow. Don't believe me on the power of tax deferral check out this article which does a great job explaining it <<power of tax deferral>>
How to simplify it - Automate your savings. Along with the company match the other good thing (maybe the only other good thing about a 401k is that it allows you to set what percentage to have taken out of your pay to contribute to your 401k. You set it and forget it. A lot of people don't even realize that they are building up a chunk of retirement savings. You can do the same thing with your IRA. Most financial institutions will allow you to link your bank account or even direct deposit into a retirement account
Prepare or a catastrophe
What does you and your family's security mean to you? Everything, right? You wouldn't think twice about buying a policy to protect against damage to your house or insuring yourself against an auto accident. What about health insurance for you and your family? Only the best! But so many forget, or choose not to protect their income. Your income is arguably your biggest asset.
A university graduate starting a career with a $45,000 annual salary, assuming raises and promotions over time, may grow his or her salary by 4 percent annually. This translates into more than $4.25-million of total earnings over a 40-year career! Over time, part of your take-home pay is slowly converted into tangible assets and investments, although during your younger years your future potential income is one of the most important aspects of your financial well-being. It could be crippling to both you and your family if something unforeseen were to happen that prevents you from being able to earn an income.
Unless you are Kenny Rogers and like to gamble there are a couple of things it makes sense to start an emergency fund and purchase Life and Disability insurance.
Insurance prices have come down over the years and it is often cheaper than people think. The process to getting insurance is pretty straightforward: Determine how much insurance you need à Get a quote for that amount of coverage à Take a medical exam à Obtain coverage
Protecting your paycheck is a great step to prevent a financial catastrophe, the other financial action to do is create an emergency fund. Have 3-6 months worth of income readily available should an emergency occur. The emergencies we are preparing for here are the ones that are devastating to your finances. Examples include a loss of your job or no income. Or a medical emergency not covered by insurance. Without preparation these types of emergencies could result in having to declare bankruptcy or losing your residence.
Just like contributing to a retirement account, the easiest way to build up an emergency fund is to automate the saving of money into it. Here is a 3 step process to get your fund going:
Step 1 - Create a new account. You could do this at the current bank that you have your savings and checking account, or at a different institution
Step 2- Calculate a goal of how much you want your emergency account to have. Lets say you earn on average $10,000 a month. A good number to start with would be $40,000 (4 months worth of income)
Step 3 - In conjunction with establishing your spending plan above, you set aside $500 a month to build your emergency savings. I recommend automating the contribution to that account by either having it directly deposited into the account or by having a monthly ACH payment made.
A question I am frequently asked is do I have to keep $40,000 in a savings or checking account that earns no interest. I usually recommend keeping half the amount in a checking or savings account and the other half in an investment account that contains liquid, conservative investments
Get a pulse on your spending habits
A lot of people think that budgets are only for people who have too much debt, are tired of never having money, have trouble paying the bills, or are blindsided by unexpected expenses. That couldn't be further from the truth. Everyone should have a handle on what they are spending. How can you know how much you should be saving for retirement, investing for your child's education, or have in an emergency fund if you do not have a handle on your cash flow.
Putting a budget together can be daunting. Here are a couple of ways to simplify it. The first way is that you can use an excel template <<template from RFC>> to create some high level buckets of spending that make sense for you. Track your spending for 2-3 months to see where it is going. The second way is to utilize the work that most credit cards and banks do for you. Most financial institutions will categorize your spending and since there are three areas that most people spend from: credit/debit cards, checks, and cash, you can pretty easily import your data into a tool like Mint or YNAB to consolidate all three areas and get a great picture of where you money is going. Here is an article on tools that people are using to budget.
Most people who make resolutions fail because of two things: Knowledge and Time. You can throw discipline in their as a third. Instead of calling these resolutions because of the stigma associated with failed resolutions, maybe these should be known as 5 Financial Actions You Should Take.
