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Financial resolutions usually don’t even last until the end of January. Making a permanent change in behavior requires time and a steely resolve to keep up the practice until it becomes habit and finally character. We can only develop financial character one action at a time.
Here are seven practices that will take you from pauper to prince if you add one each year.
If you already practice one of these resolutions, move on to the next one. Find the first one that isn’t already a practice, and make it your resolution for this year. Adding one behavioral change is labor enough for the next 12 months. Share your resolution with everyone you meet. You are 10 times more likely to act on a goal if you have articulated it to someone else. Don’t wait until you have everything perfect to take ownership verbally.
1. Resolve to be and stay debt free. You are allowed to have a fixed-rate, fixed-year traditional mortgage on your house, but nothing else. No equity line of credit on your house. No car payments. And definitely no credit card debt. You have to learn to live within your income, which sometimes means going without. Millionaires are frugal. Learn to enjoy it.
2. Compute your net worth once a year. Net worth gives you a snapshot of how much money would be left if you converted everything you own into cash and paid off all your debts. By age 45, you should be worth about seven times your annual spending. At age 65, you can only withdraw 4.36 percent of your portfolio to maintain your lifestyle. In other words, to keep the same standard of living, you will need about 23 times what you spend annually. Chart your progress.
3. Automate your savings enough to get the entire match that your company’s 401(k) plan offers. Usually this means saving 5 percent of your salary while the company adds a 4 percent match, which is the fastest way to get an 80 percent return on your money. Studies show that many Americans forgo this match, believing they need to spend 100 percent of their salary. Don’t be foolish. Learn to think like a millionaire. You can learn to live well on 95 percent of what you make.
4. Fully fund your Roth IRA, which in 2010 will be $5,000 for the year or $6,000 if you are age 50 or older. If your income is above $105,000 for single filers or $166,000 for joint filers, you will be ineligible to fund these plans. If that’s the case, see whether your employer allows you to make Roth contributions into your 401(k), which does not have income limits.
If you can’t manage the entire amount in January, put in $416 monthly. Saving this amount manually is difficult. It requires remembering and taking action every month. Millionaires have their default set at saving money. They make spending money difficult, requiring a manual override.
5. Save an additional 5 percent of your salary in a taxable account. Again, set up an automated transfer. If your paycheck gets deposited the first of the month, arrange for a transfer of 5 percent to your investment account on the second or third. You need taxable savings for a host of financial planning opportunities as well as for a plethora of life’s challenges.
By now you are saving 15 percent to 20 percent of your salary and living off the remainder. Learning to defer many of your wants is a crucial habit that millionaires cultivate. Money makes money. And the money you need to make money is called “capital.” Money spent is gone. Money saved and invested works for you, adding income every year.
6. Save an additional 10 percent for charitable giving. No matter where you think charity fits into your priorities, sensitivity to the truly needy will change your perspective on needs and wants. It will help you cut down on unnecessary consumption and become a better saver.
Put this additional 10 percent in your taxable account. By now you are saving 15 percent in a taxable account. For your charitable giving, gift the investments from the account that has appreciated the most.
No matter which organization you support, you can donate up to 15 percent more if you give appreciated stock instead of cash. If you sell $1,000 worth of appreciated stock, you will have to pay the capital gains tax of 15 percent. If most of the stock’s value is appreciation, the tax owed approaches $150, leaving only $850 for charitable giving. But if you give the stock directly to the charitable organization, you can take the full $1,000 tax deduction, and the organization will not have to pay any taxes when it sells the stock.
You have probably been giving cash to charities. Now that you are developing some taxable savings, run your giving through your taxable investments. For every $1,000 of appreciated investments you donate, use the $1,000 in cash you would have gifted to buy additional investments. Think of this as planting the saplings you will harvest later for future gifting.
After several years, your $1,000 worth of cash should have grown to $2,000 worth of investments. Gifting $1,000 worth of appreciated investments leaves the original $1,000 to keep increasing in value and fund future giving. This is one reason why frugal supersavers can be much more generous than those whose rich lifestyles preclude saving and investing.
7. Save an additional 10 percent in your taxable account for periodic expenses. You can’t plan for everything. But you can save cash for the unexpected.
When a financial crisis strikes, you will be glad you have such a fund. Then, after using the money from your emergency fund, see whether you could have predicted the expense, and adjust your plan accordingly. My wife and I learned this way to budget each month for the inevitable expense of buying our next car. The more you can foresee these expenses, the more this category can fund major discretionary purchases instead of financial emergencies.
At this point you are saving more than 35 percent of your salary and living on less than 65 percent. This is the benchmark for a millionaire mindset. As you save and invest, the appreciation on your investments can provide income that replaces your salary, bringing you closer to financial freedom.
David John Marotta and Mathew Illian manage Marotta Wealth Management, which has offices in Charlottesville and Richmond.
Excellent article and very helpful.
Thanks!
Great article. Very practical. I’ve done 1, 3, and 5. I guess that makes me odd! I’m working on #2 for this year. I’ve never done a net worth statements. I looked at #2. I’ve never understood Roth accounts. What does it take to have one and why would I want one? I don’t think my work has anything like that. Maybe I will save figuring that one out for next year.
Susie, first I want to commend you for taking your financial planning seriously. We have an article that will help you understand how to calculate your net worth viewable online at: http://www.emarotta.com/article.php?ID=370.
Roth IRA accounts allow your investments to grow tax deferred and come out tax free. We encourage all of our clients (who are income eligible) to fully fund their Roth accounts because they never have to pay tax on this money again. Tax brackets are currently at historical lows and are expected to increase significantly in the future in order to pay off the mountain of debt our nation has built up. In light of these realities, tax free growth is very attractive.
You can find out more about a Roth by reading the article, “Remember to Fund Your Roth IRA” at: http://www.emarotta.com/article.php?ID=274.
Matt
Thanks for the sound advise very well written
Let’s see now:
5% to 401k
5% to IRA
5% to taxable account
10% to charity
10% to taxable account for “periodic expenses”
30% to the IRS (maybe more)
and now I get to “live” on the remaining 35% ?
I don’t know anyone with a mere 5-figure income who could do it.
Maybe you 6- and 7-figure guys can, but not us.
Gordon, I certainly wouldn’t turn down a 6 or 7 figure salary but I’m fishing in the same pond right now. We are writing from the perspective of after-tax income but I understand that the reference to 401(k) savings could be confusing. We recommend that most people use a Roth 401(k) which is after-tax if their employer allows it.
The big picture break down is:
15% Long term savings (10% Retirement and 5% taxable)
10% Charitable Giving
10% Mid term savings
65% Living Expense
This is not easy and the first thing to go is the mid-term savings which is why we are often forced to go into debt to replace cars and heat pumps, etc.