Are you practicing the “pay yourself first” approach to saving?
We have all heard over and over that the key to retirement is saving early and taking advantage of compounding interest. This is nothing new. But again, knowing what to do is quite different than actually doing it.
For the Financial Slacker, this is even more of an issue.
How does a “pay yourself first” savings process work?
Start Investing Into Your 401(k)
For example, if you work for a company that offers a 401(k), you need to take advantage. If they offer a match, it’s even more important to take advantage. Look at the math. Let’s say you are married and earn $100,000 per year putting you in the 25% tax bracket, with an effective tax rate of 17%, or $16,500. Assuming no other deductions, your take-home is about $83,500.
When you decide to invest 5% of your gross pay into the company 401(k), you effectively lower your taxable income to $95,000, which means you’ll be paying about $15,000 in taxes (assuming nothing else changes), with a take-home of $80,000. You invested $5,000, but it only cost you $3,500 because of the tax benefit.
Now, let’s assume your employer has a 100% match up to $5,000. So into your 401(k) account goes the match (tax-free). Another way to look at it is you invested $5,000 and immediately earned $6,500 risk-free (the $5,000 company match plus the $1,500 tax benefit). Where else can you immediately more than double your money without risk? Even if you wind up spending the $1,250 in tax savings (you did give up $5,000 in spending to get it) and just invest the $10,000, in 30 years, growing at 6%, it will be worth $57,435!
So invest it in your 401(k) and leave it alone. But this is nothing new and if you’ve spent any time at all on personal finance websites, you know all this. However, once again, the key isn’t just knowing, it’s also doing.
Buckets Rather than Budgets
There is a limit on how much you can invest into your 401(k). And, I often hear the question, how much should I save? Or, how much should I invest?
Some will recommend creating a budget and forcing yourself to live within it. Honestly, I am not actually a big fan of using a budget on a month-to-month basis to manage individual expenses. I do create a monthly budget and I am a big believer in using Personal Capital to track expenses. But I tend to use the budget to track monthly expenses in total rather than trying to manage each line item. Things change throughout the month. If I overspend in one area, I can cut back in another to keep the total spend in line.
Instead of using a budget, I use a simple cash allocation model with multiple savings/spending buckets. Here’s an example:
- Income Taxes. This is not a category that you have much control over as it mostly depends on your income; however, you can and should reduce your taxable income by contributing to a 401(k), IRA, or other pre-tax account (as discussed above). Your effective tax rate as a percentage of gross income will most likely range from 12% to 30% (unless you are on either extreme of making less or more).
- Retire at 65 Accounts. This category includes all the pretax accounts that you have access to such as the previously mentioned 401(k), IRAs (Traditional, Rollover, Roth), and SEPs. If you’re just starting out and have access to a 401(k), you should start contributing as soon as possible. Do not hold off as you’re likely to start spending more money now that you’re making more. Start with 5% of your gross salary but make sure you’re contributing enough to receive the maximum company match. Continue increasing your contribution until you are contributing the maximum amount allowed each year.
- Emergency Fund. This is the cash on hand that you have to cover anything that might come up from an emergency expense to the loss of a job. Ideally, you should have around 6 months of spending available for emergencies. Contribute 10% of your gross salary to the emergency account until it’s fully funded.
- FIRE (Freedom) Fund. This is your after-tax investment account which will allow you to retire before you reach the age of 65 and start accessing your pretax accounts. Before contributing to your FIRE fund, max out your pretax accounts and make sure you have enough saved in your emergency fund. At a minimum, you should contribute 10% of your gross income into your FIRE fund.
- Living Expenses. Notice that I listed living expenses last. This is intentional. If you spend and try to save what’s left, you will find there is nothing left. Most of us have willpower limitations and if we have the money, we tend to spend it. Make your investment contributions before you start spending. In other words, pay yourself first. In general, I like to target keeping your living expenses at less than 50% of your gross income. Be especially careful about how much fixed expense you incur. I try to keep my fixed costs as low as possible. In the long run, almost all costs are discretionary, but some require significantly more effort to change (mortgage, taxes, insurance, other loans).
Pay Yourself First
Obviously, the above allocation model needs to be tailored to your personal financial situation. How much do you earn? What is the cost of living where you live? Do you have any extraordinary expenses?
But no matter what your personal financial situation, I am a big believer in using buckets to separate your savings and spending. If you create a few money buckets (emergency fund, retire at 65 fund, FIRE fund, living expenses), you know why you are putting money away and you can set up goals by age for each bucket.
And with a pay yourself first approach of saving at least 20% or more of gross income and keeping your living expenses at around 50% of gross income, whether you are making $50,000 per year, $500,000 per year, or somewhere in between, you should be in a good position to return early.
Do you pay yourself first by consistently withdrawing your savings before spending on living expenses? What other approaches do you use to manage your expenses?
[do_widget id=text-8]
This is a great overview of paying yourself first. That approach is definitely the secret to our success! And we’re also big believers in continuing to raise the bar. So if we save $1000 one month, then we’ll strive to save $1050 the next, and keep cranking that number up until we feel the real pinch, and then hold steady until it gets comfy, and then crank it up again. By living on the meager leftovers after paying ourselves first, we’ve avoided most forms of lifestyle inflation, and have saved a lot. So just chiming in to say: this really works! 🙂
I love the idea of raising the bar each month until it hurts. It’s so easy to spend money when you have it. Better to get it out of sight. And depending on how lean you want to run, you don’t necessarily have to put all the money into long-term investments. We tend to keep a relatively high cash reserve – probably 2x what I talked about. We can still access the money if we absolutely need to, but it’s not easy to get.
I like this bucket idea as it makes allocation a lot easier. You break down the buckets really well and make a big topic seem a lot simpler. Something I will keep in mind as I start to work!
I essentially work backwards when determining how to allocate to my buckets. Once I have an emergency reserve established, I start planning for my age 65 retirement. How much do I plan on spending during retirement? And how much do I need to contribute to get there? You can use 25x or 30x your retirement spending as a target. But the good news if you start early, you have 40 years of compounding to get you there.
Once that plan is established, I start working on the FIRE fund. How much will I need to bridge from early retirement to age 65 retirement. The good thing about the FIRE fund is that it doesn’t need to last forever – just long enough to get to your tax-deferred accounts.
The concept can be applied at work as well. If you need to fund a project, look for areas to cut enough expense to pay for the project – budget neutral.
Exactly right, if you want to become wealthy, you have to put that at the front of your money goals. Not last! We allocate a decent amount to be saved first, then all the bills, whatever is left we save that too.
Tristan
If you go into your career focused on early retirement rather than just climbing the corporate ladder, you’ll have a much better chance to get there. Of course, that’s easier said than done as the idea of retirement seems so far off. Plus, when you come out of school ready to make money, companies are good at continuing to raise your salary just enough to keep you from leaving. It’s up to you to plan for your future.
I pay myself first in multiple ways. I contribute a decent percentage of my income to my 401k and have automatic contributions to my Roth IRA, cash savings, and make a monthly deposit into my taxable account. You need a lot of buckets to hit FI someday!
I do the same thing. And I have smaller buckets within each of the major categories. For example, within my spending bucket, I have separate accounts for my kids’ private school, for home renovations, for my next car, and for living expenses.
Good example with the 401k and tax saving. So many people do not understand how powerful tax deferring can be. Whenever anyone asks me how much to put in their 401k, I always tell them “the max” simply on the principle that you will save $4,500 in taxes by doing so (assuming 25% tax bracket).
One thing that I did was create a simple spreadsheet that calculated federal taxes based on different income levels. It was eye-opening how much of an impact making pre-tax contributions can make. And this gets even more magnified when there is an employer match.
I am constantly amazed at how many people know nothing about the tax benefits of investing in their own superannuation fund. In Australia, employers have to make a minimum 9.5% contribution to every employees super fund but you can choose to make your own ‘salary sacrifice’ contributions as well. Although you can’t touch these funds until you’re 60 except in exceptional circumstances, you can manage your investment portfolio within the fund. The great thing is that, all contributions are taxed at only 15% and when you start to draw down funds from your scheme, the payments are all tax-free!! Great long-term savings plan I reckon.
I am not familiar with the Australian laws. Is that 9.5% of gross salary that all employers are required to contribute? In the U.S., employers typically match the contribution of the employee up to a maximum.
Great way to look at finances! I love the bucket concept and am surprised that I’ve never heard of it before. I’ll have to consider implementing this in my own routine — much more efficient than the budget method. Thanks for sharing and I look forward to seeing more great content here on your blog!
Thank you for the comment. I haven’t been to your site yet, but I will definitely check it out.
The bucket principle and pay your self first is the corner stone of our current savings level and the progress of the last few years.
We have fixed the minimal savings we want to do. We have a prty good ide of the budget we want to spend on living and fun.
This results in a monthly automated distribution of our income to savings:investing and living accounts. The buckets now took over from the budget… We have no idea what we pend on grocery, clothes, restaurants, kids, gifts… Easy to track this way!