1 - A general framework for money management
An introduction
This is a rough framework that I have used for years that has helped me to manage my money and I would like to share it. This does not constitute financial advice. Everyone’s situation is different and you should seek a licensed financial advisor in your state. All of that aside, feel free to tweak it and adjust it as you see fit. This framework is predicated on the fact that money management is primarily psychological. The way you think about the money you have and earn impacts your saving and spending habits. First, to focus the conversation, there are only a couple of starting points that really matter. The first is what are your goals? The first and most important goal you should probably have is retirement, but you should also try to come up with others. Goals are synonymous with expected expenses, so if you plan on sending your kids to college for example, that cost will need to be accounted for and the planning will be the same as if it were a goal. No need to get hung up on semantics though.
Savings Targets
To start, you can break down your income into three buckets. This makes things simple to start with. Imagine you make $80,000 per year in pre-tax (also known as gross) salary. The first bucket is easy, that is taxes. Taxes are only partially within your control in that you can consider tax rates when choosing where to live. This is not an ideal way to think about it, but it is the reality of the situation. Homeowners often do this when their office is near the border of two states and you can effectively choose which state has a lower property tax, all things being equal.
Next is the amount you plan to save. Typically, if you can save your age then you are in a good spot. By this I mean that if you can manage to save your age as a percentage of your gross income, you are saving enough. So if you make $80,000 a year and you are 30 years old, you should be saving 30% of that $80,000 per year. If you cannot save this amount, that is understandable, but you should strive to save this. If you can’t save this amount, I would start with what you can and slowly work your way to save more and more until you reach this percentage. One opportunity to increase your savings rate is with each raise. If you do not increase the amount you spend to improve your lifestyle, you can save that extra amount of money. Over many years, this can increase your savings rate to a healthier level.
Whatever is left over after taxes and savings is the amount you need to live on. At some point, usually when people have kids, this system should begin to break down because you will need to spend more to support your children. But that is fine, because if you have spent a fair portion of your pre-kids life saving, you will have a decent nest egg invested and compounding should make up for the rest. I think in all cases saving 5% is the minimum amount you should be putting away with the idea that this is a temporary floor. It’s worth noting that if your company offers a 401k and they match contributions, you should be saving this minimum amount in order to get the match above all. You can consider this part of your savings percentage.
Let’s talk about what you are supposed to do with the amount that you are saving, because this is the most powerful lever you have to increase your net worth. There are a few things you should be doing with that savings amount in order. First, make sure you have a three month emergency fund setup. Once you have that, you should still devote half of the amount that you save to your emergency fund, but the other half should go first to pay off all of your debt ranked by interest rate. Once all of your debt is paid off, then you should begin investing using a cash management account, a ROTH or traditional IRA, or your 401k through work.
I’ll keep this going next week by drilling down further into good places to put your money from a tax perspective. The goal of this is not to be prescriptive, but to provide ideas to slowly improve your financial position over time. This is not financial advice.