Budgeting sucks. Why does budgeting suck? It forces you to put limitations on how you spend your money. No one wants to be told they can only spend $50 this month on eating out. It doesn’t matter if it’s you imposing it or someone else. Our natural tendency is to fight against it. That’s why so many people struggle when it comes to maintaining a budget. So what’s the solution? Screw the budget! You don’t need one. There’s a far more effective method that starts with this, PAY YOURSELF FIRST. After you pay yourself first, the rest takes care of itself.
Pay Yourself First
The mistake many people make is paying all their bills, and then trying to save anything that might be left over. This is backward! You cannot secure your financial future with just the scraps that are left over. To get ahead, you need to pay yourself first by taking money off the top of your paycheck to save and invest. Then just live on the rest whatever way you like. Who cares what you spend money on. Pay yourself first, then pay your bills, then live on the rest however you want. This way, you’re not sacrificing savings for the latest must have toy.
I first heard about the pay yourself first concept when reading Automatic Millionaire by David Bach. I’ve talked about this book several times and the impact it has had on me. Like many personal finance concepts, the idea is a simple one and seems obvious. Many people, however, fail to put it in practice.
How Much Should You Pay Yourself?
So now that you’re on board with the concept of paying yourself first, the question is how much. That depends on your goals. Do you anticipate working until “normal” retirement age? Then 15-20% will do it. Take a person that earns $40,000 at age 25 and begins investing 17% of their gross salary into a 401k plus the employer’s match of 3%. Assuming a salary increase of 3% each year and an annual return of 8%, their portfolio would grow to $2.3 million by age 60. That’s plenty to live a comfortable life in retirement.
Let’s say your goals are a little more ambitious and you want to retire by 40. To do this, you’ll need to save 50% of your income starting at age 25. Not possible? Sure it is. You’ll need to make sacrifices, but you won’t exactly be living in a shack eating ramen noodles for every meal. Take a couple that each makes $40,000 at age 25. They begin by each contributing 15% to their employer sponsored 401k plan. In addition, they each receive a match of 3%. On top of this, they save 40% of their take home pay.
Retire at 40 Example:
Assuming their incomes increase by 3% a year and an annual return of 8%, they would end up with an after-tax portfolio of $833,000 at age 40. This would provide $41,650 of tax-free yearly income for the next 20 years. Why tax-free? Because current tax laws allow for up to $75,300 in long-term capital gains and dividends to be tax-free for couples filing jointly. Capital gains and dividends above this threshold are taxed at 15%. With the Republicans now controlling the House, Senate, and White House, Tax laws are expected to change next year. However, preferential tax treatment for long-term capital gains and dividends is expected to continue.
After 20 years of living on their after-tax portfolio, they would be able to access their 401k penalty free (there are rules that allow for early access for retirees, but we’ll stick with age 59 1/2). If this couple stopped contributing to their 401k when they retired at 40, and let it grow at a rate of 8% annually until they were 60, it would amount to $2,250,000. A 4% withdrawal rate would give them $90,000 pretax in annual income. Plenty of money to continue retirement well into their golden years.
Take Yourself Out of the Equation: Automate
Early retirement is attainable as long as you start early and pay yourself first. After looking at the example above, it seems so easy, even on a modest income. All you have to do is commit to a savings rate that will meet your goals. The couple above that wants to retire at 40 is still left with $35,820 annually to live off of. That’s nearly $3,000 per month. My wife and I lived on far less than that in our early years.
If you’re like most people and lack the self-control to save this much every month, there’s one more thing to do. Automate it. This takes you completely out of the equation. Your 401k contributions are already automated each month. All you have to do is set up your elected deferral, and it’s all set. Do the same with your taxable accounts. I currently have automated deposits set up twice a month to send money to Wealthfront. This money is then automatically invested according to the investment plan I have set up. I’ve also used Robinhood and Loyal3 to invest in individual stocks. These two platforms have zero trading fees and also offer automatic deposits. You will still have to research and pick stocks to invest in, but at least the money will already be in your account if you have automatic deposits set up.
The same goes for cash savings. When I graduated college, I started saving for an engagement ring for my now wife. I set up an auto deposit of $300 per paycheck into a separate savings account. Once the ring was paid for, I still had the money directly deposited into my savings account to use for vacations, home projects, etc. The key is once again to make it automatic, and in the case of cash savings, put it in a separate account. The harder it is to access the better.
Never Too Late to Start
The best time to start investing in your financial freedom was when you received your first paycheck. The second best time to start is now. If you are an early 20 something fresh out of college and earning your first paycheck, then get started today. Time is your most valuable asset when it comes to investing. If you’re 35 and haven’t started saving, stop kicking yourself and get started today. It really is as easy as following these steps:
1) Decide when you want to retire. Is it 65? 45? Maybe semi-retirement fits you better? It doesn’t matter. Make a decision so you can get started on the path to financial freedom. Your goals can always be adjusted down the line if your situation changes.
2) Determine your savings rate. Use one of the many investing calculators online to determine how much you need to save each year. This too daunting for you? Start with the general savings rates mentioned above – 15-20% for “normal” retirement age, 40-50% for early retirement.
3) Pay yourself first and automate. The quicker you get used to living without the 20% or 40% of your income, the easier it will be. Paying yourself first and automating the process takes you out of the equation and removes the money from your checking account before you have a chance to miss it.
Readers, are you paying yourself first? Share your savings rate and your goals for reaching financial independence.