Financial Advice That Fits on a 3×5 Card
A few months ago, I came across an article about a Washington Post contributor’s (and University of Chicago professor) condensed Financial Advice fitting on a 3 x 5 card…and thought I can improve upon that. OK, technically he wrote it on a 4×6 card but I write small so mine actually fit on a 3×5 card.
1. Live within or below your means! This should be the first order of business as you work towards achieving Financial Independence. Understandably, your “means” is a function of how much you make and improving upon those means would require education and training to optimize your “human capital” and ability to earn more. If you earn more, then you can save more…and if you can save more, then you can invest more…and so on.
2. As it currently stands, TSP and 401(k) annual contribution limits stand at $17,500 for 2014 with catch-up contributions of $5,500 for those over the age of 50. Most employers with 401(k) plans offer a match, so employees should at least contribute up to the employer’s match…and if there is more space up to the annual contribution limit, then maximize contributions up to the limit. It is worth noting, however, that some employers might not have the best investment options when it comes to mutual fund choices within 401(k) plans…so it might be more advisable to steer contributions above the employer’s match towards Traditional or Roth IRA. For those who are self-employed, a Self-Employed 401(k) (aka Solo 401(k) or Individual 401(k)) should be your best choice.
3. Take advantage of all your tax-advantaged investment vehicles in addition to your 401(k), through IRAs or Roth IRAs. Your total annual contribution limits to any IRA (whether Traditional, Roth, or a combination thereof) is currently set at $5,500 with a $1,000 catch-up for those over age 50. A Simplified Employee Pension (SEP) IRA is ideal for the self-employed and allows for annual contributions of up to 25 percent of each employee’s pay (up to $51,000 for 2013). Like a Traditional IRA, funds in a SEP IRA are not taxable until withdrawal. 529 plans (named after Section 529 of the Internal Revenue Code) are tax-advantaged vehicles designed for funding kids’ college education. There are federal and state tax breaks for certain states for 529 plans. If you want to know more about your 529 options, check out www.savingforcollege.com.
4. Aim to save/invest at least 20% of your income. The book “The Richest Man in Babylon” suggests saving at least 10% of what you make. If you want to speed up your march towards Financial Independence as well as fully take advantage of compounding, then the higher savings rate would pay dividends down the road. Additionally, the later you start, the higher this savings rate needs to be to achieve a comfortable retirement. Consider this, if assets required to retire comfortably is 25 times your expenses, then:
Years to Financial Independence at a conservative 5% rate of return for various savings rates:
|Savings rate (%):||Years to Financial Independence|
Years to Financial Independence at a conservative 6% rate of return for various savings rates:
|Savings rate (%):||Years to Financial Independence:|
Note that a relatively low savings rate of 15% means you’ll be working longer…and if you start out saving and investing later in your career, then you must surely need to save and invest more to achieve that elusive Financial Independence. Saving, is of course, not without sacrifices, considering the average savings rate for Americans is currently at 3.2% according to a USNews article. 3.2%! No wonder a lot of Americans are not ready for retirement…compounded by the fact that less and less employers are offering defined benefit plans or pensions. And with Social Security under tremendous pressure to maintain its funding, one simply cannot count on it at retirement. If it is there, then its just frosting on the proverbial retirement cake
Once you’ve maximized contributions to tax-advantaged accounts in 401(k)/TSP and your IRAs, then consider socking away more funds towards taxable accounts to take advantage of favorable tax treatments upon withdrawal. Withdrawals from taxable investment accounts are taxed at lower long term capital gains rates than marginal income tax rates for withdrawals from 401(k), Traditional TSP and Traditional IRAs. Having this diversity in tax treatments would provide flexibility at retirement, when the accumulation phase ends and it is time to fund your retirement by withdrawing funds from various accounts.
One might ask…but how do I know how to allocate my funds between equities/stock market and fixed income assets? Well, index mutual fund pioneer, John Bogle, suggests “your age in bonds” (i.e. if you are 40 years of age, he suggests 40% of your investments/savings in bonds or fixed income assets)…but I prefer 110 minus your age in equities (or your age minus 10 in bonds), but even this varies individually as someone with a very secure (all relative, I know) employment might opt to have a higher risk portfolio to take advantage of the higher anticipated return on equities vice bonds/fixed income over time. Having an asset allocation identified “encourages” one to re-balance assets between equities and bonds/fixed income when the percentages get out of whack when equity markets fluctuate up and/or down. Ideally, this is done once a year. Re-balancing reduces risk and induces one to “sell high and buy low”…when the market is roaring, re-balancing to previously identified asset allocation (AA) forces one to sell equities and contribute more towards fixed income assets to get back to desired AA. As a corollary, when the stock market is down, re-balancing “forces” you to buy equities low to get back to identified AA.
For your equities, it is also advisable to have domestic and international exposure with the percentage of your international exposure no more than 40% of your equities as some studies indicate that anything more than 40% in international markets exposes you to more risks…with little to no upside.
5. I am a proponent of index mutual funds and corresponding Exchange Traded Funds that track known indexes…as studies have shown, over the long term, only about 25% of actively managed mutual funds beat the Standard and Poor 500 index. With actively managed mutual funds charging as much as 2% expense ratio, over a long period of time, that 2% can erode as much as 2/3 of your projected gains! PBS’s Frontline documentary, “The Retirement Gamble” provides a compelling evidence of the devastating effects of high expense ratios / investment costs on your retirement savings. Investing in low cost, well-diversified index funds (with expense ratios as low as 0.05%) allows you to reduce risk as you are buying a “bucket” of shares of various companies in the total stock market or of the S&P 500, or whatever index you choose to track…although I am partial to mutual funds tracking Total Stock, Total International Stock, and even S&P 500 index.
6. “Bad” debts are those debts you’ve taken on for those things you can’t afford or don’t need. It might be tempting to put that bucket list trip to Bora Bora on your credit card…but you’ll pay for it dearly if you can’t pay for that credit card balance in a relatively short amount of time. Credit card debt ranks high in a bad debt scale, especially when you consider interest rates as high as 36% for those with bad credit rating to begin with. This is further exacerbated when you just pay the minimum amount. Consider this, if you have a $5,000 credit card balance with an 18% interest rate and a minimum monthly payment of $125, it would take you 273 months to be rid of your debt. In that time, you would’ve paid $6,923.14 in interest! And that is if you didn’t add more credit card purchases to the balance.
Aim to live within your means, delay gratification until you can afford it…and pay off your credit card balances in full every month. If you have a credit card that provides points or miles, then you are effectively getting paid to use their credit card.
Achieving Financial Independence is not going to be easy and would require considerable sacrifices…but the pay off of Financial Independence at retirement can not be beat.