Posted on May 18, 2015 in ,

Financial Planning Basics – Part II Budgeting Doesn’t Work, But Paying Yourself First Does!

Unless you expect to win the lottery or inherit the money the only way to accumulate wealth is to do it the old fashion way….save, save, save.  Budgeting generally does not work, but living below your means and saving money does.  The most effective method of saving money is to simply “pay yourself first.”   If you don’t bring the money home, you can’t spend it.  That is why the employer sponsored 401(k) is the easiest and most effective way to accumulate wealth.

We recommend you save a minimum of 10% of your gross income.  Let’s assume you are 24 years old, just completed your master’s degree and are starting your first permanent job earning

$50,000 per year.  You merely save $5,000 per year in your 401(k) over the next 41 years and earn a modest 6.7% per year, (never increasing the annual savings amount).  At age 65 you will accumulate $1 million.  Now let’sassume your college roommate earned the same amount that you did but didn’t start saving until age 34.  He and his employer add $10,000 per year to his 401(k) for 31 years, $2,500 more per year than you did.  His account only grew to $965,000, $535,000 less than yours.  Now let’s assume your employer provides a 50% match to your 401k, so the total savings is $7,500 annually.  At age 65 your account will be $1.5 million.  The moral of the story is “he who saves early and often will win the game!”  The power of compounding over long periods of time is your friend.

So how do you get started?  Begin with determining your monthly cash flow by recording your gross income before deductions.  Next deduct FICA (Social Security & Medicare 7.65%), federal withholding tax and any other deductions your employer deducts from your pay.  The result is your net take home pay.  Next record your fixed expenses such as mortgage payments, auto payment, credit cards, insurance, utilities, food and other recurring costs.  The remaining portion is available for variable expenses, for example entertainment, charity, travel, vacations, and saving.    We think your top priority should be you and your family and therefore recommend that paying yourself first through a 401(k) or IRA must have a higher priority than all of your variable expenses.  The employer sponsored 401(k) has four benefits:  First, it is tax deductible and reduces your federal income tax by your marginal bracket.  At the $50,000 income level your tax bracket is 15% so you earn an immediate 15% return.  Second, most 401(k) plans have some sort of employer match which is free money.   Third, the 401(k) is invested in a tax deferred account, therefore all earnings are tax free until distributions begin.  Finally, qualified tax deferred retirement plans are currently creditor proof in all states.  The total amount an employee can save in a 401(k) in 2015 is $18,000 and $24,000 if age 50 and older.

If your employer does not provide a 401(k), you are eligible to save on a tax deductible basis up to $5,500 per year in an IRA (Individual Retirement Account) and an additional $1,000 when you are 50 years and older.  You can add to your savings amount in excess of the above limits by saving in a personal investment account.

While we encourage you to record and track your monthly expenses (budgeting) the key to financial freedom is saving consistently over long periods of time and taking advantage of compound interest.  Your wants and needs will always exceed your available cash flow therefore saving money through a payroll deduction plan at work or an automatic withdrawal system is the most effective method to accumulate wealth.

In the third part of this series, I’ll focus on income tax planning strategies that may assist you in increasing cash flow and saving more money.

Next time:  Financial Planning Basics-Income Tax Planning:  Part III