19 Sep The Step Ladder to Financial Independence
Shmucks don’t know how to handle their money. They don’t know their net-worth. They have no idea where their paycheck is going at the end of each month. They borrow money they don’t have and maintain a history of bad credit. They’re in debt up to their eyeballs and can’t see a way to get out. They don’t have any financial safety net and certainly did not save for their future.
It’s not entirely their own fault. Although they should have completely responsibility over their financial whereabouts, they haven’t been properly conditioned to. I don’t know about you, but I didn’t learn a damn thing in school about personal finance. Not only is it some of the most practical knowledge for survival in adulthood, it’s a downright unavoidable subject throughout life – through countless mistakes.
Don’t build up credit card debt. Don’t spend more than you earn. Don’t buy a car you can’t afford payments on. Save at least 10% of your paycheck. Start a retirement account early. Build an emergency fund for rainy days. Create a budget and track it carefully. These are things we wish we all learned at a younger age rather than in our 30’s, 40’s, and 50’s through trial and error. As they say, “We are too soon old and too late smart.”
Take control of your personal finances now rather than later by educating yourself if you’re part of the millions who are clueless when it comes to money. You’ll absolutely thank yourself in the future. Here is a very common and basic step ladder to reaching financial independence. Each is ranked chronologically by importance (once you complete one step, or if it doesn’t apply to your situation, move on to the next).
1. Budget Your Money
First things first – organize everything. Sit down with your checkbook or choose a free online budgeting tool like Mint, Yodlee, PowerWallet, or HelloWallet. These programs help you track your various expenses from multiple accounts and allow you to see where your money goes and how much is left of your net income. Once you see how much you spend on various things, you’ll be more weary of your expenses and most likely be tempted to reduce them in the form of lowering bills and/or making less impulse purchases for luxuries you don’t need. The first step to financial independence is to account for your money and take control of your finances, rather than letting them control you.
2. Build an Emergency Fund
For a rainy day, such as a sudden job loss or a random health expense, you need to have some liquid backup cash saved. Liquid capital means that your money is readily accessible at a moment’s notice, such as through a written check or an ATM. The rule of thumb is to save at least $1000 to $2000 or 3 to 6 months of living expenses in an emergency fund.
Good places to keep an emergency fund include a savings account, money market account, or money market fund. Don’t stash cash in your sock drawer or safe – not only will your emergency fund be in greater danger or theft or loss, you are actually losing money each year to inflation – around 3%. A savings account, for instance is FDIC insured up to $250,000 and although it may not pay enough compounded interest to beat or negate yearly inflation, it’s certainly better than not earning any interest at all. Note that while money market accounts are also FDIC insured, money market funds are not and may run the risk of losing your principle. Other liquid investment options you may consider for an emergency fund include certificates of deposit (CDs) purchased through a bank and treasuries purchased from the government.
3. Contribute to Employer-Sponsored Matching Retirement Funds
Make contributions to your employer-sponsored matching retirement funds if they are offered. Employer matching funds, such as a 401(k), are risk-free, guaranteed returns on your investments, which are taken as a percentage out of your paycheck. You can’t beat 50% or 100% returns on your investments. If you take advantage, it’s like getting an immediate raise. Generally, this takes priority over paying off any debts because of the guaranteed, risk-free returns that usually come at higher rates. Plus, it’s important to start funding your retirement early if you wish to reach financial freedom. If your job doesn’t offer employer-sponsored matching retirement funds, move on to the next step.
The most popular route of picking an investing plan for your 401(k) is to go the 3-fund route. That is, to build a diversified portfolio of index funds made up of U.S. stocks, international stocks, and bonds. The more diversified your portfolio is among different asset classes and securities, the safer it is from under-performing the market (don’t put all of your eggs in one basket).
4. Pay Down High Interest Debts
Not all debts are created equal, but some are very predatory on the wallet. Credit card debt, for instance, has some really nasty interest rates soaring around 20%. Mortgages and school loans however, can have more manageable interest rates around or even less than 5%. You want to target the loans with the highest interest rate, regardless of balance, because the higher the interest rate, the worse it will compound exponentially. This is known as the debt avalanche method. Some people advocate the debt snowball method for psychological reasons to keep you motivated – knocking off the debts with the lowest balances first provides a few quick wins before focusing on the debts with higher balances. It’s not mathematically ideal because you will end up paying more with the debt snowball method, but if it works to motivate you to pay down the debts, then go for it.
Consider any interest rates higher than 4% or 5% as a high priority for paying down. Debts that have a lower interest rate can be paid off with minimal payments because it may be wiser to invest extra money long-term on the stock market. This is because historically, long-term stock market returns have been higher than 4%, but keep in mind, this is not guaranteed. The only thing that is guaranteed is that paying down a loan gives you the exact return of that loan’s interest rate, risk-free. Depending on your investing style and how much risk you are willing to take for a possible reward, you may choose to either focus on paying down all debts for a risk free return on your investment or put a lower interest loan on the back burner while you invest long-term on the stock market for some unexpectedly larger returns which you could later used to help pay off debts.
5. Invest in a IRA
An individual retirement account (IRA) is a tax-favorable individual retirement plan provided by many financial institutions, such as brokerages. In contrast to a 401(k), which is funded by a percentage taken out of your paycheck, an IRA is funded out-of-pocket. You should take full advantage of IRA investments because they are tax-advantaged. This means having the goal of contributing the $5,500 max (in 2014) to an IRA account by the end of each tax year (April 15) so that it will grow and grow from the magic that is compound interest. The younger you are when you start an IRA, the more your investment will have a chance to really grow into a monster of a retirement savings by the time you are ready to retire.
You have several funding options with an IRA – stocks, bonds, CDs, MMAs, mutual funds, bond funds, index funds, etc. – so it’s more versatile than a 401(k). You also have IRA options with a traditional IRA or a Roth IRA. Traditional IRAs reduce your annual taxable income by how much you contribute but your money is then taxed upon withdrawal. Roth IRA contributions, on the other hand, are taxed when initially invested and then are withdrawn in retirement tax-free. It’s wise to choose to contribute to a Roth IRA if you are currently in a low-income tax bracket in your younger years and expect to be in a higher tax bracket upon retirement so you can take advantage of tax savings.
6. Maximize Contributions to Employer-Sponsored Matching Retirement Funds
If you’ve started making contributions to a 401(k) or similar employer-sponsored retirement plan and have already maxed your contributions to an IRA, the next step to gaining financial independence is maximizing your 401(k) contributions for the year. The annual elective deferral limit for 401(k) plan employee contributions is $17,500 in 2014 while the total contribution limit for both employee and employer contributions to 401(k) is to $52,000. People over the age of 50 can play “catch-up” and contribute more (totals of $23,000 annual elective deferral limit and $57,500 total contribution). Always take advantage of investing in tax-friendly retirement accounts before saving for retirement in a taxable account.
7. Keep Saving
If you’ve come this far, you can practically smell financial independence in the air. Don’t stop saving. You obviously have other saving goals besides retirement. Perhaps you’re looking for a new car, or want to purchase a house. Even if you’re saving for a vacation or a new TV, make sure to pay yourself first because the money will rarely just drop from a tree.
Depending on what you are saving for determines how you save. For instance, if you know you’re going to make a car purchase within five years, it’s wisest to open up a savings account, money market account, or purchase a CD or bonds. These investment options are best for the short-term because they are very safe and not volatile, unlike stocks, which are only best to invest for the long-term (like retirement).
Stay financially responsible by following these most important steps and you’ll see just how great it is to finally be financially independent.