Behavioral economists have discovered that our brains are programmed to consume. That may help explain why it is easy to spend and difficult to save. We can overcome this natural tendency by set ourselves up so that we become automatic savers instead of automatic spenders. Here’s how to do it:
- Set up automatic savings by having 10% (or more) of your paycheck automatically deposited into your 401(k) or IRA.
- Set up automatic bill paying from one checking account or credit card.
- Set up automatic tracking or accounting. The monthly statement from the single account becomes your record of expenses. To get a bigger and more detailed picture of your finances sign up for one of the FREE online automatic accounting services. The most comprehensive is Yodlee MoneyCenter at www.yodlee.com. The most user friendly and fastest growing is Mint at www.mint.com. A relatively new service is Quizzle at www.quizzle.com. You can also use financial planning software such as Quicken or Microsoft Money.
- Finally, stop impulsive spending by cutting up all the credit cards except one.
More about savings: read a previous post in this blog Save money live betterwith insight why this is so critical to save. Living within your means and saving some money is a way of life, a habit. Also, read other relevant posts - How much should you save each month? and How to save money better.
All of us have this dream; we would like to feel completely free to live a life without any financial worries – we all strive for Financial Independence.
Since each one defines Financial Independence differently, let us clarify our definition and the meaning of Financial Independence. In order to reach a stage of Financial Independence one needs to advance through various stages. In this Financial Life Cycle we first accumulate wealth in all forms (interest earning, equities, and real estate) and later build a financial portfolio that is large enough typically to generates income that is equal to 50% or more of your annual living expenses. At this stage, our life may be more than half over and time becomes more important than increasing our standard of living. For many these are the peak earning years. Many people begin to freeze their standard of living, in order to have more freedom with their time. The focus now changes from your gross income to your living expenses.
In Financial Independence some people start doing what they really want to do. You can start your own business or semi-retire. You can change careers or work part-time at a job you love. All these choices are possible for you because you can supplement your earned income with income from your portfolio.
This can be a very enjoyable, but also very challenging transition. In order to generate the stable income necessary for covering up to 50% of your living expenses, you must reduce the risk in your portfolio. For more than 30+ years, accumulation has taken priority over conservation; growth and volatility have taken priority over safety and predictability. Now preserving wealth becomes more important than accumulating, and safety becomes more important than growth. Psychologically it can be a very difficult change to make. To reduce the portfolio’s exposure to stocks, even modestly, when your capacity for risk is at its height, often seems “wasteful”. But as advisors we always ask, “Why should you risk going backwards, if you have already arrived?” You have achieved Financial Independence (FI), so why not also secure Peace of Mind (POM) by changing your asset allocation to emphasize both Conservation and Accumulation equally?
We can prepare for you a customized plan to reach Financial Independence.
Your emergency reserves should enable you to survive three catastrophic events within a six month period and make mortgage payments for 24 months.
Emergency reserves are US Savings Bonds or liquid assets held inside some type of tax-advantaged account, such as a CD inside an IRA or the cash value of a fixed rate life insurance policy.
Let's define "Emergency". Paying for a vacation or new car is not an emergency. A real emergency is when your income declines to the extent that you are unable to meet your mortgage obligations. This usually means you have dropped into a lower tax bracket. Examples would be if you are disabled or unemployed for a protracted period of time.
The amount in your emergency fund combined with your cash reserves should be equal 20% of your outstanding mortgage. Twenty percent of your outstanding mortgage is usually enough to make house payments for at least 24 months.
Do not keep this emergency fund in your checking or savings account. Instead, keep it in tax sheltered US Savings bonds or a tax sheltered money market or stable value fund inside your retirement plan or IRA. By purchasing federally tax-deferred and state tax-exempt savings bonds you expand both the tax efficiency and liquidity of your investment portfolio.
The biggest risk to an emergency fund is spending it for something that is NOT an emergency. Putting your emergency fund in your retirement plan or savings bonds makes it less likely to be liquidated for the wrong reason. Any gains will be tax sheltered. And in a real emergency, any withdrawal penalty may be either waived by the IRS 72(t) exceptions or minimized because the emergency has put you into a lower tax bracket.
Our Financial Plan includes a recommendation for both your emergency fund and cash reserves targets based on an analysis of your specific financial needs.