Building Your Path to Financial Freedom
Here is my suggested order to tackle life’s financial challenges.
The goal of financial freedom is a long road, but a rewarding one. Life is about the journey and the destination will be worth the sacrifice.
For the standard young professional or person coming out of school, they are faced with many challenges. Will I be able to find gainful employment? If so, will I make enough to pay off my debts? This is not a perfect solution for everyone but this is a guideline for starting out the right way. Getting started as young as possible is a great way to gain control of your finances and work towards financial freedom. After all, you’ve lived like a poor college kid presumably for 4 years, what’s another 4 more? Living by similar standards and pocketing your ideally much higher income will get you on the right track from day one of graduation.
Step 1: Retirement: The easiest way to get started is to put an automatic savings mechanism in place. This is easiest to do by first contributing to an employer’s 401k retirement plan if you have that option, I recommend 10-15%. That creates a tax deferred automatic 10-15% savings rate, plus if you have it available, you get an employer match on top of that.
Step 2: Automatic Savings: Next, create a savings account that isn’t easy to raid. Put the highest percentage possible that strains you a little. If you don’t feel it, then you’re not saving enough. You should feel a little pinched for pennies in the beginning. This will help you reset your baseline of what you think you need vs. your monthly bills and expenses. Save at least $1,000 and then move to step 3. The goal is to have at least 3-6 month’s savings. Then you really tackle step three and when finished move to step 4. This step should also allow you to pay cash for almost all purchases in the future; cars should be paid for in cash.
Step 3: Pay down Debt: Debt is like a weight strapped to your ankle as you try to swim your way to the surface. The lighter you can make the weight, the quicker you pay it down, the sooner you will be able to swim to the top. Pay this down using a variety of methods. You can use Dave Ramsey’s debt snowball method where you pay the smallest amount down first, or focus on the highest interest rate. Either will work; just knock it out as soon as you can. Example: Pay off your house and get an immediate return of the interest percent you would have paid. In a scenario where you’d be paying 5% interest on a mortgage, you get a tax free guaranteed return. Many will try to lead you astray (likely someone who’s up to their eyeballs in debt) on the advantages of investing vs. paying off your mortgage. This is debatable; however as long as you’re continuing to invest in your retirement up to your employer match, I say invest in your debts and mortgage next. Want a big stock portfolio? Imagine you and a spouse dumping 34K-50k a year into a retirement or after tax brokerage account. Hard to do that with a mortgage looming over your head.
Step 4: Aggressively build up savings: With step 3 knocked out and no debt, savings will be much easier. So what do you do with all the savings? Well you will likely still have many large expenses ahead of you. The goal is to be as prepared for these as possible and pay for them in cash if you can. The main savings goal at this point is to have your 3-6 month emergency fund along with a car lump sum. Then your savings can be allocated to increase retirement (*up to the max of 17,500 in 2015 per individual) and then other goals such as children’s college funds or future house/home improvement funds. Now this part gets tricky because it hard to determine how much to allocate to each. My advice is once you’re contributing 15% in retirement, allocate the rest of your savings to your mortgage, if you still have one. Steps 3 and 4 can be done simultaneously as you build savings and pay down debts. Continue to pay off the house or save in an adjacent savings account. The goal would be to pay off the house minimally by the time your oldest kid is 10-12 years old. This gives you 6-10 years to allocate more future savings to your child’s education fund. If you feel that you will not be able to pay off the house in time, then save in a 529 savings account approximately 3-5K a year starting as young as possible for your kid. Something to Note: If your timeframe is 5+ years before you will buy a house, you can place your house savings in a Roth IRA. This can be used either for retirement later if you wish or to pay off your house and you can keep up to 10K of earnings tax free for your home purchase as long as you’ve held the fund for 5+ years. (*Might be a good idea to reference this with current tax code)
Step 5: Maxing out retirement accounts and/or contribute to your business or next career: After you’ve settled on a strategy in Steps 3 and 4, you are probably 35-50 years old now depending on how long it took to get to a place of being completely debt free. You are now in excellent shape with your house paid off. Now is the time to really build some wealth! You will now be maxing out all you can in retirement savings, with both you (and/or your spouse) potentially saving half your income because you have no debt payments and you live a low cost life. With lower living expenses, you don’t need quite the nest egg of the Jones’, but you’ve built one anyway through your continued 10-15% savings. You will have plenty of excess now to give to your family, friends, church, or charity because you’ve earned it. Certainly feel free to give before step 5, but do so within reason. You have to take care of yourself and family before you can help others. Greed is a necessary evil to some degree, because if you’re barely able to stay above water, how can help others from drowning?