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How to travel, live where and how you want to, and still save half your income (and how I’ve done it) – Part I

In this series of posts, I’m going to teach you how you can build a strong financial life while still enjoying the things you love most like traveling & living where and how you want to.  I’ll also talk about how I did it, showing you step-by-step what you can do in your own situation.

Part I – Create a spending plan that meets your needs

A lot of personal finance websites emphasize frugality as the sole means to financial well-being.  They come replete with tips like “don’t accelerate too quickly to save on gas” or “buy one-ply toilet paper.”

I believe that for most people, these tips are not worth the effort to implement, nor are they the key ingredients to a healthy financial life.  So…

Here’s how YOU can take control of your finances (Hint: Take action today; if you don’t, stop reading my blog, it can’t help you.)

Step 1) Put a copy of your most recent paycheck in front of you.  Write down how much you make in monthly gross income (take your pay and multiply by (26/12), or 2.167, for those with biweekly salaries.)

Add in any bonuses you expect to receive, or any income you make through other sources (baby-sitting on the side, unemployment benefits, drug-trafficking etc.)  Since you’re reading my blog, I’m going to assume you’re not retired, and thus aren’t getting social security checks.  I’ll also assume you’re a working stiff that relies mostly on your own earned income, and are not cashing in investments (but if you are, count these too, plus any sweet trust fund income that Daddy set up for you, you spoiled bastard.)

Step 2) Get a rough, back-of-the-envelope calculation on how much you spend.  This step takes the most work, but it’s also the most important; you need to know where your money is going to take control of it! I recommend an excel template like this one to track this info (combine, leave blank/delete and modify items to fit your situation.  Use the ‘Actual Cost’ columns for expenses; later, we’ll use the ‘Project Cost’ columns for what you’d like to spend.)

The steps below are in order of increasing difficulty.   If you’re too lazy to go through the 4 sub-bullets, at the very least, fill in your biggest expenses and give a rough estimate to the rest.

  • Since you already have your paycheck in front of you, calculate the expenses that come straight out of this: health insurance, other insurance like voluntary disability or life, federal/state/local taxes, and anything else.  For those with biweekly income, figure the monthly expense of these paycheck deductions by taking your biweekly paycheck’s deductions and multiply them by (26/12) or 2.167.  This is your monthly expense (which is pretty accurate assuming you don’t owe much or get a large tax refund at the end of the year.)
  • Calculate easy-to-track expenses like rent/mortgage and any other monthly or annual payments you make (internet, cable, cell phone plan, student loan payments, car payment, Netflix, magazine subscriptions, car or life insurance.)  Of course, for annual/ semi-annual/quarterly expenses, you’ll need to divide by 12/6/3 to get the monthly expense.
  • Estimate the regular payments that aren’t always the same amount each month (like utilities, or gambling losses funneled to your bookie.)
  • Estimate how much you spend on irregular items like groceries, eating out, clothes, entertainment (going out to bars/clubs, movies, CDs/DVDs), travel, gifts, and charity.  Also, create a miscellaneous category to lump together hard-to-track or infrequent purchases.  Look over your 3 most recent monthly credit card and bank statements to give you more accurate information and bring items to your attention that you otherwise might have forgotten.  Crunch some of that data to give yourself a monthly average of expenditures based on the reality shown in those statements (which should be available online.)  When you look at the hard data of what you actually spend, you’ll be surprised at what’s costing you an arm and a leg.  I certainly was the first time I did this.

Step 3) Subtract your expenses calculated in 2 from your gross income in 1.  Hopefully, your expenses are less than your income.  If so, congrats, you’ve achieved the first rule of personal finance: ‘spend less than you earn’.  Also insert into the equation how much you’re investing in your 401k, money market fund, savings account, etc.  For kicks, you can divide that number by your gross salary to see what percentage of your income you’re currently socking away.  (Depending on the number, you’ll likely want to increase that percentage to meet major goals like retirement, paying for a wedding, buying a car/house/Jackson Pollack etc.  Don’t worry about that now, we’ll talk about that in a future post.)

Step 4) Look through your expenses for areas where you are spending more money than you’d like to.  This means writing down what you’d LIKE to be spending in each category, and comparing this with what you’re ACTUALLY spending.  If you’re using the recommended spreadsheet, fill out the ‘Projected Cost’ column with your budgeted numbers.  The goal here is to cut spending on areas that don’t really add much value to your life.

If you’re not sure about what number to use for a given category budget (“is $200 per month reasonable for going out to eat?”), don’t sweat it too much; just put something down that seems reasonable to you.  If you want, you can break it down by units of consumption: i.e.: “If I want to go out for lunch three times per week, and I usually spend $10 each time including tax & tip, that’s about $30 per week and about ~$130 per month (= $30/week * 52 weeks/12 months.)”

Be honest with yourself

Think about what you enjoy doing most with your time and money (or what you wish you could be doing with more of each.)  Then, resolve to cut things that don’t matter as much to you.  Here’s a great article by Ramit Sethi on this idea of getting your finances in order and focusing spending on what matters to YOU (rather than what other people spend, or what they think you should spend.)

Congratulations!

Now that you’ve tracked your spending & set up a budget, you’re ahead of 95% of people in terms of understanding & managing your money.  In the next post, we’ll cover how to automate your savings & spending to set up an emergency fund, pay off debt, and invest simply and smartly for the things & experiences that you want out of life.

University of Washington’s Foster School of Business’s “State of the Economy Forum”

Here’s a 70 minute video on the state of the economy featuring University of Washington Foster School of Business economics and finance professors Karma Hadjimichalakis and Ed Rice.

(Note to those who care: Professor Rice was by far my favorite professor during my UW MBA program.)

Original link info:

State of the Economy Forum from Foster School of Business on Vimeo.

Re-thinking the Roth IRA – Why the Roth IRA may NOT be the best retirement vehicle for you

In this article we’re going to discuss why the Roth IRA may NOT be your best retirement vehicle (and why it certainly shouldn’t be your only one.)  If you’re not already familiar with a Roth IRA and how it compares to a Traditional IRA, please read this.

(Quick refresher: Traditional IRAs and 401ks allow you to avoid paying taxes on contributed income in the current year, but when you take the money out in retirement, you must pay taxes on it at your regular income rate.)

So, which one is better for you?  If you expect your marginal tax rate to be higher in retirement than currently, it may make sense to put some of your money into a Roth IRA (Only after you max out your employers matching contribution on your 401k; never refuse free money!)  Say you’re a student with a part-time job, and your marginal tax rate is 10%.  Assuming you’re significantly wealthier when you retire, you might be in the 25% tax bracket at age 60 and beyond.  Thus, it doesn’t make sense to save 10% on  taxes today, when you may pay 25% on your marginal income at retirement.

On the other hand, if you believe your retirement tax rate will be lower than your current tax rate, then a 401k or Traditional IRA may make the most sense hands-down.  (Imagine that you and your wife are fully employed and are supporting kids or a mortgage.  In retirement, you may not have those expenses, and thus can live on less income, which might reduce your tax bracket.)

Either way, the best retirement plan for you is likely to have some money in both types of accounts (if not all of it in a 401k.)  Let me explain why:

Fill up those low brackets!

1) The first reason (other than employer-matching) to funnel money into a 401k is to ‘fill up’ your lower tax brackets.  This concept (and many others  in this article) is excellently described here at ‘The Finance Buff’s’ site.  I highly recommend your read his article as well, especially if you have any questions about the below.  His graph (see below) illustrates what I mean:

TaxBrackets

Because the United States tax system is progressive, the first dollars of income you have are taxed at a lower rate than the last (or marginal) dollars.  In 2008, a married couple filing jointly could take 2 exemptions and the standard deduction and not pay ANY taxes on their first $17,900 of income.  Then, they’d pay 10% on their next $16,050 (“taxable income.”)  After that, they move into the 15% tax bracket and pay that rate on their next $49,050.

For simplicity, let’s assume that a 401k is your only source of income and that when you retire, the tax brackets will remain the same as they are in 2008*.  If you withdraw less than $83,000 (adding up all the amounts in the 10%, 15% and “0%” brackets above), you’ll pay only 15% at the marginal dollar of income.  If you and your spouse make, say, $100,000 combined today, you’re in the 25% bracket.  Thus, it would make sense for you to contribute to a 401k and save the 25% now, paying the 15% later (rather than a Roth which would save you the 15% later, but cost you 25% today.)

In addition to filling up your retirement low tax brackets with 401k income, there’s another reason why a 401k might be a better choice than a Roth IRA.

Like a Ford Explorer, it’s easy to rollover a 401k

2) You can rollover a 401k into a Roth IRA (after leaving your employer), paying the taxes in the year you convert the Roth.  What this means is that you effectively (but not really) cash out your 401k into a Traditional IRA, then, you convert the Traditional IRA into a Roth IRA.  You have to pay regular income taxes on the value of the conversion (because you were never taxed on the 401k contributions.)  Why might you want to do this?  Let’s look at an example:

Say you’re currently in the 25% tax bracket and expect to remain in that bracket in retirement.  Because you’ve read this article, you contribute to your 401k to fill up your lower brackets for retirement.  This year however, you’re fed up with the rat race.  Maybe you quit your old job to take a sabbatical, go back to school, or start your own business.  If your new marginal bracket is low (say 15%), you could rollover some money from your 401k/Traditional IRA to a Roth IRA, only paying 15% tax to do so.  If this chunk of your 401k represented money you would’ve paid 25% on in retirement, you’ve just saved yourself 10% (=25% – 15%)!

In closing…

There are other reasons that I’ll let you read about in the above-mentioned article by The Finance Buff (including avoiding phase-outs and the dreaded Alternative Minimum Tax.)  For most people though, I believe the above two reasons, especially the ‘filling lower brackets’ strategy, are the most important.

Don’t get me wrong, there are still some great reasons for using a Roth IRA for retirement.  Like ‘hedging’ against higher future taxes and not being forced to take the minimum distributions at age 70.5 that you have to with a Traditional IRA/401k.  There are also some non-retirement Roth IRA usages that I’ll discuss in the next column.

Bottom-line: For most people, the 401k/Traditional IRA should make up the bulk of their retirement contributions.  I see entirely too many personal finance sites that recommend putting your money into a Roth IRA as soon as you max out your employer matching.  This is dangerous, blanket advice, which I think is dead WRONG for many people.

Even if you determine the Roth isn’t the best thing for your retirement money, check out how to ‘hack your Roth’ for use as a tax-free, short-term investment vehicle.

Note: I’m not an accountant, so please review your personal tax situation with one, or make sure you understand it when planning for your own retirement.  As always, if you have specific questions about the above, please comment on this article or email me.

* This would be a good approximation if real dollar (inflation-adjusted) tax brackets stay the same.  However, it may be that tax rates increase in real dollars.  This could be due to, oh, I don’t know, our MASSIVE and increasing federal debt in the US.

More thoughts on why now might NOT be a good time to buy a home (5-28-09 UPDATE)

Check out Patrick Killelea’s site on housing.

From the above link, here’s something to think about regarding low interest rates (and why Patrick claims they make for a BAD time to buy):

“It’s a terrible time to buy when interest rates are low, like now. Realtors just lie without shame about this fundamental fact. Prices fall as interest rates rise, because a given monthly payment covers a smaller mortgage at a higher interest rate. Since interest rates have nowhere to go but up, prices have nowhere to go but down. The way to win the game is to have cash on hand to buy outright at a low price when others cannot borrow very much because of high interest rates. To buy at a time of very low interest rates is a mistake.It is definitely far better to pay a low price with a high interest rate than a high price with a low interest rate, even if the mortgage payment is the same either way.

  • First of all, your property taxes will be lower with a low purchase price.
  • Second, a low price gives you the ability to pay it all off instead of being a debt-slave forever.
  • Third, prices will definitely fall as interest rates rise — so paying a high price may trap you “under water”. Then you will not be able to refinance, and won’t be able to sell without a loss. Even if you get a long-term fixed rate mortgage, when rates inevitably go up the value of your property will go down. A low price minimizes this possibility.”

It’s an interesting counterpoint that I hadn’t heard before.  Thanks to me new favorite financial blogger, Ramit Sethi.  You can read some other things on homebuying from Ramit HERE.  Ramit has a very entertaining, information and candid take on personal finance.  I highly recommend his blog (and I’ve been reading it voraciously for the past couple weeks since I discovered it.)

Hopefully it will inspire me to post some more to mine, as I’ve been neglecting the ol’ blog for a while…

UPDATE: Another good link on things to think about (financially) when considering buying a house.

Also, here’s a counterpoint article that initially disputes Patrick’s claim that when interest rates rise, housing prices must fall, but then gives some rationale for why Patrick’s belief may be correct.