Chapter 2
Budgeting, Goal Setting, and Valuing Saving
IN THIS CHAPTER
Getting in the savings mindset
Quantifying the impact of long-term saving
Budgeting and goal setting
Prioritizing your financial goals
Unless you’re the offspring of wealthy parents or grandparents who have left you a sizable sum of money, you need to save money to accomplish your personal and financial goals. Early in your working years, saving money can be a challenge, of course, especially since you’re likely not earning a super-high income.
When you’re first starting out, your salary is probably somewhat low, and after fixed expenses (such as rent/mortgage, food, insurance, cell-phone service, and other payments that you can’t easily get rid of), you may not have much money left for “fun” discretionary spending, let alone additional savings. Remember, though, that when it comes to building wealth, it doesn’t matter what you make — it’s what you spend and, therefore, are able to save. Many wealthy people didn’t get rich based exclusively on their big salaries, but through disciplined savings and wise investing over time.
In this chapter, I discuss smart budgeting strategies and the tremendous and surprising long-term value that comes from regular saving and investing.
Developing a Savings Mindset
People typically learn their financial habits, both good and not so good, at a young age. During childhood, most people are exposed to messages and lessons about money, both at home with their parents and siblings and also in the world at large, such as at school; with their friends; and through society and media, including social media. In fact, social media presents a challenge to the savings mindset and has taken center stage in marketing to young adults on ways to spend their money.
The expression “You can’t teach an old dog new tricks” has some validity, at least for our four-legged friends, but even then, the expression actually requires some modification to be accurate. It should be, “It’s hard to teach an old dog new tricks, but how hard it is depends on the dog.”
My experiences have shown me the same to be true for people and their financial habits and decision making. For most people, spending money is easier and more enjoyable than earning and saving it. Of course, you can and should spend money, but there’s a world of difference between spending money carelessly and spending money wisely.
I show you how to save money, even if you haven’t been a good saver before. And even if you do think you’re pretty good at saving, I have some tips and tricks so you can get even better at saving more and spending less:
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Live within your means. Spending too much is a relative problem. If you spend $40,000 per year and your income is $50,000 annually, you should be in good shape and will be able to save a decent chunk of your income. But if your income is only $35,000 per year and you spend $40,000 annually, you’ll be accumulating debt or spending from your investments to finance your lifestyle.
How much you can safely spend while working toward your financial goals depends on what your goals are and where you are financially. At a minimum, you should be saving at least 5 percent of your gross annual income (pretax — that is, before taxes are deducted from your paycheck), and ideally, you should save at least 10 percent. - Search for the best values. The expression “You get what you pay for” is an excuse for being a lazy shopper. The truth is that you can find high quality and low cost in the same product. Conversely, paying a high price is no guarantee that you’re getting high quality. When you evaluate the cost of a product or service, think in terms of total, long-term costs. Buying a cheaper product only to spend a lot of additional money servicing and repairing it is no bargain. Research options and comparison shop to understand what’s important to you. Don’t waste money on bells and whistles that you don’t need and may not ever use. Is that $700 (or $1,000) smartphone significantly better than the best $200 or $300 smartphones?
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Don’t assume brand names are the best. Be suspicious of companies that spend gobs on image-oriented advertising. Branding is often used to charge premium prices. Blind taste tests have demonstrated that consumers can’t readily discern quality differences between high- and low-cost brands with many products. Question the importance of the name and image of the products you buy. Companies spend a lot of money creating and cultivating an image, which has no impact on how their products taste or perform.
When you’re grocery shopping, consider the store or house brand. Most of the time the ingredients are the same as the brand-name product (and may even be made by that same manufacturer). You don’t need to shell out money to pay for the name, as store/house brands are typically much less costly than the well-known brands in a given category. -
Get your refunds. Have you ever bought a product or service and not gotten what was promised? What did you do about it? Most people do nothing and let the company off the hook. Ask for your money back or at least a partial refund.
If you don’t get satisfaction from a frontline employee, request to speak with a supervisor. Most larger companies have websites through which you can submit complaints. Reputable companies that stand behind their products and services will offer partial refunds or gift cards good toward a future purchase. If all else fails and you bought the item with your credit or debit card, dispute the charge with the credit-card company. You generally have up to 60 days to dispute and get your money back. - Trim your spending fat. What you spend your money on is sometimes a matter of habit rather than a matter of what you really want or value. When was the last time you comparison priced and shopped for the most common things that you buy? See Chapter 5 for lots of tips for reducing your spending.
- Turn your back on consumer credit (for example, credit-card debt, auto loans). Borrowing money to buy consumer items that depreciate (such as cars and electronics) is hazardous to your long-term financial health. Buy only what you can afford today. If you’ll be forced to carry a debt on credit cards or an auto loan for many months or years, you can’t really afford what you’re buying on credit today (see Chapter 19 for the details on saving on cars). Not only does consumer debt enable you to spend more than you can afford today, but the interest rate on that consumer debt is generally high, and it isn’t tax-deductible.
If you spend too much and spend unwisely, you put pressure on your income and your future need to continue working, perhaps at a job that you don’t really enjoy. Savings dwindle, debts may accumulate, and you won’t be able to achieve your personal and financial goals. Living within your means and continually growing your savings can give you more freedom, choices, and comfort with taking some risks (for example, changing careers, leaving your job to raise children, joining a start-up or starting your own company, and so on) that you may not otherwise feel as comfortable taking.
What It’s Worth: Valuing Savings over Time
Without a doubt, the amazing financial success stories get the headlines. You hear about company founders who make millions — sometimes billions — of dollars. Early investors in stocks such as Apple, Google, and Facebook have made gargantuan returns. Who wouldn’t want to make a return of 100 times, 200 times, or more on his investment?
However, expecting to make such gargantuan returns is a recipe for disappointment and problems. (In Chapter 10, I discuss how to use the best investments in stocks, real estate, and small business to earn generous long-term returns.) The vast, vast majority of folks I’ve worked with and seen accumulate long-term wealth have done well because they regularly save money and they invest in somewhat riskier assets that produce expected long-term returns well above the rate of inflation, as the following sections discuss.
The power of continual savings
Continually saving money on a regular basis can generate amazingly large returns.
For example, suppose you haven’t been able to save money because your spending equals your income. Further suppose you earn (after taxes) an extra $1,000 this year at a side job and you decide to save that money. In future years, you decide it’s not worth the bother to do the extra work, so you’re unable to save the money.
Now, compare that situation to one where you reduce your spending so you can save $1,000 per year every year from your employment earnings. In both cases, assume that you put the money in a savings account and earn 3 percent annually (which has actually been about the long-term average over the generations). Historically, such a return is achievable from bonds. Table 2-1 shows an example.
TABLE 2-1 Nest Egg Growth
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Amount Saved |
Nest Egg after 40 Years |
|---|---|
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One-time $1,000 saved |
$3,260 |
|
$1,000 saved annually |
$75,400 |
That’s quite a stunning difference, huh? And that’s just putting away the small amount of $1,000 annually and earning a modest 3 percent per year (and you can do better than that as I highlight in the next section). If you can put away $5,000 or $10,000 annually, then simply multiply the figures by 5 or 10.
The rewards of earning a (slightly) higher annual return on your investment
When you save money, you want to try and get higher returns. Bonds, stocks, and other investment vehicles (check out Chapter 10) typically produce much better long-term average returns than a savings account or a certificate of deposit (CD), which usually offers a measly 3 percent annual return over the long term (or much less in recent years). The trade-off with the stocks, bonds, and such is that you must be able to withstand shorter-term declines in those investments’ values.
If you put together a diversified portfolio of mostly stocks and a lesser number of bonds, for example, you should be able to earn about 8 percent per year, on average, over the long term. You won’t, of course, earn that amount every year — some years it will be less and some years it will be more. The following table shows how much you’d have after 40 years if you got a 3 percent annual return versus an 8 percent annual return.
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Investment |
3% Annual Return over 40 Years |
8% Annual Return over 40 Years |
|---|---|---|
|
One-time $1,000 saved |
$3,260 |
$21,720 |
|
$1,000 saved annually |
$75,400 |
$259,060 |
When you combine regular saving with more-aggressive yet sensible investing, you end up with lots more money.
Saving $1,000 yearly and getting just an average 8 percent annual return results in a nest egg of $259,060 in 40 years compared to ending up with just $3,260 if you invest $1,000 one time at a 3 percent return over the same time period. And remember, if you can save more — such as $5,000 or $10,000 annually — you can multiply these numbers by 5 or 10.
With historic annual inflation running at about 3 percent, you’re basically treading water if you’re only earning a 3 percent investment return. In other words, your investments may be worth more, but the cost of other things will have increased as well, so the overall purchasing power of your money won’t have increased. As I discuss in Chapter 10, the goal of long-term investors is to grow the purchasing power of their portfolio, and that’s where investments (such as stocks and bonds) with expected higher returns play a part.
Budgeting and Boosting Your Savings
When most people hear the word budgeting, they think unpleasant thoughts, like those associated with dieting, and rightfully so. Who wants to count calories or dollars and pennies? But budgeting — planning your future spending — can help you move from knowing how much you spend on various things to reducing your spending.
The following process breaks down budgeting in simple steps:
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Analyze how and where you’re currently spending.
Chapter 5 explains how to conduct your spending analysis.
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Calculate how much more you want to save each month.
Everyone has different goals. This book can help you develop yours and figure how much you should be saving to accomplish them.
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Determine where to make cuts in your spending.
Where you decide to make reductions is a personal decision. While many people need to save more (and spend less) to accomplish their goals, it’s possible you may not need to reduce your spending. In Chapter 5, I provide plenty of ideas for how and where to make reductions if you’re among the many who want to save a greater portion of your current earnings.
Suppose you’re currently not saving any of your monthly income and you want to save 10 percent for retirement. If you can save and invest through a tax-sheltered retirement account — such as a 401(k), 403(b), SEP-IRA, and so forth (see the section “Valuing retirement accounts and financial independence” later in this chapter) — then you don’t actually need to cut your spending by 10 percent to reach a savings goal of 10 percent of your gross income.
When you contribute money to a tax-deductible retirement account, you generally reduce your federal and state income taxes. If you’re a moderate-income earner paying approximately 30 percent in federal and state taxes on your marginal income (see Chapter 6), you actually need to reduce your spending by only 7 percent to save 10 percent. The other 3 percent of the savings comes from the lowering of your taxes. (The higher your tax bracket, the less you need to cut your spending to reach a particular savings goal.)
So to boost your savings rate to 10 percent, you simply need to go through your current spending, category by category, until you come up with enough proposed cuts to reduce your overall spending by 7 percent. Make your cuts in areas that are the least painful and in areas where you’re getting the least value from your current level of spending.
If you don’t have access to a tax-deductible retirement account or you’re saving for other goals in nonretirement accounts, budgeting still involves the same process of assessment and making reductions in various spending categories.
Setting and Prioritizing Your Savings Goals
You probably have some financial goals. If you don’t, you should begin thinking about some personal and financial goals you want to reach. Because everyone is unique, you surely have different goals than your parents, friends, neighbors, and siblings. Although goals may differ from person to person, accomplishing personal and financial goals almost always requires saving money. In this section, I discuss common financial goals and how to work toward them.
Unless you earn a large income from your work or have a family inheritance to fall back on, your personal and financial desires probably outstrip your resources. Thus, you have to make choices.
Identifying common goals of accomplished savers
As a result of my experience counseling and teaching people about better personal financial management, I can share with you the common traits among folks who accomplish their goals. No matter how much money they made, the people I worked with who were the most successful were the ones who identified reasonable goals and worked toward them.
Among the common goals for young adults with whom I’ve worked are the following:
- Making major purchases: You need to plan for major purchases. So if you have a future purchase in mind for a car, living-room furniture, the newest smartphone, vacations, and so on, you should save toward that.
- Owning a business: Many people want to pursue the dream of starting and running their own business. The primary reason that most people continue just to dream is that they lack the money (and a specific plan) to leave their job. Although many businesses don’t require gobs of start-up cash, almost all require that you withstand a substantial reduction in your income during the early years.
- Buying a home: Renting and dealing with landlords can be a financial and emotional drag, so most folks aspire to buy and own their own home. Real estate has a pretty solid track record as a long-term investment. Sure, there are downturns just as there are in the stock market, but buying during such times may be good because real estate is more affordable then. (See Chapter 7 for more on housing.)
- Starting a family/educating kids: Having children leads some parents to cut back on work, which requires planning for living on a reduced income and facing higher expenses. And, if you have kids or are planning to have kids, you may want to help them get a college education or other higher education. Unfortunately, that can cost a truckload of dough. Although you may never be in a position to cover all that cost, you’d probably like to be able to pay for a portion of it.
- Retiring: Retiring is a catchall term for discontinuing full-time work, or perhaps not even working for pay at all. It can also mean achieving financial independence and feeling that you no longer have to work for the income. While your retirement may still be many years away, planning ahead for retirement is important. You may enjoy working and thus may not have given retirement much thought, but most people eventually do want to retire, and you want to be prepared. I address how to do that in the next section.
Valuing retirement accounts and financial independence
Where possible, focus on saving and investing in accounts that offer you tax advantages. Retirement accounts — such as a 401(k), 403(b), SEP-IRA, and so on — offer tax breaks to people of all economic means. So, start thinking of them as “tax reduction” accounts, rather than retirement accounts! In fact, lower-income and moderate-income earners have some additional tax breaks not available to higher-income earners (see my discussion of them later in this section).
Consider the following advantages to investing in retirement accounts:
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Contributions are generally tax-deductible. By putting money in a retirement account, you not only plan wisely for your future but also get an immediate financial reward: lower income taxes. Paying less in income taxes now means more money is available for saving and investing. Retirement account contributions are generally not taxed at either the federal or state income-tax level until withdrawal (but they’re still subject to Social Security and Medicare taxes when earned).
If you’re paying, say, 30 percent between federal and state taxes (see Chapter 6 to determine your tax bracket and get more details on tax-reduction strategies), a $5,000 contribution to a retirement account immediately lowers your income taxes by $1,500.
- Returns on your investment compound over time without taxation. After you put money into a retirement account, any interest, dividends, and appreciation (investment returns) add to your account without being taxed. Of course, there’s no such thing as a free lunch; these accounts don’t generally allow for complete tax avoidance. Yet you can get a really great lunch at a discount: You get to defer income taxes on all the accumulating gains and profits until you withdraw the money down the road. Thus, more money is working for you over a longer period of time. (Health savings accounts, which I discuss in Chapter 14, can offer complete tax avoidance. Also, though it offers no upfront tax breaks, the Roth IRA, which I discuss in Chapter 6, enables future tax-free withdrawals.)
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Lower-income earners can get a special tax credit. In addition to the tax breaks I discuss previously, U.S. tax laws also provide a special tax credit, which is a percentage (ranging from 10 to 50 percent) of the first $2,000 contributed (or $4,000 on a joint return) to a retirement account. Unlike a deduction, a tax credit directly reduces your tax bill by the amount of the credit. The credit isn’t available to those under the age of 18, full-time students, or people who are claimed as dependents on someone else’s tax return.
Married couples filing jointly with adjusted gross incomes (AGIs) of less than $66,000 and single taxpayers with an adjusted gross income of less than $33,000 can earn this retirement saver’s tax credit (claimed on Form 8880) for retirement account contributions.
- Matching money may be available. In some company retirement accounts, companies match a portion of your own contributions. Thus, in addition to tax breaks, you get free extra money (terms vary by company) courtesy of your employer. But you have to contribute some of your own money to get the matching money. If you don’t, you’re essentially throwing away money, which you should never do!
Dealing with competing goals
Unless you enjoy paying higher taxes, you may wonder why you’d choose to save money outside of retirement accounts, which shelter your money from taxation. The reason is that some personal and financial goals aren’t readily achieved by saving in retirement accounts. Also, retirement accounts have caps on the amount you can contribute annually and restrictions for accessing the account.
Because you’re constrained by your financial resources, you need to prioritize your goals. Before funding your retirement accounts and racking up those tax breaks, you should consider your other goals, such as starting or buying a business or buying a home.
If you withdraw funds from traditional retirement accounts before age 59½, you not only have to pay income taxes on the withdrawals but also usually have to pay early withdrawal penalties — 10 percent of the withdrawn amount in federal tax, plus whatever your state charges. So if you’re accumulating money for a down payment on a home or to start or buy a business, you probably should save that money outside of a retirement account so you get penalty-free access to the funds.
Saving When You’re Strapped
You know that putting aside some money on a regular basis is important, but you may wonder how realistic it is, especially when you’re burdened with a never-ending list of bills or are starting out on your own. And, those six-figure-per-year jobs haven’t yet come your way! So what do you do? The first and most important thing is to work at paying down high-cost debt (see Chapter 3).
You can get into the habit of saving even when your income is low. Even if you can set aside just $25 or $50 of every paycheck, you’re on the road. As you earn raises or bonuses, you can increase the amount you save. The bottom line: Put a little in savings on a regular basis. Develop the savings habit by making it automatic from your paycheck or an automatic draft from your bank or other transaction account into a savings or investment account.
You may consider getting a second job. You can put the money you make from this second job right into savings. Don’t even touch it. If you decide to get a part-time job, make sure that it’s something you enjoy so you don’t end up dreading it. For example, perhaps you enjoyed playing sports growing up and you’d enjoy putting that knowledge to work as a youth sports referee or umpire. If you’re strapped and barely making ends meet, you can also cut expenses. Chapter 5 has tips on reducing your spending.