Step 1: Reduce Your Spending Until You're
Earning Significantly More Than You Spend
Getting off the consumer
treadmill can reduce your level of anxiety and leave you with greater
appreciation for the deeper joys in life. This is the step where personal
growth, concern for the environment, and your foundations for prosperity can
meet. Here are some tips that various experts have recommended:
For one week, keep track of
all the money you spend. At the end of the week, think about whether each type
of expense could be reduced or eliminated. Do the same thing with the bills you
paid at the end of the previous month. If you're surprised by how much you're
spending dining out, then try to find a workable arrangement under which you do
all of your week's cooking on one evening. When you do need to dine out, you
might try one of your city's Vietnamese noodle soup (``Pho'')
restaurants -- they're delicious and very inexpensive.
Hold entertainment to high
standards. Ask yourself: Would this evening out be more satisfying that a
candlelit evening at home -- enjoying dinner or watching a rented movie -- with
my friends? Can I trade CD's with a friend, or borrow them from the library,
when I'm tired of the ones I have?
If you're renting an
apartment or house all by yourself, then keep a close eye on the amount you're
spending on rent. Shared living arrangements, ideally on a direct bus line to
your day job, are the best value. If you need insurance: choose the highest
deductible you can afford (so your premiums will be low), and don't carry life
insurance unless you actually need it. If you DO need life insurance, then you
may wish to look into an inexpensive ``term'' policy rather than ``whole
life.'' With disability insurance, you can often lower the premium by
increasing the claim waiting period.
If you must purchase a car,
then if at all possible pay for it in cash rather than taking out a loan or
arranging financing. Also, try to find a good used car before considering a new
one; it might be worth your time to contact the most car-savvy member of your
circle of friends, and work out an arrangement under which he or she helps you
locate a mechanically sound and reliable used car, and then shows you how to
maintain it.
One of the easiest ways to
improve the quality of your life, while also saving money in the long run, is
to improve your health. Exercise, adopt a heart-friendly diet, and quit
smoking.
Before you purchase new
clothing, try some of the better second-hand shops. Avoid being restricted by
minimum balances or monthly fees on your daily checking account, and do what
you can to avoid ATM fees. Libraries are a great place for fiction and
documentaries, and I've found that the larger bookstores now provide
comfortable reading chairs.
If you're itemizing
deductions on your federal taxes, then be sure you're taking all the deductions
you're eligible for. For example: you can deduct work expenses that your
employer doesn't reimburse, expenses related to changing jobs, and expenses for
continuing education classes that help you do your day job better. You can also
deduct the ``fair market value'' of items you donate to charity; you'll need to
keep a list of the donated items, but the charity may be able to provide you
with the forms you need. Of course, there are caveats: see the official IRS
publications for full details.
In Step 2, you'll work on
eliminating your credit card debt. For now, at least try to lower the interest
rate. Find a credit card offer you're eligible for that has a very low interest
rate, and tell your existing credit card company that you'll need to switch
unless they can bring your rate down to that level. Avoid annual fees on credit
cards, particularly once you've paid them down.
As the book The Millionaire
Next Door describes, it's a myth that millionaires spend money frivolously: the
majority of real millionaires wears reasonably-priced
clothing, drive reasonably-priced cars, and look for bargains when they shop.
This is one of the reasons they were able to become millionaires in the first
place.
Your Affirmation for Step 1: ``Each Dollar Has Value''
Step 2: Eliminate All Credit Card Debt
No investment can
consistently give you a higher rate of return than your credit card debt takes
from you. In other words, it's pointless to begin any actual investing until
your credit card debt is eliminated, and it makes sense to use existing savings
to pay down this debt.
There are circumstances when
it's necessary to pay for something using Visa or MasterCard. However, this
does not mean you need a credit card; most banks now offer Visa debit cards,
which pay for purchases out of your checking account balance but offer no
credit.
In general, the only circumstances
in which debt can be ``good'' are as a home mortgage or (under the assumption
you cannot afford to purchase these things outright) as low-interest loans to
attend college or start a small business.
Your Affirmation for Step 2:
``Interest is not something I pay to other people, it
is something that other people pay to me.''
Step 3: Open an Investment Account
Possibilities for Long-Term Investments
For the last two centuries,
stocks have outperformed all other investments. Financial experts are now
practically unanimous in recommending that your long-term investments (i.e.
which you don't anticipate needing to spend in less than five years) be in
stocks.
Stocks get a bad rep because
individual investors misuse them, typically in ways that suggest they're
approaching the market as a gambler rather than as an investor:
They'll ``day trade''
(rapidly buying and selling individual stocks on a daily basis), which
eventually runs them into the ground due to commission fees and unfavorable
taxes on their short-term gains. They'll invest all their money into one or two
individual stocks rather than into stock funds, hence tying themselves to the
future of just one or two companies rather than to the future of the market as
a whole. They'll invest money in stocks which they know they'll need in only a
few years (perhaps for a home down-payment), and hence constantly fret about
short-term market fluctuations. They'll
buy high and sell low, after they get caught up in the latest media hype.
In Step 1, I mentioned the
confluence between healthy living and saving money. Now, I'd like to identify
the confluence between stress-reduction and effective investing: when you
invest in stock funds for the long term, you're free to disregard market
fluctuations while still getting the best possible yield for your money.
Many financial experts agree
that, given the choice, you should select ``no-load'' index funds when you
invest in the stock market. ``S&P 500'' funds and ``Total Market'' funds
are two of the most popular types of index funds, and the book You Have More
than You Think goes into more detail as to why load-free index funds can be
such a wise choice.
Possibilities for Short-Term Investments
But what about the times when
you do need to make short-term investments?
Money market funds (e.g.
Fidelity's "Cash Reserves" fund) and bond funds (e.g. Fidelity's
"Short-Term Bond Fund") are to short-term investing what stock funds
are to long-term investing, and are also available in tax-exempt versions (though
the tax-exempt versions would probably only make sense for someone in the
highest tax bracket who is investing outside their retirement plan).
What About ``Socially
Responsible Investment'' Funds?
I don't believe SRI's are all they're cracked up to be. To start with, on a fundamental level you
can't invest in companies that have something other than self-interest as their
basis: only for-profit corporations may issue public stock, and by definition a
for-profit corporation is looking out for itself.
The best that SRI's can do is avoid certain
companies, rather than actively encouraging positive change. Even so, you still
can't completely avoid the ``bad'' companies, because almost any financial
institution or company you may deal with might itself invest in such a way that
includes them.
I talked to a financial
advisor recently and confirmed that something else I suspected was true: the
return on SRI funds is often terrible.
I believe a viable alternative is to select something like a no-load
total market index fund (which invests in every company in the market, both
``good'' and ``bad'') and use what you earn to assist the efforts of non-profit
organizations that are actively doing good.
Where Can I Open Investment Accounts?
Vanguard (see www.vanguard.com),
established in 1975, is currently one of the largest providers of no-load stock
funds; they also offer bond funds, money market accounts, and retirement plans.
Fidelity (see www.fidelity.com) is
another popular choice, though many of their funds aren't no-load funds.
Your Affirmation for Step 3: ``The money I invest
deserves the best available rates of return.''
Step 4: Maximize Your Retirement Plans
Introduction
Money in ``retirement plans''
can grow and compound tax-free until you reach retirement. In most cases you
can also deduct from your taxable income the amount you contribute to them.
Mentioning the word
``retirement'' brings up, for many people, the question of whether they're
sacrificing enjoyment in their youth for a future in which they might be less
able to enjoy themselves. To that, I would say:
It doesn't take that much
money every month to make a huge difference in your future, and the fact that
you can typically deduct these contributions on your taxes means that you get a
big percentage of this money ``back'' at tax time. Furthermore, if you reduced
your spending even a little through Step 1, then in combination with your tax
deduction you may find that making these contributions does not require any
sacrifice at all.
It's entirely possible that
you'll find a charity during your lifetime which you consider worthwhile.
Naming a 501(c)(3) charity as the beneficiary of your
retirement plans, life insurance policy, or estate (via your will) can be a
fantastic way to leave the world a better place. [To do this, at a minimum you
need the charity's full name, legal address, and EIN number (which I'm sure
they would be happy to provide); if you're changing the beneficiary to them
from someone else, then you might also ask whether you need a ``spousal
waiver,'' or whether this action might affect ``minimum distributions.''] If
you start at age 20 and contribute $1000 each year into a retirement plan
(which comes out to just $83 per month), choosing an investment with a 10% rate
of return (i.e. slightly below the historical return for the stock market),
then in 40 years you'll have about $681,000 from these contributions alone.
Contributing $122 per month rather than $83 per month would make you a millionaire.
This is a tremendously easy
way to generate a staggering amount of wealth, for your good or the good of a
worthy cause.
Types of Retirement Plans
There are four basic types of retirement plans. You
may contribute to as many of them as you qualify for.
Employer-sponsored plans [401(k) or 403(b)]
We all need to do what we
love, both for the sake of personal happiness as well as for the long-term
viability of our chosen careers. However, particularly if you cannot contribute
to a retirement plan through your spouse's employer, I would encourage you to
look long and hard within your favorite profession for an employer who (at a
minimum) offers health insurance along with a 401(k) or 403(b) retirement plan.
If your employer matches your
contributions, then you should definitely max out their plan before looking at
any of the other retirement plan options that follow.
If a no-load stock index fund
isn't one of the investment options that your company currently offers under
their plan, then nag your CFO until they offer it. Your contributions to this sort of plan are
tax-deductible.
Self-employment plans
[SEP-IRA, SIMPLE, or Koegh] These
are the equivalent of 401(k)'s for people who are self-employed. Your
contributions are tax-deductible, and by law you can sock more money annually
into these plans than you could into a 401(k) or a Traditional/Roth IRA. You can set up SEP-IRA and SIMPLE plans
through Vanguard, Fidelity, etc.
Individual plans [Traditional IRA or Roth IRA]
You can contribute up to
$2000 a year to one of these plans. They're available to individuals with
employment or self-employment income, to non-working spouses of individuals
with employment or self-employment income, or to individuals receiving alimony.
You have complete control over what investment to select within your IRA.
Although your money always
grows and compounds tax-free within your IRA, whether you can deduct your $2000
contribution depends on how much you earn, whether you're married / filing
jointly, whether you're covered by any employer-sponsored retirement plan, and
whether you're contributing to a Traditional IRA or a Roth IRA (you can never
deduct the amount contributed to a Roth IRA).
For 2000 as a single filer you
could take the full deduction on a $2000 Traditional IRA contribution if you
weren't covered by any other retirement plan, OR if you did participate in
another plan but your income was less than $32,000. Making this contribution to
a Roth IRA instead of a Traditional IRA was only an option if your income was
less than $95,000. For current information on IRA eligibility (including
information of interest to married filers) see IRS Publication 590. You can set up Traditional and Roth IRA's
through Vanguard, Fidelity, etc.
Annuities
If you don't qualify for any
of the above plans (perhaps because you don't earn money through either an
employer or formal self-employment, and you aren't the spouse of someone who
does), or if you've maxed out all the plans you're qualified for and still want
to contribute more to your retirement, or if you've only just realized that
your child is about to go to college and you want to dump a bunch of
non-retirement money into a retirement plan in the hopes of not looking too
wealthy for your child to receive financial aid, then you might consider an
``annuity.''
You don't get to deduct your
contributions to annuities, but the money you put in them does grow and
compound tax-free (like all of the other retirement plans described above).
Their advantage is that you can contribute as much money to them as you like,
whenever you like, essentially regardless of where your income comes from.
Annuities should be a last
resort: you don't get to deduct the money you put in them, and because they
involve higher fees it takes longer for their returns to outstrip
non-retirement investments.
But what
about my kids' education? Some parents believe that rather than
contributing to their retirement plans they should put their money into a
non-retirement account to save for their children's higher education. Often,
this strategy can backfire: since (as of 2000) the money in your retirement
plans is frequently excluded from consideration when you apply for financial
aid (particularly for state universities), by continuing to max out your
retirement plans throughout your life your child might qualify for financial
aid that he or she might not otherwise qualify for. Because your own retirement
remains secure, you'll also never have to worry about feeling like a burden to
your children later on in life.
Of course, if you earn so
much money that you have tons of it sitting around even after you've
systematically maxed out your retirement plans, then you might want to take
advantage of some of the special educational investment options described in
Personal Finance for Dummies. You could also think about transferring some of
this extra money into an annuity.
Your Affirmation for Step 4:
``I am taking charge of my financial future, and
sowing the seeds of positive change.''