The Five Fundamentals of Fiscal Fitness

Save At Least 10 Percent Of Your Annual Income

One of the secrets of financial independence is to never spend more than you earn.  It sounds rather obvious, however there are many people who are unable to do this.  In order to never spend more than you earn it is essential to save at least 10 percent of your income.  This is a fundamental practice in the domain of finances.  As long as you are always saving at least 10 percent of your income, you will never be in debt. 

In our work with clients over the last decade, we have found that one’s ability to generate wealth has very little to do with the amount of money one is earning. Some of the clients who we have worked with who have the biggest debt problems are those with the largest incomes.  Saving is not a function of earning.  It is a learned behavior that anyone at any level of income can master.  To begin with, you must pay yourself first.  What this means is that when you receive your paycheck, before paying any of you other bills, you must put away 10 percent of your income into a separate savings account.  It does not work to wait until you have paid all of your bills before saving.  Saving must be your top priority.  When you save 10%, you are affirming that you care about yourself.  It is an act of self-love.  What you are saying is that you care enough about yourself and your well being to put aside 10% of your income for a future time when you may need it.  Looking in nature, we find that the squirrel is a great example of this behavior.  In the summer when food is plentiful, he collects and puts away nuts for the winter.  He knows that there will be a season when food will not be as plentiful and he stores nuts for that time.  We can learn from the squirrel and also put away 10% of our income for times that may be less plentiful.  This is a fundamental practice and the earlier one starts the better.  Once you are able to live on 90% of what you take in and put away the other 10%, you will always have a surplus and never be wanting.  I invite you to take this action now and demonstrate your own self-care.

Build Sufficient Liquidity

After saving 10% of your income the next question that arises is where to invest this money. Prior to investing we recommend that our clients have adequate cash reserves. Many financial planners recommend that clients should keep cash reserves equal to three to six months of annual income.  For most people, this is not possible.  With our clients we tend to be more practical.  For those clients who are employed by someone else, we generally recommend that they keep ten percent of their annual income in their checking, savings or money market account. For those who are self-employed we increase this amount to 20% of annual income.  And for those in retirement, adequate cash reserves means 30% of annual income.  We have found that this amount of cash reserves is sufficient to provide a sense of stability and peace of mind for most people.

After our clients have met their cash reserves goal, our next step is to build emergency liquidity.  The purpose of emergency liquidity is to protect you if you are disabled or unemployed for a period of time.  We generally recommend that our clients save two times the amount required in cash reserves.  These funds are generally kept in an IRA, 401K, money market fund or in US Savings Bonds. Currently Series I US Savings Bonds are yielding 4.66% and are not taxable until they are cashed in. They can be bought online at www.savingsbonds.govwith a credit card and you can earn airline miles on your purchase. This is an ideal place to build your emergency liquidity and get free airfare to boot. 

Fully Fund Your Retirement Plan

The first place that we recommend that our clients begin saving 10% of their annual income is inside of their retirement accounts. One of the advantages of saving inside of a retirement account is that your contributions are tax-deferred.  What this means is that you receive a tax deduction for whatever money you contribute into your retirement plan, and your money grows without having to pay taxes on the earnings until you take the money out.  In addition, many employers have a matching program where they will match your contributions into you retirement plan up to a certain percentage of your income.  This is basically free money that you would not otherwise receive.

We recommend that all of our clients contribute to the tax-deferred retirement plans that are available to them. Our thinking behind this is that if you are in a 28% federal tax bracket and 5% state tax bracket, or a combined 33% tax bracket, then for every $3000 you contribute to your retirement plan, $1000 of taxes is saved.  In other words, it is only costing you $2000 to contribute $3000 to your retirement plan.

If you are permitted by your employer to contribute 10% of your income into your retirement plan, then we strongly recommend you do so.  The only time you would not want to contribute 10% of your income into your retirement plan would be if you have not yet built up adequate cash reserves.  In that case, a percentage of your income needs to be saved in a checking, savings or money market account so that you can build your cash reserves.  If this is the case for you, and you don’t yet have adequate cash reserves, we recommend that you contribute into your retirement plan at least up to the amount your employer is matching.  The advantage of fully funding your retirement plan is that it helps you to achieve both the first and second fundamentals of fiscal fitness; it helps you to save 10% of your income and can be used toward building adequate liquidity.

Buy the Right Size Home

Very few financial advisors will recommend that their clients go out and buy a home.  The main reason for this is because if they are being paid by commission or a percentage of assets under management, they will earn less money.  From our point of view, it doesn’t make sense for our clients to go out and buy mutual funds, stocks and bonds if they don’t first own a home.  Here’s why:

First is the fact that our tax system works heavily in your favor if you own a home. The mortgage interest and property taxes you pay on your home are tax deductible.  To illustrate, let’s say you buy a home for $200,000.  You put $40,000 down and take out a mortgage for $160,000 at 6%.  Your total monthly payment (principal, interest, property taxes and insurance) would be approximately $1100.  Let’s say you currently pay rent of $800 a month and assume that you couldn’t afford another $300 a month that it would cost you to own a home.  Yet, because $966 of that $1100 monthly payment is tax deductible and you are in a combined 33% tax bracket, after taxes it is only costing you $781 a month, a savings of $19 per month over what you are currently paying in rent.

The second reason to buy a home is long-term leverage.  Let’s say that you buy a $200,000 home with a down payment of $40,000.  If your home appreciates at 6% a year, it will increase $12,000 per year.  This appreciation represents a 30% return on your $40,000 investment.  This return is also tax-free.  When you go to sell you home, you can exclude up to $500,000 of the gain if you are married or $250,000 if you are single.  Where else can you get that kind of return on your investment with so little risk?

The third and most important reason for purchasing a home is that it is one of the few investments that you can derive tangible personal enjoyment from. While your home is appreciating, you get to enjoy living there. 

We generally recommend that our clients purchase a home that is worth 2 to 2 ½ times their annual income and make a down payment of 20%.  If you put down less then 20%, the lender requires you to purchase private mortgage insurance.  This premium gets added to you monthly mortgage payment.

Owning a home is so critical to your financial independence that we encourage you to do whatever it takes to buy a home now, and not wait.  We have found that those clients who wait for the right time end up waiting a very long time.  Don’t wait.  Do it now!

Pay Off Your Credit Cards and Consumer Debt

We have found that one of the biggest obstacles to achieving financial independence is consumer debt.  Yet debt, in and of itself is not the problem.  It is how we choose to use it.  We can use it wisely to build financial independence or unwisely to keep us stuck in financial dysfunction.  We have helped our clients to make a distinction between “good” debt and “bad” debt.  In order for debt to be “good”, it must meet these two criteria:

1)      Whatever is being financed should last longer then the loan.

2)       Financing should allow for positive leverage.

Based on this criteria, we can see that a mortgage would be considered “good” debt because your home will last longer than the mortgage and because the mortgage allows for positive leveragingas we discussed in “Buying the Right Size Home” above.  On the other hand, acquiring consumables with your credit card and not paying it off immediately would be considered “bad” debt.  Applying the two criteria above, we can see that the consumables would be used up immediately but that the credit card payments would continue after the meal or vacation is long gone.  Also, the credit card allows for no leveraging.  You actually end up paying much more for the item then if you had originally paid for it in full with cash.

Many people currently have some consumer debt.   According to the National Foundation for Credit Counseling, in the year 2000, the average household with at least one credit card carried a balance of $7942.   If anything, that amount has grown.  How much debt is a problem?  Having no consumer debt is ideal although as long as it is less than 10% of your annual income (not including home mortgages or educational loans) it is considered acceptable.  If your consumer debt equals 10% to 25% of your annual income, we consider that it is a problem and we recommend that you get rid of you credit cards, create a spending plan and consolidate your debt.  If your consumer debt equals 25% to 45% of your annual income, you are definitely in trouble and we recommend that you make drastic changes such as selling your house and downsizing, getting a second job and seeking credit counseling.  If your consumer debt exceeds 45% of your annual income, your financial situation is pretty hopeless and the only realistic course of action is to seek bankruptcy planning.

These “Five Fundamental of Fiscal Fitness” which we have discussed are the key practices for developing Financial Independence.  We invite you to score yourself in each of these practices, to commit to raising your score over the next year, and if necessary, to seek financial guidance and support in developing practices that lead to financial independence in your life.

How Are You Doing?

Please score yourself on the following five fundamentals.

We encourage you to pass this article along to friends, family andcolleagues.  For more information on how we can help you to achievefiscal fitness, please visit our website at www.markstempel.com, email us at ms@markstempel.comor call us at 520-531-9977.