Top 5 places to put your money TODAY

Where should you put your money?  There are a ton choices including credit card debt, retirement accounts, mortgage payments, that new Le Creuset stockpot that you’ve always wanted, a trip to Tahiti, etc.  Below is a list of where I think most people should put their money in order of priority.  That means that I recommend maxing out the first item on the list before going down to the others.

This list assumes a couple of things:

1) You have some cash to put towards these things.  If you don’t, you need to read Rule #1 of personal finance, cut costs where you can, optimize your spending, and automate your savings.

2) You are not endangering your health, have proper levels of insurance, and aren’t making yourself miserable by living like a total pauper because you’re following my savings suggestions to the extreme.

3) You’ll tailor this order to your own personal situation.  (But even so, I strongly recommend following items 1 & 2 in that exact order.)

Okay, ready?  Numero Uno for where your money should go is….

1) Employer 401k matching

If you’ve read my articles on retirement, you’ve heard me say this before: don’t leave free money on the table!  What type of return do you  historically get from a risk-free investment?  Treasury bonds have returned about 4-5% annually.  What is your employer match return?  If you get matching of 50 cents on the dollar up to 6% of your salary, your return on that first 6% saved is an instantaneous, huge, risk-free 50%!!! There’s no better investment in the world that I’m aware of.  Max this out no matter what!

2) High-interest debt, like a credit card

- Some readers might quibble with this as #2, I can hear them now: “What!? Paying off your credit card balance is always the first thing you should do!”  There may be emotional benefits to making this #1 that you should consider, but  if your employer matching is 50% instantly, and your credit card rate is 25% annually, you’ll do way better to first max out your 401k matching.  After that, put the rest of your cash towards that VISA balance.

(Of course, if you have a rate as outrageous as this one, you may want to switch to paying this off first…)

3) Emergency fund (3 – 6 months worth of living expenses)

You need to have some money socked away for unforeseen expenses or losses of income.  While you should at least have long-term disability insurance to protect yourself against injury, you also need a shorter-term stash of cash to tide you over if you lose a job, get sick, or have to replace something valuable, like a car.  The general rule for insurance is to insure things which you wouldn’t be able to replace relatively quickly and that would cause you hardship if you had to go without them.  This includes your home, life, health, and possibly your car or jewelry, depending on the retail value of these items and your personal savings.  (Make sure to avoid useless insurance.)

Expenses you can afford should be ’self-insured’ by your emergency fund or other savings.  Raising insurance deductibles and banking (NOT spending) the difference in premiums is a good way to self-insure against small losses ranging from a few hundred to a few thousand dollars.  Store emergency money for unexpected car repairs, insurance deductibles (which can be large if you have catastrophic health insurance like I do), or high vet bills for your disgustingly-cute Cavalier King Charles spaniel.

Whether you need more or less living expenses saved depends on how steady your income is & how many liquid assets you already have (like non-retirement stocks that you could tap.)  The more financially secure you already are, the less of an emergency fund you need: a self-employed person with few liquid assets needs more emergency funds than a union schoolteacher with 20 years seniority and a sizable investment account.

Like all short-term (less than 3-5 year) savings, your emergency fund should be investing in something that is not only stable and liquid (easily accessible), but that will also give you a decent return on your investment.  High-interest savings accounts like the kind from INGDirect* fit the bill for very short-term savings since the principal is guaranteed by the FDIC.  Bond funds, which may vary slightly in principle but generally yield a higher return than savings accounts or CDs, work better for money that might sit there awhile.  I use a low-fee, highly-diversified bond index fund for my emergency fund due to the higher returns compared to high-interest savings accounts.

(Read this for an advanced way to juice your emergency fund interest rate while keeping your principal safe & accessible.)

4) Tax-advantaged retirement accounts (401ks, Roth or Traditional IRAs)

After you’ve maxed out your employer retirement matching, paid off your debts (except perhaps your lower-interest mortgage or student loan), and stored money for emergencies, it’s time to go back to saving for your retirement.  Read up on the Roth IRA, and then read this to see if it would be better for you to put your retirement savings in a pre-tax account like a 401k or an after-tax account like a Roth IRA or Roth 401k.  For people in high-ish tax brackets (25% and above as a rule of thumb) and who don’t already have a large pre-tax dollar nest egg saved up, I recommend putting the bulk of your retirement savings into a 401k plan (or a Traditional IRA if your employer doesn’t offer a 401k.)

If retirement is still 5-10+ years off, invest in broad, low-fee stock-market index funds like those that track the S&P 500 or the total stock market.  Index funds outperform mutual funds about 70-80% of the time and require no maintenance on your part since they passively track the entire market for you!  Any good 401k plan should offer at least one of these indexes.  If you’re investing in a Roth or Traditional IRA, select a mutual fund company that offers a good selection of  low-fee index funds like Vanguard or Fidelity.

Putting money into a tax-free retirement vehicle is critical to building up a nest egg for the future.  Assuming you’re in the 25% tax bracket (and some other things**), an investment in a tax-advantaged retirement account made when you’re 25 will be worth about 55% MORE in real dollars when you’re 65 than would an equivalent investment in a taxable account.  (Obviously, if your tax bracket is higher, it’s even more advantageous to avoid taxes.)

5) ‘Regular’ taxable investment accounts & short-term savings for big purchases

After you’ve either maxed out your retirement options (you’re a beast!) or decided you’re contributing enough to retire how you want to at a given age, it’s time to look at plain ol’ taxable investment accounts for long-term savings.  (Index fund recommendations still apply.)  I like to think of these as early retirement accounts; the more you sock away now, the quicker you can exit the rat race (or do something for lower pay that you like more.)

Also, you should be saving regularly for big purchases like a house, wedding, vacation or new car.  For these short-term items, I use the high-interest savings sub-account technique that I learned from Ramit Sethi (you could also use the Roth IRA ‘hack’ I mentioned in priority 3 above.)

Simply open an ING high-interest savings account*, then create multiple savings accounts, labeled according to each item you’re saving for (‘Wedding’, ‘San Francisco trip’, etc.)  Then, set up an automatic monthly contribution to each account based on the amount of time you have to save and the amount of money you’ll need.  For example, if you need $30,000 to put down on a house in 2 years, that’s $1250 per month that you need to be saving ($30,000/24 months = $1250 per month.)

Note that you might sometimes rank some short-term savings goals as higher priority than maxing out your retirement accounts (#4.)  That’s fine, but do NOT neglect your retirement.  Investing early, even with just a little bit of money, is the most important factor to building wealth.  Saving for retirement will be way easier if you start today with whatever you can.

Conclusion

So there you have it, the rank-ordered top 5 places to put your money: 1) Max out employer matching contributions before anything else, 2) pay off high-interest debt like credit cards, 3) create an emergency fund of 3-6 months worth of expenses, 4) put as much as you can into tax-advantaged retirement accounts, and 5) bankroll anything left into short- & long-term (taxable) savings/investment accounts.

Take each step one at a time until you’ve successfully mastered it, then move on to the next one (don’t try to do it all at once!)  Once you’re eventually able to do all of these things, consider yourself pwning your money!

* If you want to set up an ING Direct high-interest savings account, the first 24 people that email me can get a referral link that will get them a $25 bonus if they deposit at least $250 when setting up the account (I’ll get a $10. referral bonus.)

** This assumes dividends & capital gains remain at the historically low rate of 15% for those in the 25% and up brackets.  It also assumes an effective tax rate at retirement of 16%, which corresponds to an income in today’s dollars of about $90K for a married couple.  If dividend or capital gains rates go up, tax-advantaged accounts perform even better against taxable accounts.  On the other hand, if your tax rate goes up relative to the capital gains rate after you’ve retired, tax-advantaged accounts lose some of their edge (but they’re always better.)

Do you suffer from these common big money mistakes?

Even though you may think you’re handling your money rationally, there’s many psychological factors that even very sophisticated people fall victim to.  Learn how to fix these big money mistakes below.

I just finished reading the fantastic “Why smart people make big money mistakes and how to correct them.” The authors focus on the behavioral economic factors that cause us to do boneheaded things with our money.  The book concludes with actions for people to take to overcome some of their irrational financial behaviors.

See if you’re making some big money mistakes, and learn how to fix them:

1) Raise your insurance deductible. Gary Belsky & Thomas Gilovich explain that because we count highly memorable events as more probable events (think fear of airplane crashes), we tend to overestimate the odds that we’ll have to file an insurance claim for life, auto or health.  Therefore, we pay too much in premiums for low deductible policies.  Instead, raise your deductible from, say, $100 or $250 to $500, $1000 or more.

2) Next, create an emergency fund to “self-insure” against paying deductibles and for other smallish losses. Read my other articles about paying less for auto insurance premiums, and also about using catastrophic/high-deductible health insurance. Because we think about all the terrible things that could happen to us, no matter how unlikely, we sometimes buy insurance we don’t need.  Go here to learn about insurance you should avoid.

3) Pay off credit card debt with emergency funds or other non-retirement savings. Often times, we use ‘mental accounting’ to separate different accounts of money in our mind.  We might treat our emergency fund as sacred, and at the same time max out our credit cards.  Once you accept that a dollar in your emergency fund has the same value as a dollar on your credit card, you’ll realize that making 5% in a money market fund and paying 14% in credit card interest at the same time just doesn’t make sense.  Besides, if you have an emergency after doing this, you can just put it on the plastic.  (Of course, once you pay off your credit card debt, keep paying your full bill every month!)

4) Switch to index funds. I often champion the virtues of low-fee index funds. They give you instant diversification and ensure that you’ll beat about 80% of actively managed mutual funds by just matching market returns.  Also, they let you put your investments on near-autopilot, freeing up your time to do the things you really love without worrying about quarterly earnings reports or whether your fund manager really knows what he’s doing  investing in Siberian oil fields.  Be honest with yourself that you probably don’t have any business trying to outperform investing professionals (who themselves often don’t have any business doing it.)  Also, DON’T be fooled into picking the latest ‘hot’ fund or stock.  Funds with high recent past performance are often just random aberrations, and are likely to perform worse than average going forward.

5) Review your assets and track your spending for a month. Take a snapshot of your personal wealth by tallying up all your debts and savings.  Then, track your spending for a month.  This second part is hard, but the rewards are absolutely huge.  You may think you know where your money is going, but if you’re one of those people that have credit card debt or just can’t seem to save enough, you must do this.  Even if you’re pretty on top of your money, tracking where your cash is going can be very revealing (I know it was for me.)  Fortunately, credit cards and online software like Mint or Quicken help you do this pretty painlessly.  Just make sure to account for cash expenditures too.

6) Set up a payroll deduction. We often find it painful to send our hard-earned dough to a savings account when that money’s already in our checking account.  Eliminate this phenomenon (called ‘loss aversion’) by making investments straight out of your paycheck through a payroll deduction.  That way, you’ll miss the money less since it will never feel like you had it in the first place.  Your 401k plan is a great place to start, but you should also consider automating the rest of your money to build wealth without thinking about it (hardly.)

7) Max out your retirement savings (or at least the employer matching part until you can save more.)  Retirement accounts like 401ks, 403bs, and IRAs are great places to build wealth because of their tax savings.  Read more about retirement savings here.  At the bare minimum, max out your employer’s matching portion of your 401k. (It’s free money!)  This is so important that you should do it at the expense of putting more money towards paying off your credit card debt! (And I really hate credit card debt, so that’s saying a lot.  Pay that plastic off as your second highest financial priority.)

So there you have it, 7 steps to fixing some of the biggest and most common money mistakes that even smart people make.  As always, email me with questions about your particular situation, or leave a comment and I’ll answer back as soon as I can.

Automate your finances – Perspectives from the Fool and Ramit Sethi

Below is a good summary of the automations you can make to simplify and improve your finances, courtesy of the Motley Fool:

Use the tips in this article and automate:

1) Your savings via direct deposit of your paycheck to your checking or savings accounts.  Depending on what your employer allows (ask HR), you can break up your direct deposit by placing some of your money in a checking account and some in a savings or brokerage account.

2) Your retirement via 401k contributions straight from your paycheck.

3) Your credit card bill by automatic payment of at least the monthly minimum plus whatever else you can afford (if you have a revolving balance) or the whole amount each month (the preferable choice.)

4) Your other bills by signing up for automatic payment on utilities, student loan, car payment, and even your rent or mortage (using your bank’s online bill payer if the company you’re paying doesn’t have an online payment option.)

5) Take a page out of Ramit Sethi’s book by opening high-interest savings accounts to auto-save for large purchases like weddings, cars and houses, or smaller things like a plasma TV or that $500 pair of Jimmy Choo heels.  (A really fantastic article on finance automation by Sethi is link here.  The article gets into the nuts and bolts of how to picture and implement the above.  I highly recommend reading it.)

Automate your finances to save time, money and peace of mind!

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.