Automating your finances (Ramit Sethi-style)

I’m a big fan of automation, especially for personal finance & investing (think automatic 401k withdrawals.)  A ‘classic’ video from Ramit Sethi is at the bottom of this post, outlining his approach to automating your money.  I recommend watching it (12 minutes) and trying to automate your own money to the extent possible.  It takes a little up-front effort (which you never have to leave your computer chair for), but it pays off big time in making life simpler & helping you effortlessly hit your financial goals.

Using INGDirect for online banking is a big step in the right direction on the automation front.  I use them to automatically mail out my monthly rent checks, and to automatically put pieces of my direct deposited-paycheck into various high-interest savings sub-accounts.  Here’s how I do it.

How I automate my money

I generally have a ‘cycle’ of automatic things that happen per each paycheck.  A certain percent goes to my 401k at Vanguard (and invested according to the index funds I picked.)  The remainder (minus taxes and insurance premiums) is direct-deposited into my ING checking account online.  Of that, a fixed dollar amount goes into a vacation sub-savings account, an account for money that I spend on myself to make more money, and to my no-ATM-fee Charles Schwab checking account that I use for miscellaneous cash needs.

Once a month, my rent check is automatically mailed out to my landlord from my ING checking.  All my other bills (including utilities, cell phone, internet, etc) have been set up to be automatically paid by my credit card.  Thus, I just have one automatic credit card payment out of my ING checking that occurs monthly.  (Some bills can be set up to automatically come out of your bank account if paying by credit card is not an option; but I prefer the latter for the simplicity.)

Anything left over is available for me to either spend (without feeling guilty since I’ve hit all my savings goals), or add to my savings.  If you know me, you can guess that I generally choose the latter, but every once and a while I loosen the purse strings and splurge on myself in the form of good beer or relatively-inexpensive travel.  (I know, I know, I’m a wild man when it comes to my spending sprees.)

Below is a picture from Ramit’s post (linked below) that illustrates how this works:

Having my money automatically going to various savings places BEFORE I get to spend it on discretionary items is part of the idea.  I’m ‘paying myself first’ as the mantra goes.  Of course, you’ll want to have a rough idea of your more ‘mandatory’ spending like rent/mortgage, utilities, gas, groceries, plus a little spending money so that you can estimate how much you can sock away.  If you want to have more money to save, scroll down to the 30 excellent tips in this post.

Ramit’s more detailed explanation

Ramit outlined the approach he discusses in the below video in a blog post here as well.

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Do you know how much you need to save for retirement, college, or a home?

This handy savings calculator from Lifetuner.org helps you answer that question.  Just plug in a yearly savings amount (like $200/month = $2400/year), the ages you start and stop investing, your desired retirement age, and an interest rate.  For this last assumption, I would use 6.8% (or 7% if decimals are too much to handle) to match the historical, real (inflation-adjusted) stock market return.  That way you won’t fool yourself into thinking you’ll have more purchasing power (which is what matters) than you really will have.

You can run up to three side-by-side simulations.  Compare starting ages, amounts you save, or the difference due to small interest rate changes.  This is a great calculator for estimating the return from regular investing, or the difference in gain from, say, a 0.5-1% increase in return due to switching to low-fee index funds, which beat the returns from (higher-fee) actively-managed mutual funds 70 – 80% of the time.

You can use this to calculate ANY regular investment, not just one for retirement.  For example, if you want to have a house downpayment in 3 years, assume a bond fund return of 3-5% (rates are low today) and then see how much you’d need to invest yearly to achieve your goal.  The longer you can wait, the more you’ll have.

Or, to calculate savings for your kid’s college (new parents, pay attention!), enter your kid’s current age as the ‘start saving’ age and 18 as the ‘stop saving’ & “retirement” ages.  (“Retirement” in this calculator just means the date when you want to know how much you’re investment will be worth.)  Use the historical, real, stock market return of 6.8% if you have a long time (>5 years) to invest, since that’s where your college savings should be.

Top 5 places to put your money TODAY

This is NOT the place for your hard-earned dollars!

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!

Now that you know where to put your money, find out WHAT to invest it in here.

[And just for good measure, here’s a link from the Motley Fool’s insurance page, which should contain some complimentary info to this post.]

* 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.)

Hack your Roth for tax-free short-term savings (Re-thinking the Roth IRA – Part 2)

You may remember my admonitions that ‘retirement savings are for retirement!’, but today I’m going to show you how to use your Roth as a sort of savings ‘hybrid’: you can use the Roth as short-term savings vehicle AND get the benefits of tax-free interest for retirement.  Before we get any further into this, make sure you understand how the Roth IRA works.

You may have decided that investing in a Roth IRA isn’t the best move for your retirement (opting instead for a 401k perhaps.)  Contributing to a Roth may still be a smart move, even if you want to use the money sooner rather than at retirement.  (Anyone with earned income whose modified adjusted gross income is less than $105,000 can contribute to a Roth IRA, regardless of age or participation in other retirement plans, like a 401k.)  Before we delve into the details, I want to let you know that this is an ADVANCED (though not hard) technique.   Make sure you understand all the details before deciding to use it.  (Post a comment with any questions you have.)

Recall that a Roth IRA lets you contribute after-tax dollars to a variety of investments including index funds, individual stocks and bonds.  The benefit over a ‘normal’ taxable account is that the money then grows tax-deferred, meaning you don’t pay interest on reinvested dividends or interest.  Plus, if you take out the gains AFTER age 59 1/2, you don’t pay any taxes on those either!  The catch is that if you DO take out any gains before turning 59 1/2, you generally must pay a 10% penalty on top of regular income taxes.  BUT, because you’re contributing after-tax money already, you can pull out amounts up to the value of your contributions with NO penalties/taxes at any time you want!

For example, say you contributed $2,000 to a Roth IRA in 2007, then another $4,000 in 2008.  You can take out up to $6,000 with no penalties/taxes.  IF however, your account increased to $7000 in value due to appreciation, you can still only take out up to the $6,000.  The extra $1000 gain must remain in the account until you’re 59 1/2 to avoid penalties (with a few exceptions detailed here.)

Since your money accumulates tax-free, you earn a higher after-tax rate of return in a Roth than in a taxable account.  If you’re earning say, 6% interest on $5000 and you’re in the 25% tax bracket, your after-tax return is only 4.5%  ($225 per year) in a taxable account.  If you had that money in a Roth IRA instead, you’d earn the full 6% ($300), which equals 33% more money per year.  Over time, small differences in interest rates make a huge impact on your wealth due compounding interest as shown by the below graph.*

Roth IRA vs taxable account - real growth difference

After 5 years, your Roth IRA will have $400 (7.5%) more in it, in 10 years, about $900 (15%) more.  When we combine the two facts above, being able to take out contributions at any time plus tax-free growth, we get a great way to use the Roth IRA as BOTH a short-term savings vehicle AND a way to earn higher returns on that money.

First, open a Roth IRA account that is completely SEPARATE from any Roth IRA account you might have designated for retirement.  This is because you do NOT want you to think of any Roth money you set aside for short-term savings as retirement money.  This makes it easier to keep track of your contributions that you plan to take out.  I have two Roth IRA accounts at Vanguard, one for retirement (invested 100% in stock index funds) and one for short-term savings, like emergencies, invested 100% in a diversified bond index fund.  Here’s how it looks:

Roth IRA - 1 is for retirement (hands off!) and Roth IRA - 2 is for short-term savings

Next, use an Excel spreadsheet, like the one I developed here, to track your Roth IRA contributions.  Your spreadsheet should have at least two columns: one that shows the amount of money you either contributed or took out of ANY of your Roth IRA accounts and one that shows the date of the transaction.  To find past contributions, the financial institution where you have your Roth IRA should keep records of these transactions for a few years (or check all Form 5498’s that you might have received from your financial institution(s) over the years.)  Make sure you never take out more than you’ve contributed, or you’ll likely face taxes or penalties.

Next, fund your separate, non-retirement Roth IRA with money that you need in the short (or long) term.  If you’re saving for the short-term, like an emergency fund, choose a relatively safe investment like a bond or money market fund.  The beauty of using a Roth for an emergency fund is that you get the benefits of easily-accessible principle (your contributions) with the added bonus of tax-free growth that can be used for retirement.**

This is great because your emergency funds might be invested for a really long time, if you’re lucky enough to avoid costly emergencies.  In light of this, you’d like to maximize your gains by avoiding taxes while the money sits there.  You can use a similar strategy when saving for a down payment on your first home.  If (and ONLY if) you’ve had a Roth account open for at least 5 years, you can use up to $10,000 of Roth IRA gains towards a first-time home purchase tax- and penalty-free.  So in this special case, you can even use the earnings (plus all the contributions) from your Roth IRA.

(Remember, you must have opened a Roth IRA account and deposited money into it at least 5 years ago to use this exception.  There is a similar exception for qualified education expenses, except the earnings withdrawals are NOT tax-free, only 10% penalty-free.  However, there are better ways to save for education.)

As a final note, remember that the IRS doesn’t care which IRA accounts you deposit to or take money out of, all that matters is your total contributions & distributions from all your Roth IRA accounts combined.  (Even so, I strongly recommend keeping Roth accounts you intend to use for short-term events separate from retirement-designated Roths.)

Start using this strategy today by opening a Roth IRA online at a reputable mutual fund house like Vanguard, Fidelity or T. Rowe Price.  With minimum initial deposits as low as $50 for T. Rowe Price, there’s no excuse for not starting a Roth.

* The graph is inflation-adjusted because we always want to talk about ‘real dollars’, aka purchasing power.  Another way of saying this is that we don’t really care about how many dollars we have, but how much stuff we can buy with them.  If we didn’t factor in inflation, we would actually understate how valuable the tax-savings from a Roth are.

** If you really want to optimize your investment performance, you could periodically (perhaps annually) move the gains on your non-retirement Roth into a Roth you’ve designated for retirement.  You would do this in order to move these gains (which shouldn’t be taken out until retirement) into a more volatile long-term investment, like a stock index fund, rather than having them sit in a stable, but lower expected return, short-term investment.

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