How Do I Make a Budget? Looking at the 50/20/30 Rule

The short answer: it depends. Not everyone is going to spend and save the same percentage of their income each month. However, deciding upon a feasible plan to allocate your monthly spending is important, and something that everyone should be doing once they receive an income. Currently, Americans have one of the worst savings habits in the world, demonstrated through the high average retirement age of 62. This means that knowing how much money to save as well as how much to spend are crucially important to financial well-being. In this article, I will discuss how much income should be saved and spent each month, and where your money should be placed to ensure financial security and freedom. I will be discussing the 50/20/30 rule, the hallmark budgeting rule, and why I believe it is the best rule to use.

The 50/20/30 Rule

When you start looking at your budget, you should follow the simple 50/20/30 rule. Spend 50% of your income on necessary expenses, 20% on savings, and 30% on discretionary goods and services. This layout will give necessary flexibility, but also a good baseline to start your budget from.

50% – Necessary expenses include rent, car payments, and groceries. These expenses are, by nature, going to take up the largest chunk of your budget.

20% – Money that is saved should go to various different savings and investment accounts to maximize the return on your savings. After all, that money is useless if it isn’t being put to work.

30% – Discretionary goods are goods and services that you want to buy. These include clothes or a gym membership. These types of products are not necessary, but purchased through a consumer’s decision.

Why the 50/20/30 Rule Works

You’re probably thinking to yourself, “why do these specific values work?” This is a good question. These values are seemingly arbitrary; they don’t adjust to context for different situations. You would be correct in thinking this way. The 50/20/30 rule is not meant to be followed to the penny, but in fact adjusted to different financial realities. Suppose you have a lot of college debt in addition to the normal necessary expenses such as car payments and rent. That college debt has not been factored in to the 50/20/30 rule. Thus, you are going to have to adjust your budgeting plan. Perhaps a 55/20/25 rule would suffice. Less money should go to discretionary spending, and more should be allocated to necessary payments.

The 50/20/30 rule has been praised by experts, and still remains one of the most popular and successful methods out there. It was created by Harvard economist Elizabeth Warren and her daughter. And most experts agree that at least 20% of your monthly income should be saved.

It is important to note that are many other budgeting methods out there, including the much simpler 80/20 model, which eliminates the need to differentiate between wants and needs. The only thing you should focus on is saving 20%, and using the rest on the other spending.

How do I implement this budget?

The hardest part of budgeting is actually following the budget. It is easy to set goals for yourself, but to follow them is the hardest part. To implement a budget, pick one of the following methods:

The Old Fashioned Spreadsheet Budget

To use this budget, simply print out some budgeting worksheets from online such as this one or keep a log in Microsoft Excel. Then, choose one regular spending months out of the year, and track all of your expenses. Keep all of your receipts, track your monthly income pulled in, and write it all down in the spreadsheet to the nearest penny. Make sure that all of your expenses are in neat columns, so everything is easily organized and understandable.

Budgeting Apps

Lately, budgeting technology has exploded, providing new alternatives for keeping track of budgets. Also, new technologies can link credit cards to your phone, allowing you to easily track all purchases.

The best budgeting app on the market by far is called Mint. It is an application released by Intuit that can manage your money, including your budget allocation. Your credit cards and bank accounts can be linked to the app through your phone, allowing you to easily centralize all of your expenses.

In Conclusion

Each method of budgeting isn’t going to work for everyone. For some, perhaps sitting down at a table, looking over all expenses, and recording numerical expenses each week is best. For others, a budgeting app will allow them to see their spending habits each time they make a purchase, and will also allow them to adjust accordingly. The goal of budgeting is not to use “the best” strategy, but to use what benefits you the most. There is no clear-cut budgeting strategy. That said, using a budget is much better than not using one at all!

The Importance of Insurance: The Benefits of a Safety Net

Life is very unpredictable. You could get in a car accident or contract a terminal illness. These things can all lead to massive debt if not handled correctly. This is where insurance comes in. Although paying for insurance may be bothersome, and researching various plans for different scenarios is difficult and often complicated, you’ll be thankful for a solid safety net when an unpredictable event happens.

What is insurance?

Insurance is where a company or government agency provides protection against some type of loss, such as damage to property, or surgery to correct a health problem, in return for a payment, called a premium. The idea behind insurance is that you are protecting yourself against any future uncertainty. It is more likely than not that you will need to use your insurance plan in the future, so ensuring that you are protected from the unpredictability of life is important.

Insurance Vocabulary

When talking about insurance, there are many vocabulary words that you may not know. This section will define some of those terms.

Deductible: The amount of money the insured person needs to pay before the insurance company starts to pay for the loss experienced

Premium: Amount of money paid for an insurance policy

Co-pay: A fixed amount the insured pays for covered services (usually only applies to health insurance)

Types of Insurance

There are many types of insurance, but I will be talking about the most important types in this sections.

Life Insurance

Life insurance is important especially if you have a family. It can replace lost income, pay for your child’s college education, and help pay debts for your family after you die. If you’re single, life insurance can pay debts you leave behind and pay for your burial.

There are two types of life insurance, term life insurance and permanent life insurance. Term life insurance is a policy where you pay for a certain amount of time. Permanent life insurance is where you have to pay for your whole life. Term life insurance is more flexible while permanent life insurance has an investment component. Most people have term life insurance as it is much more affordable. You can learn more about term life vs permanent life insurance here. Remember, life insurance is cheaper when you are younger so don’t wait until you need it to get it. You are more of a liability to the insurer as you age.

Health Insurance

Health insurance is very important because if you suddenly fall sick or obtain an injury, health insurance is what pays for your treatment at the hospital. If you don’t have health insurance, you may find yourself unable to receive treatment at the hospital. Furthermore, medical debts are responsible for nearly half of all bankruptcies in the United States.

Unfortunately, health insurance is expensive, and has continued to increase in price. However, that is not an excuse to not get it. If you don’t have health insurance through your employer, one option is for a high-deductible health insurance plan combined with a Health Savings Account (HSA), a tax-advantaged savings account specifically for paying medical expenses. Benefits of having a HSA are tax-free growth, tax deduction, and tax-free withdrawal. You can also explore the federal healthcare marketplace or even buy your own health insurance. Although buying it yourself may seem more expensive, if you’re self-employed, health insurance premiums count as a tax deduction.

Automobile Insurance

Everyone needs auto insurance as it is against the law not to have it. It also covers a very expensive asset that most people do not want to lose. Besides covering the car, auto insurance can also help pay medical and legal defense expenses. Auto insurance has different types of coverages. Liability coverage will cover the cost of injuries or property damage you caused in a collision to the other car. Collision coverage covers the cost of damage to your own car. Comprehensive coverage covers the damages caused to your car that are not from a wreck, such as fire, theft, or vandalism. The level of coverage one needs depends on the type of car, and the price of auto insurance will depend on where one lives, their age, and driving record.

Homeowners/Renters Insurance

If you have a mortgage, homeowners insurance is required. When you borrow money from a bank, insurance premiums are typically built into the mortgage payment. Property is usually a person’s greatest asset so it is important to keep it insured. Additionally, homeowners insurance can include extended dwelling coverage. This means that the insurance company will replace or rebuild your property even if the cost is higher than your insurance policy. They’ll usually pay about 25% higher than the amount you are insured for. If your property is of very high value, extended dwelling coverage is something you should look into. You should also make sure that your homeowners insurance includes floods and earthquakes, as not all insurance policies do. You can check with your insurance agent regarding your insurance policy.

If you’re a renter, you might be thinking “Great! I don’t need to pay homeowners insurance!” However, you still have to pay insurance, just a different type, called renters insurance. If there is a burglary or a fire, renters insurance will cover most of the replacement costs.

Long-Term Disability Insurance

Long-term disability insurance covers the loss of income that will happen when you are unable to work for a long period of time due to illness or disability. Although you may believe that you will never get disabled, statistics show that 30% of workers entering the workforce will become disabled and unable to work before they reach retirement. This means that you should definitely have long-term disability insurance just in case. Otherwise, you may not be able pay for your kid’s college or buy a car. Even if you have great health and life insurance, without long-term disability insurance you may find yourself unable to cover living expenses if you can not work for an entire year. Many employers offer long-term disability insurance as well as short-term disability insurance. However, you can skip on the short-term disability insurance if you believe you can cover your living expenses for a few months.

Steps for Choosing and Maintaining Insurance

Most Americans get insurance from the company they work in. You should check with your employer as that insurance is usually the most affordable. However, if you are currently unemployed or want to explore more options, this is how you should pick your insurance.

  1. Speak to an insurance agent
  2. Consider the co-pays, deductibles, premium costs, network coverage and covered expenses to determine which plan saves the most money by doing research on the internet (there are various sites and online resources to do this)
  3. Calculate effect of new premiums on your spending and disposable income
  4. Constantly monitor whether or not your insurance is adequate for your current scenario

Conclusion

Insurance is very important to your financial well-being. You should definitely have the five types of insurance that are covered in this article. However, you can also invest in more types too, such as pet insurance or long-term care insurance. Although insurance may seem very expensive, you will feel grateful to have it when something happens. Never skip having insurance, as it is a crucial tool that ensures your protection in the future.

Seven Things Students Can Do to Guarantee Future Financial Success

Seven Things Students Can Do to Guarantee Future Financial Success

For many students finishing up high school and heading to college, the prospect of planning for your financial future might seem intimidating. Between taking steps towards financial independence and learning how to rely on yourself as a primary income source, trying to navigate the world of money and finance for the first time can be overwhelming. Fortunately, we have compiled a list of seven things you should be doing as you head into college to ensure the financial security and success of your future.

1. Budget Your Income

One of the easiest and most often overlooked steps towards financial security is creating and sticking to a budget. We often hear about corporate and government budgets, but for an individual, budgeting simply means creating a financial plan for how to allocate future income and handle anticipated expenses. Setting up a budget early on is critical in helping you meet your financial goals and making sure that you always have enough money for your non-discretionary expenses. Another thing to keep in mind when creating a budget is thinking about both short term and long term financial goals, as the failure to acknowledge them both can be problematic.

Simply creating a budget is only half the battle. Once you have established your financial goals and designed a budget that will help you meet them, it is important to learn how to stick to your plan. In today’s world, there is no shortage of tools that can be used to aid you in this. From spreadsheet programs like Excel or Google Sheets to track and manage expenses, to new budgeting applications like Mint, Pluto Money, or PocketGuard, you can experiment with different methods of sticking to your budget to figure out what works best for you.

2. Prioritize Your Spending  

Along with creating a budget, comes the ability to learn how to prioritize your spending. This means creating a list of your monthly expenses. Once you have established a list of all the different ways you are allocating your money, you should go through the list again and classify your expenses as either necessary (bills, rent, food, transportation, savings, etc.) or discretionary (all other non-essential expenses). If this still seems complicated, think about as a way of sorting your expenses into wants and needs: what payments are absolutely critical and where do you have unnecessary financial leakages? Learning to evaluate your spending and cut back on discretionary expenditures can help you grow your savings and ensure a more promising financial future.

3. Pay Yourself First

As you learn to prioritize your spending, your number one financial priority should be paying yourself first. Even before allocating money to cover your necessary expenses like food and transportation, set money aside for savings. Learning to save your money early on is one of the simplest and most powerful ways of building wealth and creating financial security, and yet many people never learn this critical skill. The alternative— saving what is left over after your monthly spending— is not nearly as effective, as much of the money that might have been saved earlier on will go to discretionary spending. If you are unfamiliar with how to best safeguard this saved money, there are a number of savings vehicles you can familiarize yourself with, such as high-interest savings accounts or retirement savings plans.

4. Build Credit

Like with savings, it is important to start building credit early on. Often, young people share the common misconception that establishing good credit is only useful for significant far-off purchases, like buying a home. While good credit is certainly important when buying a home, it is also something that is very applicable for college students. For instance, student loans can affect both your credit report and credit score. Although student loans have the potential to impact credit negatively, if you are informed and actively work to build good credit, they can be an opportunity to build a history of positive credit. So how do you establish credit anyways? Building credit doesn’t happen overnight, but if you are diligent and make sure that all of your payments are done in full and on time, you will be in a good position. It can be tricky to build your credit up from scratch and it’s often said that it’s easier to damage your credit then build it back up, so it’s important to develop good credit habits early on.

5. Don’t be Afraid to Take Risks

So far we have discussed the many steps that you can take to ensure the security of your financial future, but it is also important to learn how to take risks. Although your youth is a good time to start saving and establishing good credit, it is also the best time of your life to take financial risks. In comparison to older and middle-aged adults, there is a lot less at stake and a much greater payoff from taking financial risks in your youth. That being said, in order to ensure that you can be in a position to take risks with your money, you should make sure that you have covered your bases in other ways (like, as mentioned earlier, by establishing credit and building savings).

6. Improve your Financial Literacy

The best way to guarantee that you are setting yourself up for future success is to make sure you are making informed decisions about your personal finances. If even the mention of building credit and sticking to budgets seems overwhelming, the best thing you can possibly do is to start learning about how to handle your money by starting with some of the most basic concepts in finance. Improving your financial literacy doesn’t have to be difficult, and in fact, if you have an open mindset, it can be very fun and rewarding. You can start by checking out some of the other lessons on our website!

Even if you feel like you already have a good understanding of personal finance, don’t let that be an excuse to stop educating yourself. To have a good sense of how to manage your money, you need to not only understand the basics but also be able to keep up with the ever-changing nature of markets, economic trends and the publications of new research and emerging theories.

7. Invest in Yourself

At the end of the day, the most important thing that you can do to ensure a successful financial future is to invest in yourself. Learning to take care of yourself and maintain healthy habits with regard to exercise, sleep, nutrition, and mental health is a necessary skill that often goes overlooked. Earning capacity tends to increase as you continue through life and more opportunities and prospects will open as you advance in your career, but you will only be able to enjoy these benefits if you are in good health.

It is also important to prioritize your education, to ensure stable employment and financial well-being in the future. Investing in a college education may be the best decision for you, even if that means taking on debt. Prioritize the educational opportunities that you feel will best benefit you in the long-run.

Instead of being overwhelmed by the growing financial responsibility that comes with graduating high school and starting college, by making use of some of the aforementioned tips, you can use your youth to your advantage.

Additional Sources:

https://www.thebalance.com/financial-tips-for-high-school-graduates-4140397

https://www.forbes.com/sites/kathycaprino/2014/08/21/7-simple-steps-college-students-should-take-to-build-financial-literacy-and-responsibility/#7498717025bb

What’s a College Degree Really Worth?

With admissions rates dropping and college tuitions rising, making decisions about which college to attend or what to study can present students with a difficult set of challenges. Often, labels of prestige and other societal preconceptions can overwhelm the decision making process. Fortunately, there are a number of tools that students can employ to help facilitate these choices, especially with regard to personal finance. In this lesson, we will analyze the different postsecondary steps for students and the economic impact they might have on one’s future. For many students, college (or other post-secondary paths) is the first time they are given significant financial responsibility for their future, and it is therefore important that students recognize this responsibility and make well-informed decisions.

Is going to college even worth it anyways?

Reliance on one’s conventional wisdom might make the answer to this question seem obvious: of course college is worth it. For decades, a four-year university education has been the unquestioned next step to financial security and personal success. Those who attend college will have better opportunities, greater employment prospects, and earn more money, right? Well, kind of. A college education is undoubtedly beneficial, and it is true that college graduates face much lower rates of poverty and unemployment than their peers that lack four-year degrees. Yet in recent years, this same conventional wisdom that a college education guarantees success, has also come under fire, with some arguing that the economic benefits of college are often overstated, and failing to account for delayed graduation, drop out rates, and much more.

In economics, we often study opportunity cost, which is the forgone benefit of the next best alternative. This concept can be directly applied to the question of whether or not it makes sense to attend college. Students should ask if the benefits of a college degree, when coupled with astronomical tuition prices and burdensome student loans, outweigh all the alternative paths a student could pursue with the same money and time. The answer to this question is by no means uniform. For many students, a four-year university education is the safest and best choice. Between scholarships and financial aid to combat the price tag, the security of college guarantees the future that many aspire for. For others, an associates degree can be the perfect way of combating the economic and time constraints of college. And in the very rare cases of those such as Bill Gates and Mark Zuckerberg, a revolutionary idea and an ability for hard work can outweigh the cost of college. Regardless of the decision you make, analyzing the opportunity cost of your choice will help ensure that you have made the best decision.

So how do I decide which college to attend?

Let’s say you fit in with the majority of current high school students that make the decision to attend a four year college. Whether you are deciding which schools to apply to, or have already applied and are trying to figure out what school to attend, such decisions can seem incredibly daunting. Unfortunately, in the hypercompetitive world of college admissions that we live in, a student’s election of educational institution is often clouded by prestige. Recently, however, more and more people have been questioning whether it matters what school a student goes to.  And while what a student does in colleges is much more significant than the specific institution they attend, the school itself is certainly remains important. So how can one best evaluate their options for college and decide which school to attend? Although conventional measures of choosing a college, such as location, size or general atmosphere, remain a necessary means of analysis, it’s also important to evaluate an institution from a financial perspective. This analysis is different for all students, and depends on both a student’s motives for pursuing secondary education and their plans after college.

For those that are interested in obtaining a four-year degree with the intention of immediately entering the labor force upon graduation, gauges such as starting salary level or job earning potential can provide important insight. Many schools publish statistics showing the employment statistics of their alumni. These statistics are a valuable source of information for a potential student. Specific indicators to focus on include the average salaries of graduates upon entrance to the labor force, the average maximum income or earning potential of alumni, and the relative employment rates of graduates in comparison to the rest of the population.

What should I study?

Not only is it valuable for students to evaluate how a specific institution may impact their financial prospects, but it is also helpful for students to think about the area they plan to study. Of course, the highest priority for a student choosing a major or area of study should be to pick an area of interest and genuine passion. Yet while it is important for students to study areas that interest them, it is also critical that students understand the ever-changing nature of the job market. With the continuous technological advances in areas such as automation and artificial intelligence, the job market even ten years from now, will be greatly different from how it is today. In fact, a recent report from McKinsey found that roughly half of current jobs could theoretically be automated. The increasing automation of many modern jobs means that future employment opportunities will require creativity, complex problem solving, critical thinking, and emotional intelligence in greater demand than they do today, while jobs in areas that are easy to automate will continue to become increasingly obsolete. It is therefore important that students are cognizant of how the areas they study and the careers they desire will be affected by automation.

What if I want to continue education after college?

Many students choose to continue their education after college, whether that is by enrolling in a program to obtain a Master’s degrees or by going to Law or Medical school. Although this may seem far away for students making decisions about their undergraduate studies, the intention of continuing education beyond a four-year college degree should influence a student’s undergraduate choice. For example, students interested in either continuing on to graduate programs or following a more academic path may be attracted to accessible research opportunities during their undergraduate studies. Students can analyze the schools with the best opportunities for research by looking at the amount of research funding that schools receive from the federal government, as well as by analyzing an institution’s budget and spending. Schools that prioritize spending on aspects such as new athletic amenities and housing might not have as strong of research opportunities as those universities that allocate a greater amount of money to funding research projects and initiatives. Another way of analyzing the quality of an undergraduate program with regard to plans of future graduate studies is by looking at an undergraduate institution’s acceptance rates to graduate programs, and the subsequent success of the students that enroll in said programs. This helps illustrate the degree to which an institution prepares its students for further studies. Finally, those students interested in continuing formal education should be aware of the additional costs that they might incur.

How do I pay for all of this?

Another important thing for many students to consider are financial aid and scholarship options. The price tags of American universities are astronomically high and can present a significant financial burden for many students. So far, we have talked about ways to maximize benefit by choosing an institution that provides the best value for students, but we can also look at how to minimize cost and most effectively finance secondary education. The world of financial aid is complex and deserving of its own article, but fortunately, there are many resources available for students. The Federal Student Aid office of the U.S. Department of Education offers a substantial amount of information for students about paying for college, as well as pointers to other pages that might serve as interest. Additionally, many online databases provide a large set of scholarship opportunities.  

In Conclusion

In this day and age, students are often attracted to institutions for the label of prestige that they represent. While the prestige an institution is associated with is not unwarranted, an analysis of the aforementioned factors can help students determine the best path to pursue with their post-secondary plans.

Interesting additional reading:

https://www.bls.gov/careeroutlook/2018/data-on-display/education-pays.htm

https://www.wsj.com/articles/the-right-way-to-choose-a-college-11553266896

Mitigating the Effects of Inflation

If you have ever held on to money for an extended period of time, you may have noticed the money being worth less. Perhaps you were saving money to buy a new phone, but when you checked the price again it went up by twenty dollars. Perhaps you noticed that, although your wages went up, prices increased much more dramatically. This is because of inflation. In this article, I will talk about what inflation is and how it affects people.

What is Inflation?

Inflation is a sustained increase in the price level for goods and services over a relatively lengthy period of time. The target inflation rate for the economy is 2%. If the price level only increases for a short period of time, that is not inflation, as inflation occurs over an extended period of time. An example of inflation, as shown by this calculator from CNN, is how $2000 in 1957 would be equivalent to $16,634 now.

You may have heard of Venezuela, the South American country, known for its political upheaval and hyperinflation. Venezuela is currently dealing with the effects of unrestrained, uncontrolled inflation. The economic situation is spiraling out of control. According to the IMF, cited in The Washington Post, “Venezuela’s hyperinflation is poised to reach an annualized rate of 1 million percent by year’s end.” To put the sheer magnitude of that inflation rate in perspective, locals sell artwork made up of thousands of Bolivar notes because they are essentially worthless. In the United States, the government and the Federal Reserve are responsible for preventing hyperinflation through fiscal and monetary policy.

How Inflation is Tracked

Inflation is tracked through the Consumer Price Index (CPI). The CPI tracks the changes in the cost of living over time.The CPI is a major index and is the one used by the government. Since the CPI calculates inflation, the government can use it to determine the economic policies needed to prevent inflation. Inflation is also tracked through the GDP Deflator, which is used to deflate the GDP to base year prices, indicating real output.

Each year, the inflation rate is an important factor for the government and other agencies tasked with protecting the economy, particularly economic advisors in the White House and the Federal Reserve. Inflation can often dictate whether or not the economy is overheating, and if necessary fiscal or monetary policy actions must be taken.

Inflation Effects on Borrowers and Lenders

Let’s say you take out a loan on a fixed interest rate. You expect the inflation to be 3%, but it actually is 5%. If you are the borrower that means that the amount of money you have to return is worth less, so it benefits you. However, if you are the lender, the amount of money you get back is worth less than the original amount so it is detrimental towards you. Similarly, if the expected inflation rate was at 3% but the inflation turns out to be 1%, the borrower would have to pay back more than he or she borrowed, benefiting the lender but not the borrower.

What truly matters is your real interest rate, which is the nominal rate adjusted for inflation. If there is more inflation than expected, the real rate decreases, and the borrower ends up owing less. If there is less inflation that expected, the real rate increases relatively, and the borrower ends up owing more. The lender receives a high payment than before.

How Inflation Affects Individuals and How to Protect Yourself

Inflation commonly affects people’s savings. Suppose you decide to save $100 and put it in a cupboard in your house. If the inflation rate is 2%, then a year later you would need $102 to buy the same amount of goods $100 would buy the year before. As a result, individuals should invest their savings so that their purchasing power will not decrease. Many investments will rise with inflated prices. There is an opportunity cost to not putting your money to work.

Inflation especially affects retired people, as they will not be receiving additional income anymore. According to Poonkulali Thangavelu from Investopedia, you can safeguard your money by investing your money in Treasury Inflation-Protected Securities, stocks, or mutual funds. Although those are riskier than a savings account, you are able to get a higher return. Furthermore, consumers should know that inflationcompounds when trying to calculate the inflation for the future.

In order to further protect yourself from inflation, you can invest your money into real estate. However, you should realize that you need to hold onto real estate for a couple years in order to see the prices increase by a sizable amount. Furthermore, you can invest your money into real assets like gold. You should also make sure that you are protecting your savings and getting the best interest rate from savings accounts and investments. If you manage to find a good deal, your money could have a higher interest rate than the inflation, causing your money to have more purchasing power over time. You want to avoid having your money depreciate. You should also attempt to hold a job where your raises increase at a faster rate than the inflation, through negotiating wages that reflect expected inflationary prospects in the future. If this is the case, then you will not succumb to inflation and you will preserve the purchasing power of your money at the same level or higher than before the inflation.

Final Thoughts

Next time your wages go up, think about if you really got a raise. If the price level in the economy increased by 5% but your wages only went up 3%, your money is worth less and you have less purchasing power. Make sure to see if your real wages went up, not only your nominal wages! Hopefully this lesson will have made you more educated in making borrowing and lending decisions. There are important steps that you can take to protect against inflationary pressures that have the potential to devalue the purchasing power of your money. Inflation an important macroeconomic concept and one that needs to be understood in order to make educated consumer and financial decisions.

The 401(k): How to Save for Retirement

The 401(k) retirement account is one of the best ways to save for retirement. Unfortunately, living off Social Security just isn’t a reality for everyone, so being able to understand how to use retirement accounts to its fullest is crucial. In this article, I will detail what a 401(k) is, a little bit about the types of 401(k)s, benefits and limitations, and strategies.

What is a 401(k)?

A 401(k) is a type of retirement account that is employer-sponsored. A 401(k) plan is employer-sponsored because it is only offered to employees. This is because money can only placed into your 401(k) account from your paycheck, and some companies offer “matching contributions,” but it is capped to a certain percent. For example, if you are making $100K a year and your employer offers a 3% match, this means that if you choose to allocate $3000 a year from your paycheck to your 401(k) retirement account, your employer will give you another $3000. If you want to put any more than $3000, that’s fine, but you won’t be receiving any more money in the form of an employer match because that would exceed 3%. This percent varies at every company, and some companies may not offer any matching contributions at all.

Traditional 401(k) vs. Roth 401(k)

There are two types of 401(k)s, the Traditional and the Roth. The biggest difference between the two is that the Traditional 401(k) is tax-deferred. This means that you pay taxes on the money after you withdraw from the account, as opposed to before you put the money in the account in the first place. This means that you are paying taxes on both your principal and the compounded interest gained during the time you made contributions to the time you withdraw. The Traditional 401(k) is more common.

The key difference with a Roth 401(k) is that you are not taxed on the money you withdraw. Your contributions can only be made with the money you have after paying income taxes. So this means you don’t pay taxes on any of the money you made while your money was in the account. It is a subtle, but very important distinction. This is very very good, because it means you are losing money to income taxes only on your principal, and not everything you earned in the decades of compounded interest that took place while getting to retirement.

You may be thinking that the Traditional 401(k) sounds pretty pointless if the Roth 401(k) is so similar, yet is not tax-deferred. However, you have to make your decision based on whether or not you think you will be in a higher tax bracket in retirement than you are right now. If you will likely be in a higher income tax bracket in retirement, you would want to pay the taxes now, rather than later, to pay less taxes. If not, you would want to opt for the Traditional 401(k). In general, more companies will offer a Traditional 401(k) than the Roth, and individuals will use a combination of Traditional 401(k) and a Roth IRA to set up for retirement, which we will discuss at length later on.

Limitations

There is a caveat to the 401(k) plans. Each 401(k) plan has their own tiny little details and such, but in general, you can technically withdraw from your 401(k) retirement account at any time, but you may be subject to a 10% penalty if you are not at least 59.5 years of age. For the Traditional 401(k), this means you’ll be paying income taxes on your withdrawal and another 10% on that! 10% is a lot, so it is a really bad idea to withdraw from your account before you are 59.5 years old. There are some exceptions, like disability or emergencies, but that varies by plan. As of 2019, there is an annual contribution limit of $19,000 for individuals under 50, and $25,000 for those over 50 years of age. The big idea is that you should expect to put your money away for good, until you are about 60 years old.

Common Strategies

First off, it is best to invest as much as your employer matches, assuming that there is a match. A match effectively doubles your savings! While most people would call it free money, some actually see it as part of your compensation package. More employer benefits means less base salary; perhaps at another company that does not offer a match, you could be making more money. So in a way, not contributing to your 401(k) to fully utilize the employer matching contributions is similar to leaving money on the table.

Although a Traditional 401(k) is tax-deferred and technically not as preferrabe as a Roth IRA in that sense, the match makes the Traditional 401(k) a must. If you still can contribute to retirement accounts after making contributions to your Traditional 401(k), then start contributing to your Roth IRA. This is because putting more money into your Traditional 401(k) reaps no more matching contributions as you’ve hit the percentage limit, so the Roth IRA, with its tax-exempt withdrawal benefit, becomes more preferable. If you still have money after contributing to 401(k) up to the employer match and maxing out your Roth IRA limit of $6000, only then you go back to your Traditional 401(k). To learn more about IRAs, visit this article.

That was a lot. Here’s some numbers to see what it might look like in real life.

Let’s say you are making 100K a year(nice!), and your employer offers a generous 3% match on Traditional 401(k) contributions. This would be the strategy for most people:

  1. Contribute $3000 into your 401(k) to fully take advantage of the matching contributions. Your 401(k) is now at $6K, which is $3000 from you, and $3000 from your employer. Note that any more contributions will not be matched, since you’ve hit the 3% limit. That’s why we now move on to…
  2. Your Roth IRA account. The Roth IRA limit of $6000 is relatively low when compared to the 401(k) limit of $19,000 because it enjoys the tax benefit of not having to pay taxes upon withdrawal. So, max out your Roth IRA with $6000 of contributions. Since you can no longer put any more money into the Roth IRA, we now go back to the 401(k) account.
  3. With any remaining money you have left to contribute to your retirement account, which will vary with your own personal budget, place it in your Traditional 401(k). Based on our initial contribution of 3K back in Step 1, the max amount you can contribute at this point is $16,000 because you would then hit the 401(k) limit.

Essentially, it boils down to:

  1. Traditional 401(k) up to however much your employer matches, because you don’t want to leave any money on the table. Skip this step if your employer doesn’t offer a match.
  2. As much as you can into your Roth IRA, because tax-exemption on withdrawals is a massive benefit.
  3. Back to Traditional 401(k).

Retirement accounts are preferable to having plain cash in your savings account because you can use the money in your retirement accounts to invest in stocks, bonds, ETFs, and other financial instruments. That’s why we go back to the Traditional 401(k) in Step 3 after maxing out on Roth IRA contributions, even though we no longer get the matching contributions from an employer. The idea is to let that money accumulate for decades, up until you start withdrawing from those accounts to retire. With retirement accounts, those investments allow for compounded interest, which is extremely powerful and is discussed here. If you were to leave money in your savings account instead, not only would you be losing out on the money you could have earned in returns from investing, you are also losing money due to an average annual inflation rate of 3%. Most people use 8% as an estimated average ROI in the stock market over long periods of time, which means that you can either invest with money in your retirement account to make average real annual returns of 5%(8% returns – 3% inflation), or put it in a savings account, losing 3% per year due to inflation.

Ok, so we’ve established that retirement accounts make more sense than letting money sit in a savings account. Right now, I hope you’re asking yourself this: “Why should I use retirement accounts instead of a regular brokerage account that can also invest in investments like stocks and bonds?” If you are, then you are asking the right questions, which is 50% of the way there. If not, that’s fine too. This is the point of reading Financial Literacy Journal articles: to build a sense of financial literacy, which allows for better decision making.

The reason we want to invest in retirement accounts over regular brokerage accounts, when each can invest in the stock market, bonds, and other investments in the same way, is twofold. The biggest reason is that retirement accounts have massive tax-benefits. These benefits exist because the government wants to incentivize retirement investment so that you are better off, leading to less people that need to request for government welfare to retire. For one, 401(k) contributions are tax-deductible. This means that if you make $100,000 and you put aside $20,000 per year into retirement accounts, you are only taxed by the government on that $80,000 remaining! A 401(k)’s tax-deferral status is also a huge tax benefit. This is because you are only paying taxes upon withdrawal, somewhere around 60 years of age. With a regular brokerage account, you would have to pay taxes on each year of returns that you made by investing in the form of capital gains! Long-term capital gains rates can reach as high as 20% too, so even if you hold a stock over a long period of time, the returns will be taxed. Tax-deferral allows for your savings to grow much faster because your money is allowed to stay in that account to continue growing, rather than be subject to annual taxes on the money you made through investments. For a Roth IRA, the tax benefit is that you do not need to pay taxes on the money you withdraw. However, you may only contribute with post-tax income, any money you have left after paying taxes. This is very good because it is much better to pay taxes on your just principal, which would be a smaller amount than your principal plus decades of compounded interest.

The other reason is psychological; contributions made into retirement accounts are easily set up to be automatically done from your paycheck every month, and the 10% penalty of withdrawing from retirement accounts before 59.5 years of age is a huge mental deterrent. This makes for a much more painless way to contribute, and keeps you from picking away at your account.

Final Thoughts

By now, what a 401(k) is and why we use them should start to make sense. Don’t be discouraged if you aren’t getting 100% of this immediately. This was a dense article. However, these ideas and strategies are extremely important to know, even if you’re not currently employed – understanding retirement strategies is one of the biggest components of financial literacy. I highly suggest you to bookmark this article and reread this at a later time. Financial literacy is all about setting yourself up in a mindset to ask the right questions and make the right decisions in order to build wealth and reach financial independence. With knowledge of the 401(k) retirement account and its strategies, you will be able to set yourself up for a comfortable retirement.

Marginal Tax Rates: How Do They Work?

With tax season quickly approaching, many Americans are yet again faced with the daunting task of filing their returns. Taxes are nearly always given a bad reputation, for their confusing nature and because of the incredibly mysterious tax laws that the United States currently has in place. However, understanding the tax system of one’s country is one of the most important ways to be financially literate and responsible. By understanding the tax laws, you are able to potentially save money and regulate your spending so you know what to expect each year when it comes time to deal with the IRS.

In this article, I will explain a particularly confusing aspect of income taxes – marginal tax rates. There are many misconceptions, especially with regards to income taxes, as the United States taxes different income brackets at different rates. This may seem difficult to understand at first, but it will become clearer soon.

How does the marginal rate tax brackets work?

The 2019 tax brackets with marginal rates listed in the left-hand column

As of 2019, the tax brackets for earned income are shown above. For the sake of simplicity, only focus on the “Single Filers” column on the left (the “Married Filers” column on the right simply means that a married couple is filing their taxes jointly as one income, so they get lower tax brackets). To file as a “Single Filer” means that an individual is eligible to file as a single person in the eyes of the IRS.

As you can see, there is a “Rate” on the very left, with tax rates up to 37%. This is the marginal tax rate. For each rate bracket, you owe that given rate on the income that is specified for each bracket. This will make more sense in one moment.

View the 2019 federal income tax brackets here

Example

Suppose you have an annual taxable income of $50,000, and you are filing as a single filer. Note that we are ignoring deductions and other factors that could potentially decrease your federal income taxes owed, such as a standard deduction of $12,200. To find your total federal income tax owed, first check to see where you fall in terms of the highest marginal rate. Since the annual taxable income is $50,000, you would find that this corresponds to a top rate of 22%, for incomes between $39,476 and $84,200.

To find the federal income tax owed, first we deal with the first marginal rate of 10%. This rate applies for income from $0 to $9,700. This means that your first $9,700 earned is taxed at a rate of 10%. Thus, the total federal tax income owed for this tax bracket is 10% of $9,700, or $970. Next, we will go to the 12% bracket. Here, all income from $9,700 to $39,475 is taxed at the marginal rate of 12%, meaning our next $29,775 earned is taxed at a rate of 12%. Thus, we owe 12% of $29,775, which is $3,573 for that bracket. Finally, we are at the top bracket. Here is where it gets complicated. Since we earn only $50,000, we are going to be paying the rest of our income at a top marginal rate of 22%, even though this bracket goes all the way up to an income of $84,200. Since there is only $10,525 left to be taxed, this $10,525 is taxed at a rate of 22%. Thus, we owe 22% of $10,525, which is $2,315.50 for that bracket.

Finally, we add all of the taxes calculated up to find the total federal income tax owed. This is $970 + $3,573 + $2,315.50 = $6,858.50, so your total federal income tax owed is $6,858.50.

Common Misconceptions

Not surprisingly, there are many misconceptions about marginal taxes. You may hear people say “I paid a 35% federal income tax this year.” This statement is misleading, as it may lead you to believe that a 35% rate was paid on all taxable incomes. This is not true. This was simply the highest marginal rate that could be taxed with that person’s income.

As you can see from the example we did above, the total federal income tax owed was $6,858.50. Dividing this number by $50,000, our income, would give us a percentage of 13.7%. If the hypothetical taxpayer in this scenario were to say “I paid a 22% federal income tax this year,” referring to the top income bracket in which they owed taxes, they would be misleading you. Their “effective tax rate” was really only 13.7%, much less than 22%.

Final Thoughts

If you are a taxpayer, it is important to understand the tax laws, and how your taxes work. If you fail to understand what you owe, you will be confused, and may fail to spot deficiencies in your annual calculations, owing more than you actually should.

How to Get a Mortgage Loan

Getting a loan is one of the most important things in the life of an adult which the US education system has failed to teach its students. It allows us to set up our lives without having the money to do so. In this article, I will try to talk you through, step-by-step, getting a fixed interest rate loan for a house, and after you have finished this article, you should know everything you need to know about the loan process.

The Five C’s

The traits that determine whether you are approved for a loan is Credit, Capacity, Collateral, Capital, and Conditions.

Credit is the most important trait. It measures your history of paying your financial obligations; when you pay all your debts on time, every month, your credit rises, but if you fail to, your credit falls. A credit score of 760 is excellent, and you will struggle to get a loan with a credit score under 630. In addition, if you have very low credit, you will be unable to pay the loans you can’t make, making raising your credit impossible. As a remedy, you might cosign with someone with a higher credit score which will increase the likelihood of approval of the loan.

The very important 5 C’s of credit

Capacity is your ability to pay back the loan; it is mainly measured by your Debt to Income Ratio (DTI). Banks determine DTI by taking all necessary spending, like loan payments and rent, and dividing it by the client’s monthly income. The lower the DTI, the better; Generally, you should try to keep it under 35% which would put you in the top category for loan officers.

Collateral and capital both essentially mean assets, but collateral is assets which you ensure your loan with, while capital is assets which you can use to help pay the loan. As a result, if you are unable to pay the loan, your collateral might be seized, but putting up collateral is critical to securing a loan.

Conditions are all other external factors. They can include your plan with the money, the amount of money, the economy’s health, and even your history as a customer. These weigh less than the above values.

A more in depth explanation of the critical characteristics are on most bank sites such as here

Application

The first step of actually securing a loan is the application. While applications vary bank by bank, they all require the same things: your name, phone number, social security number, annual income statement, your bank account balance, and equity. In addition, you will fill out the amount of money you request and the time period you will pay it off over, but these are both subject to change. With the application, you will also need to pay an application fee, which ranges from zero to several hundreds of dollars for house loans, dependent on the bank.

All this information will go to a loan officer. Their job is to check the accuracy of all the submitted information by going over your pay stubs, loan payments, bank statements for the last 60 days, and 2-years worth of tax returns, all provided by the applicant. As loan officers earn a commission on loans, they often support the applicant when in negotiation with the underwriter.

Approval

The underwriter is the “gatekeeper” of the loan. They decide who gets approved and who gets denied. They decide based on the 5 C’s, which includes credit. For the underwriter to check your credit, they will need to contact credit agencies, which costs money. The bank charges you the fee, which is usually around $25.

To preserve his impartiality and thus profitability for the bank, you will not be able to speak with your underwriter. Instead, your loan officer will try to convince the underwriter, as he earns a commission, but his ability to change the outcome of the review process is very limited; The underwriter judiciously reviews the raw documents and values and makes the decision.

Negotiation

Negotiation is a misnomer; in reality, your power to affect the deal is very limited unless you are a serious investor who can bring significant business, in which case you can leverage the future loans you will make.

Your credit score is important for getting a good loan

Firstly, interest rate is heavily reliant on your credit. If your credit is high, it is low, and if your credit is low, it is high. Additionally, the length of the loan and amount affects the interest rate; The larger they are, the more you pay.  As an aside, you may get offered the option of a percent buy. A percent buy is the option to pay money at the start of the loan to lower the percent interest. While it depends on your situation, if you plan on paying it over 4 years, you should take the option. From the values above, a formula is used to calculate the obligatory monthly payments; there is no leeway in negotiating this. For a more in-depth explanation on the factors that determine your mortgage interest rate, see here

While you determine the general length of the loan, the amount loaned is based on your down payment and the appraisal of the house. The required down payment depends in large part to how many houses you already on. On your first house, with assistance by the government, you may not have to put any down; on your primary residence, you will usually have to put down 10 to 15 percent of the value of the house, and on investment houses, you will usually have to put down 20 to 30 percent. The value of the house is not determined in negotiations; rather, it is decided by the appraisal process. The bank will arrange for an third party appraisal company to decide on a value of the house. The cost of the appraising is charged to the person seeking the loan and usually is around $1,000.

Another significant cost is the escrow payment. Essentially, it is money taken from you when you get the loan to pay for future expenses. Most commonly, banks will take half a years worth of property tax and insurance. The reason banks do this is to ensure you’re irresponsibility doesn’t cost the bank by missed payments.

The greatest and least known cost is hiring a title company. Title companies make sure the current owner of a house is legally allowed to sell it. This is necessary because sometimes a house will be tied up in legal disputes and other people may have a legitimate claim against it, called a lien. Usually hiring a third-party company, which is required by banks, will cost 0.5 percent of the house’s value.

All these terms and costs will come to you in a loan disclosure document, which you must sign to move forward. It is not legally binding, but may be used as a record of agreement. After signing this document, the official legally-binding loan document will be drawn up. The bank may charge up to $1,000 as an origination fee for drafting the documents. You may back out of the loan as long as you haven’t signed the loan document, only losing the money paid in fees and possibly earnest money – a small amount of money paid to the house seller to reserve the house. Additionally, all fees – except for the credit check fee, the appraisal fee, and the application fee – will be collected when you sign the loan document. After paying the fees, signing the loan document, and transferring the down payment to the title company, you will then own the house; the bank will transfer the loan directly to the title company, who will send it to the house seller after taking its share. As a side note, the fees must be paid in cash unless you take some legal, but very uncommon steps.

Final Thoughts

Loans are complicated and take a lot of work. You should expect it to take around 45 days and cost close to $3,000 in fees, but it is all worth it if you use the money wisely. However, if you invest poorly or take loans from unsavory sources like payday loans or subprime loans, they may ruin your life. NEVER take money from these loan sharks; their predatory interest rates will destroy your financial situation for possibly many years.

I didn’t talk about business loans because they are much harder to get and far more uncommon; however if you are interested, you can expect them to cost substantially more and take substantially longer, all depending on the size of the company. As an alternative, most small business raise money either out of pocket or by private investors. I didn’t talk about car loans because they are far simpler. There is no title company, no appraisal, no negotiation. As soon as you’re approved, which takes no more than a day, you can buy the car. The fees will amount to about $100, but you will have to pay somewhere close to 30 to 50 percent of the value of the car as down payment if you use a legitimate bank.

What is Credit? Why is Credit Important?

Credit is an important financial concept that each and every individual in an economy must be aware of and understand. Whether you want to buy goods with a credit card, or want to be able to take mortgage loans from the bank so that you can buy a house, you must have a good understanding of what credit is, and ensure you keep your credit healthy. In this lesson, I will cover the definition of credit, where it is used, and why you must keep a good credit score.

What is credit?

In school, you may have heard of credit with regard to an assignment. A teacher may tell you “if you do not put your name on your paper, you will not receive credit for this assignment.” The teacher is willing to give you that credit, but is trusting you to do that assignment first. The teacher has to have a belief in you before you receive the credit.

The financial definition of credit is a little more nuanced and has a different conceptual meaning than the one you may hear in school, but the idea that trust and faith between two parties remains constant. When we refer to credit in the financial sense, we are talking about a certain level of trust or belief that one party will be able to repay a debt or a loan granted to them. This may sound complicated, but I will guide you through it.

Credit Cards

You probably know about credit cards, how they work, and when they are used. Credit cards are now the widely used method of payment for any consumer good, ranging from grocery store items, to gas, to retail purchases such as clothes. You may commonly see commercials for different credit cards, offering different benefits for using their card, such as cashback on purchases and loyalty rewards.

Credit cards rely on credit, as we have defined above, in order to be used and issued. Suppose that you want to get a credit card in order to buy goods. You will have to apply for the credit card through one of these companies. In order to be considered for the credit card, you will definitely need to have a good credit score.

Credit Score and How to Build It

Credit score refers to a number that a person is assigned based on how trustworthy they are regarding their payments on debts and loans. The credit score is calculated to reflect how well one can be trusted to be responsible for their payments. Credit scores are incredibly important for financial well-being and security. A FICO credit score is within the range of 300-850, but a good credit score is defined as being between 670-850. Based on statistics from Experian, only 66% of Americans have a good credit score or better.

A look at credit scores and what they mean for your finances

It is very crucial to maintain a good credit score. This can be done by ensuring a few things. Firstly, you must make sure to keep your spending under control. If you spend too much money, have to take out loans, and then can’t repay your debts, your credit score is going to be lowered permanently. Secondly, you must pay your bills on time and in an orderly fashion. Even if you have the money to settle all of your debt obligations, you must pay them in the first place. Forgetting to repay a debt can also permanently affect your credit score.

Why is credit important?

Once lowered, your credit score can put you at risk for financial downfall. Assuming you don’t have much extra cash for unexpected costs, you are at a great risk. What if your car breaks down? You can’t take out a loan, because your credit score is too low and banks don’t trust you to loan you money. As a result, you can’t drive to work. What if you are hit with unexpected medical costs that your insurance doesn’t cover? You are stuck in a hole. In order to truly maintain financial freedom, a healthy credit score should be one of your first financial priorities.

Top 10 countries based on their gross savings as a percentage of GDP

In today’s economy, especially in America, consumers save only 18% of GDP. America is a consumer society. In other countries, savings rates are as high as 40%. It is especially important to live below your means, so that your credit score and freedom will be preserved. Don’t get caught up in purchasing the new iPhone, or a new sweatshirt that you so desperately want but know you can’t afford. Although these concepts may not affect you now, it is good to start building healthy financial habits that carry on into the future.