Let’s face facts: Budgets kinda suck. They aren’t fun. They take time and effort to create and maintain. And, they typically cause so many of us to manage our finances completely backward. Maybe it’s time to ditch the budget. Maybe it’s time to pay yourself first.
Wait, what? Ditch our budget? Yes. Hear me out.
Traditionally, budgeters take their money and pay other people or entities first. That could mean the government through income taxation, social security taxes, property taxes, etc – or loan repayments, or monthly service fees, or anything else. Those things tend to come first. Then, whatever we have afterward becomes ours to do with as we please. To spend. To save.
This means our retirement comes in second (or third, or fourth) behind other people or entities – including our own spending.
When you pay yourself first, on the other hand, you flip the equation on its head. Paying ourselves first means we fully fund our retirement accounts before paying anyone anything…yes, even the government. And best of all, there is nothing illegal about it. It’s called a 401k (or a 403(b), or SEP IRA) plan.
These accounts let us take our own income and immediately contribute pre-tax money into a retirement account that will grow along with the stock market before the government gets its hands on our money. Amazing, isn’t it? And better yet, many corporations will match a certain percentage of your contributions. That’s free money!
And, that’s what “pay yourself first” means. You’re funding your future before forking out your hard-earned money to anyone. In essence, you are pre-paying your retirement expenses now. And, you aren’t paying a single penny in taxes until you withdraw that money later in life. Even better: pre-tax accounts reduce your taxable income as well, which cuts the amount of money you’re required to pay to the government.
Such a deal!
It’s not just about your 401k, either. Roth IRAs are a pretty sweet deal as well, which requires that we pay taxes now but allows us to withdraw tax-free in the future when we actually need the money. We fund Roth IRAs with post-tax money. But, they are still a good deal. No tax later!
How much money do we pay ourselves?
Opinions on this question are varied, but I like to set the minimum threshold at around 15% of your income. That doesn’t necessarily mean that you should go into work tomorrow and immediately increase your 401k contribution to 15%. It’s okay to do this gradually. If you aren’t saving anything, start with just one or two percent, then increase it over time.
Save as much as you can. Before my wife and I quit our full-time jobs, we saved a whopping 70% of our combined income. We did this by maxing out our 401k and Roth IRA accounts. We also opened a Vanguard Brokerage account and funneled money into it. Lastly, we opened an Ally savings account to build up a sizable liquid asset collection of money. In other words, money that we can get at quickly and easily. We have three years of living expenses saved in an easily-accessed savings account.
But, this took time. Saving money in general always takes time. Once you begin paying yourself first, your lifestyle will adjust accordingly. Soon, you won’t need that additional money to feel happy or satisfied.
Do these four things to begin your savings adventure:
If your employer offers a 401k retirement account, use it! If they match a percentage of your contributions, contribute at least this much. This is 100% free money. No gimmicks. No exceptions. Matched contributions amount to extra money for your retirement. If you already have a 401k, consider increasing your savings percentage. Remember, this reduces your taxable income, too, which keeps more of your money in your hands.
Open a Roth IRA account if you don’t already have one. Roth accounts are built using post-tax money – your “after tax” take home cash. You won’t pay taxes on this money later in life when you withdraw those funds.
Consider a savings account for easily-accessed cash. Look for high-interest accounts to make a little money on whatever you have saved there. Ally’s online savings accounts typically offer interest rates around 1%.
Make it automatic. Setup auto deductions from your paycheck or checking account to fund these accounts. Don’t rely on you to make those transfers every month. It’s way too easy to forget or lose interest. Automation is key.
Don’t forget emergencies!
When we talk about saving money, it’s easy to pinpoint retirement accounts as the primary destination for that money. In reality, your retirement accounts are the only thing to focus on when you pay yourself first.
Let’s talk a second about emergency funds.
What happens if you get into a car accident and need a few thousand dollars for repairs? Or a medical emergency sends you to the ER and, naturally, a nice big bill in your mailbox days later? Or a family member has an emergency and needs some money, quick? Or, you suddenly lose your job and you’re forced to live for months without any income. What happens?
Well, you sure as hell can’t withdraw any money from your retirement accounts (without penalty). In fact, you don’t want to withdraw money from your retirement accounts anyway. You want that money to stay put.
You may not have several thousand dollars sitting around in your non-interest bearing checking account, either. And you’d hate to put emergency spending on your credit card, right? Because…credit card debt!
This is where your emergency fund comes in. Emergency funds are typically stored in a savings account separate from your checking. This is money that should never be spent unless an emergency requires it. It’s money that you’ve set aside for when you need it most. You can always depend on it being there. It’s lying in wait, for a situation you hope never comes.
Great, but how much money should we keep in our emergency fund? It seems everyone has an opinion on this point, and I am no exception. I recommend at least three months of living expenses – minimum. This will easily support you through sudden job losses for a little while, and will probably provide enough resources for any other emergency that might befall you. Yup, three whole months.
Fund your emergency savings first (especially if you don’t yet have any!). Then, focus on your retirement savings. My wife and I use an interest-bearing Ally savings account to hold our emergency stash. Each month, we’ll get small interest payments that help pad that stash a bit, which is cool.
Lastly – the benefit to using a savings account rather than your checking account is separation. You’ll be less likely to spend your emergency savings if it’s not easily accessible from your everyday spending account. But if you do need access to it, it’s still relatively easy.
It’s a win-win with emergency money.
So remember, pay yourself first.
Steve is a 38-year-old early retiree who writes about the intersection of happiness and financial independence. Steve is a regular contributor to MarketWatch, CNBC, and The Ladders. He lives full-time in his 30′ Airstream Classic and travels the country with his wife Courtney and two rescued dogs.