Kicking Financial Ass

by Paul Christopher Dumont

35 25

  40 22

  45 19

  50 17

  55 14.5

  60 12.5

  65 10.5

  70 8.5

  75 7

  80 5.5

  85 4

  90 3

  95 2

  100 1

  Assumptions:

  •You earn 5% investment returns during your working years, inflation-adjusted.

  •You withdraw 4% a year after retirement and continue to live on your spending rate.

  •You only withdraw your gains.

  •Your starting net worth is $0.

  Instead of memorizing the above chart, a shortcut is to take the number 60 and subtract your savings rate from it. The remainder is roughly how long you need to work before you have enough savings to support yourself in retirement, assuming you start with zero net worth. This calculation breaks down with savings rates over 40%. So, if you save more than that, subtract from 70.

  Years needed to retire with a savings rate of 40% or less=

  60 - 30% savings rate= ~30 years

  Years needed to retire with a savings rate of greater than 40%=

  70 - 50% savings rate= ~20 years

  Note: Historically U.S. stocks have increased 9.7% per year or 7% after adjusting for inflation. The 5% returns in the examples above are conservative estimates and assume a mixed stock/bond portfolio.

  THE POWER OF SAVING VS. SPENDING

  Contrary to what people think, income is not equal to financial stability. In other words, how much money a person makes does not determine if they will be financially stable or not. Let’s use the following comparison between a dentist18 and a receptionist19 living in San Francisco using average salary levels as of March 2018.

  Carl, the Dentist

  •Carl, 38 years old, is doing quite well for himself, pulling in $184,000 last year. Originally from Seattle, he recently moved to San Francisco to set up a new practice. Even though real estate is expensive, he wanted to be close to work, so he rented a 2-bedroom apartment in the prestigious Marina district. The view from his place is unreal. He can see the Bay and the Golden Gate bridge and walk to Fisherman’s Wharf. Carl is living the dream. His rent payment is $5,000 a month.

  •He drives to work in his 2017 Cadillac Escalade, which he leases for $1,170 per month. He pays an additional $300 in car insurance.

  •He loves to eat out at the nicest restaurants with his wife, paying $1,000 a month for food.

  •He frequently entertains at his place and has a healthy red wine habit. Entertainment expenses are $1,000 a month.

  •Carl and his wife share the same credit card, often spending more when traveling than they can afford. On average, they pay $300 a month toward credit card debt.

  •Dental school was not cheap, so Carl continues to make student loan payments of $300 a month.

  •Utilities are normally $350 a month, which consists of power, gas, water, broadband, and two cell phone connections.

  •Fortunately, his wife stays at home with the kids, so he does not have to pay for childcare.

  Joe, the Receptionist

  •Joe, 22 years old, recently graduated and landed a job at the new dental clinic near the Golden Gate Bridge in San Francisco.

  •He moved in with a friend in the Panhandle neighborhood, near the University of San Francisco. His portion of the rent is $750 a month.

  •He drives around in his 2007 Honda Civic, which he has been driving since high school. Other than maintenance and oil changes, it has not caused him any issues. He pays $100 a month for car insurance.

  •He likes eating out but mostly for special occasions. Joe spends his Sunday afternoons meal prepping so that he has easy-to-eat lunches and dinners during the week. He keeps his food costs low, at $200 a month.

  •Joe bikes a lot using the city bike lanes but likes to take road trips down to Mountain View and San Jose to visit friends. He spends about $120 a month on gas.

  •Joe likes going out with his friends as his primary source of entertainment. He spends $300 a month on this.

  •Joe also likes to travel but looks for good flight deals and stays in hostels to keep costs down. Usually, he can pay off his travel expenses using his savings, so he does not have any credit card debt.

  •Joe is also paying off his student loans, making $150 payments per month. He has no other debt.

  •Utilities are about $150 a month, which consists of power, broadband, and one cell phone connection.

  Income Carl, the Dentist Joe, the Receptionist

  Annual Income $184,000 $42,577

  Standard Deduction $12,000 $12,000

  Taxable Income $172,000 $30,577

  Federal Income Tax $36,730 $3,479

  California State Income Tax $15,368 $1,220

  Social Security $7,886 $2,640

  Medicare Tax $2,668 $617

  Total Tax $62,652 $7,956

  Annual Take-Home Pay $121,348 $34,621

  Monthly Take-Home Pay $10,112 $2,885

  Expenses Carl Joe

  Mortgage or Rent $5,000 $750

  Food $1,000 $200

  Car Insurance $300 $100

  Gas $200 $120

  Credit Card Payments $300 $0

  Car/Lease Payment $1,170 $0

  Student Loan Payment $300 $150

  Entertainment $1,000 $300

  Utilities $350 $150

  Total Expenses $9,620 $1,770

  Savings per month $492 or 4.9% $1,115 or 38.6%

  *Based on 2018 U.S. single filing status rates using taxformcalculator.com

  Carl has it all—a new house in a prestigious area, the latest luxury SUV, traveling in style, enjoying the pleasures of the upper-middle-class life. He is not too worried about saving since he has a stable job and figures he can always save later when his kids are grown. He does not have an emergency fund because he knows he can just throw the expense on his credit card.

  Joe, on the other hand, makes below the median20 household income in the U.S. He might even be considered poor by Carl’s standards. And, Joe certainly would not be able to afford to buy a home in San Francisco with his current salary. Most months, he saves close to 40%, but unexpected costs pop up, which is why he has a $1,000 emergency fund in a separate bank account. Fortunately, he read this book and modeled his expenses after the spending bucket concept in Chapter 2: Know Where Your Money Is Going. He puts everything else into his investment account and invests in a stock/bond split, like the allocation in the Trinity study.

  Who is more financially stable? Carl saves only 4.9% of his monthly take home, while Joe saves 38.6%. The $623 a month savings difference is staggering. If Carl and Joe continue to save money at their respective saving rates, Joe can comfortably retire in 23 years, by age 45. His investment portfolio will be worth $582,057 by then, assuming a 5% annual return using the Trinity study assumption. Using the 4% withdrawal rule, he would be able to live on $23,282 or $1,940 a month, slightly more than what he spends today.

  Savings over 23 years=

  $1,115 x 12 months x 23 years x (1 + 89.139% compound interest)= $582,057

  Money needed for Joe’s retirement (25x yearly spending rate)=

  $1,115 x 12 months x 23 years= $307,740 in savings

  +

  $274,317 in interest= $582,057

  4% yearly withdrawal=

  $582,057 x 4%= $23,282.28

  4% monthly withdrawal=

  $23,282.28 / 12 months= $1,940.19

  Carl, on the other hand, would be able to retire in 66 years. Let’s assume, however, that he cuts back his spending in retirement and is debt-free by age 65. His portfolio would be worth $338,905. Using the 4% withdrawal rule, he would have to live on $13,556 a year or $1,030 a month, 10.2% of his take-home pay during his working years. Something tells me he will not be able to retire fully at age 65 and will continue to work to support himself well past then.

  Savings over 27 years=

  $492 x 12 months x 27 years x

&n
bsp; (1+ 112.602% compound interest)= $338,905

  4% yearly withdrawal=

  $338,905 x 4%= $13,556.20

  4% monthly withdrawal=

  $13,556.20 / 12 months= $1,129.68

  Joe can retire at age 45, while Carl must wait until age 65 and still will have a fraction of a nest egg. Even with Joe making $140,000+ less per year than Carl, who would you rather be?

  The above example is used for simplicity. It is likely that Joe and Carl will make more money over time, but hopefully, they put that earning potential into savings rather than increase expenses. It also assumes that neither has an unexpected major emergency and each withdraws 4% of their income in retirement. If they invested in an S&P 500 index fund, their returns would have averaged 9.7% per year, not 5% per year.

  SUMMARY

  Remember the 4% rule and save 25 times your annual spending. It is a very conservative metric and meant as a guiding post to help you save. The beauty of this rule is that it is flexible, and there is little difference between a 30-year period and infinity. If you spend less money, you can retire on less. It is one of the most important concepts in this book.

  Another important concept to remember is that it is not how much you earn but how much you save. It is possible to be able to retire faster making $40,000 a year than someone making $100,000 a year. The key is that the more you cut back on non-essential expenses, the more you can save, and the faster you can retire. Who would you rather be, Carl, the Dentist, or Joe, the Receptionist? Do not cut back so much that you do not enjoy life. The point is to spend on things that maximize your happiness while cutting back on things that do not add to it.

  •Calculate your monthly expenses, take-home pay, and savings rate.

  •Once you know the years until retirement, decide if that is soon enough. If not, reduce your expenses or increase your income using a side hustle to save more.

  CHAPTER FOUR

  BUILD A SMALL EMERGENCY FUND

  WHY YOU NEED AN EMERGENCY FUND

  Bankrate’s January 2018 Financial Security Index survey stated that 34% of American households experienced a major unexpected expense over the past year. However, only 39% of survey respondents said they would be able to cover a $1,000 setback using their savings. How can anyone afford to save if they cannot afford a $1,000 setback? People need emergency funds. Personal finance expert Dave Ramsey says, “It’s crucial to have an emergency fund because it prevents a twist in the track from completely derailing the journey.”

  Many reasons exist to avoid emergency savings, such as purchasing something we want, paying down our debt, or investing it in the stock market. But it is one of the most crucial things you need to do to get your finances in order. If you prefer to invest that money consider this: What if you invest $1,000 and your investments are at a low when an emergency happens? You are going to lose money.

  An emergency fund is not a waste of resources. Having an emergency fund is vitally important, so I strongly recommend creating an emergency fund over paying down debt, and I explain that reasoning later in this chapter. It is better to keep some money liquid for a rainy day. Liquid means easy access to your money without incurring penalties.

  The most liquid asset is cash, so I suggest opening a separate bank account and storing it there. Because having cash on hand is so accessible, you might be tempted to spend this money. To mitigate this temptation, open an account at another bank so that the funds are out of sight and out of mind.

  You might be wondering, “Are credit cards a form of emergency fund?” Yes, and no. Depending on the emergency, you might not be able to pay off the balance of your credit card. I strongly urge you to avoid payday loans at all costs, however.

  Some of the most common financial emergencies people face and why an emergency fund is recommended:21

  1. Job Loss

  This is the primary reason for an emergency fund. If you lose your job and do not have a cash cushion, your credit card debt could spiral out of control in no time.

  2. Major Health Expenses

  Unexpected health expenses still require you to pay the deductible, even if you have health insurance.

  3. Major Dental Expenses

  A lot of dental plans have limitations on the amount they cover. People with dental insurance commonly have what is described as “100-80-50” coverage, meaning the insurance company pays 100% of the cost of routine preventive and diagnostic care, like cleanings and checkups; 80% for fillings, root canals, and other basic procedures; and 50% for crowns, bridges, and major procedures.22

  Most dental plans also max out at $1,500 a year, which is only a fraction of the cost of your kid’s $6,000 braces. Even fillings and root canals can cost you hundreds of dollars. Having an emergency fund will help cover any dental costs.

  4. Emergency Pet Care

  You might be able to afford the everyday expenses of owning a pet, but are you prepared for thousands of dollars in vet bills? If you own a breed of dog that is susceptible to health issues, I recommend pet insurance, but you will still be on the hook for deductibles.

  5. Car Repairs

  Whether replacing your tires, brakes, cracked windshield, battery, or damage from an accident, you want spare cash to cover car repairs.

  6. Home Repairs

  Have homeowner’s insurance for major expenses, but you must first pay the deductible. And insurance does not cover everything that can go wrong. For example, your balcony might need replacing but may not be covered by insurance.

  7. Larger Than Expected Tax Bill

  Unexpected taxes can come due during tax time. Be prepared with an emergency fund so that you avoid paying any late penalties. In the U.S., that means 5% of the taxes owed for every month, up to a maximum of 25%. If you file more than 60 days after the due date, the minimum penalty is $205 or 100% of your unpaid tax, whichever is less.

  In Canada, late penalties are 5% of your balance owing plus 1% of your balance owing for each full month your return is late to a maximum of 12 months, or 17% a year.23 The real kicker is if you have been charged a late filing penalty in any of the three previous tax years, then your penalty for the current year is double. This means paying 10% of your balance owing, plus 2% per month to a max of 20 months or 50%. Ouch! That hurts the wallet. Having an emergency fund prevents you from having to deal with potential late penalties.

  8. Unanticipated Travel

  A death in the family can force you to purchase a last-minute plane ticket to go to the funeral. You do not want this expense lingering on your credit card, racking up interest.

  9. Funerals

  Funerals can cost over $10,000. If your loved one had life insurance, this might cover the cost of the funeral. Often, it takes months to receive reimbursement, so you will need a source of cash to make the payment.

  Beyond financial stability, other advantages to having an emergency reserve of cash are that:

  •It helps lower your stress level.

  •It keeps you from spending frivolously.

  •It prevents you from making bad financial decisions.

  Why Build an Emergency Fund Over Paying Debt?

  This may seem counterintuitive at first. You are putting money into an emergency fund, but you still have debt to pay. Shouldn’t you pay your debt first and then build an emergency fund? Think of it this way: Say you throw 100% of every dollar toward debt repayment and do not have a spare dollar left at the end of the month. Things are going smoothly, but then BAM, you need a new transmission. Where are you going to get the money to pay for that? It is going right back on your credit card, and you have not gotten ahead. Psychologically this feels like defeat.

  If you build a small emergency fund first, like $1,000, which you can build up faster than a larger fund of say six months, then it can help keep you from derailing your financial goals. Once you have a $1,000 fund and have your debts paid off, increase this fund to two months’ worth of salary. Any emergencies that go beyond your two-month fund can be funded us
ing springy debt. Springy debt is debt you can pay off or increase at will. A credit card is one form (although not ideal), and a line of credit is another (better) option. The important thing is to keep this debt at a zero balance until you have an emergency or another circumstance that requires you to draw on it.

  BUILDING AN EMERGENCY FUND

  Three main strategies for building an emergency fund:

  •The prioritization method: This strategy makes your emergency fund your #1 priority. Every spare dollar you have builds it up until it is complete.

  •The “take advantage of windfalls” method: This approach uses things like bonuses, inheritances, and gifts to build up your emergency fund.

  •Percentage-based emergency savings method: This process takes a percentage of your monthly income and builds up your fund over time.

  I advocate the prioritization or percentage-based methods. In either case, you make creating an emergency fund a part of your budget, whereas with the “take advantage of windfalls” method, you wait for funds that you may or may not receive.

  As for building an emergency fund, there are 4 steps I recommend:

  Step 1: Open a High-Interest (or “High-Yield”) Savings Account for Your Emergency Fund

  The first step is to open a high-interest or high-yield savings account for your emergency fund. A high-interest savings account, as the name suggests, pays higher interest than standard savings accounts. Unlike checking accounts, which are meant for daily transactions, high-interest savings accounts are designed to hold money over a longer period—perfect for an emergency fund. Research the accounts offered at your current financial institution, but also look at alternative accounts. If you live in the U.S., use Nerdwallet.com to find the highest-interest savings accounts. In Canada, look at Ratehub.ca. You can find interest rates between 1.4% and 2.3%, much better than the 0.05% interest rates on regular savings accounts.24

  A few things to consider when opening a high-interest savings account:

  •Interest rates: Also known as APY. The higher, the better.

  •Fees: See what the fees are. Try to find accounts with low or no fees as the entire purpose is to save money.