by David Bach
Think about it. Earn a dollar and pay taxes first, and you’re left with only about 65 cents to invest. Put it in an IRA or some similar retirement account that allows you to defer taxes, and you’ve got the full dollar to play with.
Which would you rather invest—a dollar or 65 cents? If your investment grows at an annual rate of 10 percent, your pretax dollar will have swelled to $1.10 within a year. Your after-tax investment of 65 cents, on the other hand, will be worth just 72 cents. Quite a difference, isn’t it? Now multiply this by some real money and then take it out 20 years, and pretty soon you’re talking about a difference that may total some tens of thousands of dollars. Run it out 30 or 40 years and we’re in six-figure territory.
Here is a simple chart that illustrates the power of pretax investing. Once you get your head around this concept, you’ll never want to pay the government first again.
The above example is for illustrative purposes only. It shows a 30-year-old individual investing $100 a month through the age of 65 and compares the growth of the money invested in a taxable account vs. a tax-deferred one. The taxable account assumes a 28% tax -bracket.
3. HOW MUCH SHOULD YOU PAY YOURSELF?
Here’s a simple rule of thumb: if you don’t want to have to struggle to keep your head above water when you retire, you should be saving at least 10 percent of your pretax income each year. Period.
That’s right—10 percent of your pretax income. Not your after-tax or take-home pay, but your gross pay. If you and your spouse jointly earn $75,000 a year, the two of you should be putting aside at least $7,500 a year for retirement. And I mean just for retirement. Any savings you’re doing so you can buy a house or a new car or take that dream vacation should be on top of the $7,500. That 10 percent you’re paying yourself first is not for anything else but your retirement. Ideally, I suggest you save more than that. If you’ve read my other books such as The Automatic Millionaire you know I recommend saving at least one hour a day of your income. One hour a day of your income comes out to 12.5 percent of your gross pay. And If you want to know the true magic formula for never having to worry about money again, the answer is 15 percent or more.
IF YOU ARE NOT PAYING YOURSELF THE FIRST 10 PERCENT OF YOUR INCOME, YOU ARE LIVING BEYOND YOUR MEANS
Maybe that sounds brutal, but it’s true. If you and your partner are not currently putting 10 percent of your pretax income into a pretax retirement account, you are heading for trouble. I don’t mean to sound overly gloomy or harsh. By now, I hope you have learned to trust that I really do care about you and I appreciate the opportunity to be your “financial coach.” And I want you to let this coaching sink in.
I know plenty of people who seem to be very well off, who live in nice homes and drive nice cars, wear nice clothes and belong to country clubs with more nice people who also have and do nice things—and none of them are saving 10 percent of their income. As I said before, this is true of many Americans. Well, guess what? Many Americans, when they reach retirement age, won’t have enough money to maintain their comfortable lifestyles through what are supposed to be their “golden years.” This is because most people who look rich really aren’t. In fact, they are working their tails off, and once you peel back the facade, what you find isn’t wealth and security but stress and debt.
You and your partner deserve more than that. But it won’t just happen. You’ve got to decide to act and make it happen.
IF YOU WANT TO BE REALLY RICH, YOU SHOULD SAVE 15 PERCENT OF YOUR INCOME
What do I mean by “really rich”? Everyone has his or her own definition, but here’s a fairly straightforward standard: to be considered really rich, you should have at least $1 million in liquid assets, above and beyond the value of your home.
Obviously, that’s not Bill Gates rich. Or even your average dot-com IPO jackpot-winner rich. But it is a nice, comfortable nest egg. And it’s something anyone can accumulate. You don’t have to be lucky, you just have to be disciplined enough to put aside 15 percent of your income. Fidelity’s research, by the way, backs me up on this. They did a study that looked at the 72,000 people who had become millionaires in their plans and they had saved on average 14 percent. So actually I am pushing you to beat that 14 percent average savings rate. I know its not easy. But let’s try.
You want more? Then put aside more. If you’d like to enter the ranks of the richest 1 percent of Americans, you’ll need to save 20 percent of your income.
It’s important to note that the younger you are when you start saving, the better off you’ll be. In fact, the best time to become a massive saver and investor is when you are in your twenties. Unfortunately, this also happens to be the time in our lives when we are the least motivated to save money. When most of us get out of college, get our first job, and start having a family, we generally find ourselves stretched pretty thin. A savings and investment program isn’t our top priority. We tell ourselves it’s something we’ll get around to when things aren’t so tight.
Before we know it, of course, we’re in our forties or fifties and we’re still telling ourselves that we’ll get around to it eventually.
Now, if you happen to be in your forties or fifties and you’re just getting started, I don’t want you to panic. Still, I do want you to recognize that you’ve got some serious catching up to do. It won’t necessarily be easy, but it can be done.
THE TIME TO COMMIT TO SAVING—TO PAYING YOURSELF FIRST—IS NOW
Whatever else you do, I hope that you and your partner don’t finish this chapter without having a serious conversation about this idea of paying yourself first. As a couple, you should set yourselves a “pay yourself first” goal. It should be a percentage of your pretax income that both of you can handle, can stick to, and can increase a little each year.
Let’s say you start this year with a “pay yourself first” target of 10 percent of your income and agree to increase the amount by 1 percent each succeeding year. Within 10 years, you’ll be saving 20 percent of your income. At that rate, you won’t ever have to worry about your financial future. You’ll be set for life.
BUILDING A NEST EGG WITH FREE MONEY
Putting aside 10, 15, or even 20 percent of your income may sound like a lot, but over the next few pages you will see that it can be both easy and fun. Why is it fun? Because when you pay yourself first into a retirement basket, you wind up paying less in taxes up front and your money grows, tax-deferred. The results of this can be truly amazing. It’s like getting free money from the government!
If you don’t understand exactly how this works, you’re not alone. Millions of Americans don’t—and as a result, they fail to take advantage of all the different retirement accounts and programs available to them. As far as I’m concerned, this is one of the great shames of American education. Every child should be taught about basic financial planning in middle school or high school. If we learned this stuff early, we’d all be much better off. Unfortunately, personal finance has never been part of the curriculum, so you need to learn it now. Anyway, the fact is that paying yourself first into a retirement basket is really quite simple.
HOW TO SAVE $5,000 A YEAR WITHOUT GIVING YOURSELF A $5,000-A-YEAR PAY CUT
Before I describe all the different types of pretax retirement accounts there are, I want to go over something I know is probably bothering you.
Let’s say you and your partner earn a combined total of $50,000 a year. In order to follow my suggestion that the two of you save a minimum of 10 percent of your pretax income, you’d have to start putting aside at least $5,000 a year. Now if you’ve never done this before, I know how you’re going to react. You’re going to say, “There is no way we can do this! We’re living paycheck to paycheck. No way can we afford to take a $5,000-a-year pay cut. And don’t tell me the Latte Factor is going to save us $5,000 a year.”
Is this what you’re thinking? Well, don’t worry. The two of you can save $5,000 a year without giving yourselves a $5,000 pay cut.
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hat’s right. You read that correctly. If you are not currently saving 10 percent of your income, you can start doing so tomorrow—without decreasing your spendable income by 10 percent!
How can that be?
It’s simple. Normally you earn $50,000 a year, right?
Wrong.
Assuming you’ve got a combined tax rate of 35 percent or so (the average for most Americans), what you actually bring home is about $32,500 in spendable income. Now, despite what you might think, putting $5,000 into a pretax retirement account will not reduce your spendable income from $32,500 to $27,500. Remember, you’re paying yourself first—before you pay the government. In other words, the $5,000 you’re saving comes off the top. What gets reduced is your gross income, which will drop from $50,000 to $45,000.
So let’s do the math: $45,000 taxed at 35 percent leaves the two of you with a spendable income of $29,250. Before, you had a net spendable income of $32,500. Now you’re getting $29,250. The difference is $3,250 a year. Divide this by two (there are, after all, two of you) and it comes out to a pay cut of $1,625 a year each. Divide that by 12 months, and that comes to a pay cut of $135 a month. Divide that by 30 days a month and it comes to $4.51 a day—an amount the Latte Factor can easily cover!
Of course, most couples who earn a combined income of $50,000 a year are not saving 10 percent of their income. If they were, millions more of us would be millionaires.
I grant you, the math can be a little confusing. If I were explaining it on a chalkboard at one of my seminars, it might take 15 to 20 minutes before everyone got it. So don’t worry if you don’t understand it right away. Just keep rereading the explanation until it sinks in. It’s simple, basic math that can change your life forever.
If, after all this, you still don’t feel you can save 10 percent or more of your income right now, do what I did when I started paying myself first. I was 25 at the time, and I didn’t fully realize how important paying yourself first was. I also didn’t believe that I could handle the pay cut. So instead of putting aside 10 percent of my gross income, I started by saving an amount that I figured I’d barely notice; in my case, it was 3 percent. At the same time, I made a commitment to myself, which I put in writing, to bump up my contributions to my 401(k) plan by another 3 percent at the end of six months.
I figured if I increased my contributions by 3 percent every six months, I’d be fully maximizing my 401(k) plan within two years. What actually ended up happening is that I quickly realized that putting money aside wasn’t as difficult as I thought it would be. As a result, in less than a year, I increased my contributions from 3 percent to 6 percent, and then from 6 percent to the maximum. I was doing what I needed to do, but because I had gotten there gradually, I barely felt the difference in my spendable income.
THE INS AND OUTS OF RETIREMENT ACCOUNTS
There are basically two types of retirement accounts: the kind your company provides for you (called employer-sponsored retirement accounts) and the kind you provide for yourself (known as individual plans).
Over the next few pages, I will review how these plans work and how you go about setting them up and contributing to them. If you work for a company that has a retirement plan in place, you won’t need to worry about the retirement accounts I describe for self-employed people. Then again, in this constantly changing economy where more and more people are becoming self-employed, it may be worth reading about these plans even if you are currently covered by a company program.
THE MOTHER OF ALL RETIREMENT ACCOUNTS: THE 401(K)
By far the most popular retirement program U.S. companies make available to their employees is the 401(k) plan; nonprofit organizations can offer employees a similar program known as the 403(b). The 401(k)—it takes its name from the section of the law that brought it into being—is what is known as a self-directed plan. This means that while the plan is administered by the employer, it is directed by the employee. In other words, it is up to you to tell your company whether you want to participate in the plan, how much you want to contribute to it, and where you want your money to be invested.
THE BASICS OF 401(K) INVESTING
The first thing you need to know if you work for a company is whether your employer has a 401(k) plan in place. It constantly surprises me how many people don’t know if their company offers this sort of retirement plan. You really should find this out before you accept a job with a new employer. Not having a 401(k) plan puts your financial future at risk, and you might want to think twice before you go to work for a company that refuses to provide one.
Assuming your company does have a 401(k) plan, the second thing you need to do is make sure you’re signed up for it. Enrolling shouldn’t cost you anything. It’s a benefit that is provided by the company to the employee. What normally happens when you start a new job is that you get a ton of paperwork handed to you. This generally includes what is known as the “sign-up package” for the 401(k) plan.
Many people mistakenly assume that signing up for a 401(k) plan is automatic. IT’S USUALLY NOT! The good news is that since I originally wrote this book many companies have made “automatic enrollment” a part of their 401(k) plans. The best plans offer not just automatic enrollment features but also “automatic increase features” that increase the savings rate automatically on a set time frame (usually annually). This single change in the retirement planning industry has done more good than probably anything ever done in regard to savings. Companies that have automatic enrollment have seen up to 85 percent of employees participate in their 401(k) plans, according to Aon Hewitt, from an average participation rate of 62 percent. That’s the good news. The bad news is that many of these plans are automatically opting employees in at 3 percent, and then the employees are leaving it at this low rate, thinking they are “good to go.” If you have automatical enrollment, you MUST look at what the automatic enrollment level is and then increase it! Among companies without automatic enrollment, many unfortunately find that fewer than half of their eligible employees participate in their 401(k) plans. It’s not hard to understand why. As a new employee, you are handed this huge package of material and you’re so busy getting used to your new job that you simply don’t have time to read it all. Or, worse, today everything is sent via e-mail and it just gets lost in your in-box. The next thing you know, six months have gone by and you are still not signed up for the plan.
So here’s my recommendation. If you work for a company that offers a 401(k) plan, first thing tomorrow check with the benefits manager in your company’s human resources department to make sure you are properly signed up. If it turns out that you are not enrolled, ask for a sign-up package. (This goes for your partner as well.) If your company does all of this online, then get online right now, look at what your enrollment level is, and then increase it!
Some companies won’t let you join their 401(k) plan until you’ve worked there for some minimum amount of time, usually 6 to 12 months. This is not a legal requirement but a matter of corporate policy. If you ask “loudly” enough, sometimes they will waive the rules and let you join early. If not, find out when you will be eligible and mark the date on your calendar. As soon as it arrives, run (don’t walk) to the benefits department or go online and get signed up. Believe me, no one from the benefits department is going to remind you to sign up for the plan. Not to be negative, but they aren’t watching this stuff. That’s why you have to.
IF YOU’RE ALREADY SIGNED UP…
If you and your partner are already signed up for 401(k) plans, the most important question to ask is whether you are “maxing out.” That is, are you taking full advantage of the “pay yourself first” system by making the maximum contribution your plan allows?
Please don’t assume for one second that you are doing this. It’s simply too important not to double-check. Paying Yourself First as much as you can into your 401(k) plan is essential if you and your partner are really serious about getting—and finishing—rich. You both need to be doing this.<
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By law, the maximum dollar amount you can contribute to a 401(k) plan in 2018 is $18,500 if you are under the age of 50 and up to $24,500 if you are over age 50. With the new tax legislation, the allowable contribution is now raised each year by a specific amount so keep checking with your benefits department to make sure your contribution level is up to date. You can also go to www.irs.gov each year to see if the amount you can save has increased (simply search “IRA or 401(k) retirement maximum contributions” and you should find the latest rules). Keep in mind that just because the government has raised the amount you can contribute to a 401(k) plan doesn’t mean your employer will raise your contribution accordingly. Most likely, you will have to go back to your benefits department and give them specific instructions to increase the amount. This may sound like a bother, but, believe me, it’s worth it. Keeping an eye on these sorts of details is what makes the difference between having to struggle at retirement and finishing rich.
If you do just one thing today after finishing this chapter, please let it be that you contact your benefits department to make sure you are truly maximizing your contributions to your 401(k) plan, or go online and get it done. If it turns out that you’re not, make it a goal to increase the size of your contribution immediately, even if it’s by only a few percentage points. Remember my story about how I managed to ramp up my contributions gradually without it hurting. Believe me, it’s worth doing. In the long run, a small increase in your 401(k) contributions can make a huge difference in your wealth.