Oftentimes, people think the secret to getting wealthy is through get-rich-quick schemes such as penny stocks and day trading. The thing is, the world's wealthiest people didn't amass their fortunes overnight, and it's unreasonable and risky to think that you can. Such an approach often leads to unwise and money-losing decisions.
The reality? Personal financial planning is something you should keep plain and simple, with a focus on what you can control.
The best approach requires patience and a systematic process built on a long-term plan that takes advantage of things that you know add value. Here are three things that you should include in your personal financial-planning process.
1. Pay yourself first
This one seems really simple, but let's talk about how you should be paying yourself. If you don't have a stash of cash somewhere, this is probably where you should start. Sure, interest rates on savings accounts and certificates of deposit are so low that you get essentially no return. Yes, the stock market is the best way to grow your wealth over long periods of time. But an emergency fund isn't about returns, but rather certainty.
The idea here is to avoid having to dip into retirement savings or other investments in a crisis. It's short-term protection for your long-term plan. You can't predict what Mr. Market will do from one month to the next, but cash in a savings account can be predicted down to the penny.
How much should you have? While circumstances vary, a year's worth of expenses is ideal. The best approach is to set incremental goals, starting at three months, then six months, and so on, until you reach your personal target. If you own property or a business, or if you have other obligations and expenses, you need to factor that in as well. As the saying goes, hope for the best but plan for the worst. Click here for some Foolish resources to help you start saving.
2. Get all the free money you can
Your employer may offer some sort of retirement plan -- probably a 401(k) -- and may match your retirement contributions up to a certain level. If you're not contributing at least enough to max out the employer match, you're not contributing enough. Sure, most of the mutual fund options available to you probably underperform the market's rate of return, but your employer's matching contributions still make it worthwhile.
Case in point: Let's say your employer matches 50% of your contribution, up to 3% of your salary. For the average American household, that 3% is about $1,500 per year in contributions based on $50,000 in annual income. Now, the average annualized stock market return over the past 100 or so years is around 8%. So if you were to invest that $1,500 per year and increase it 2% annually to adjust for inflation, after 20 years, you'd have almost $82,000. Not too bad.
Now, let's add in that 50% employer match. Even if the investment options in the company 401(k) significantly underperformed the market and netted only a 6% annualized rate of return -- a full 25% worse than the market -- you'd still amass $102,000 in 20 years, putting you $20,000 ahead.
3. Get every tax advantage you can, too
This is another thing many people overlook, yet it adds significantly to your ability to grow your wealth. Contributions to your 401(k) at work are usually pre-tax, meaning your take-home pay doesn't drop by the full amount of your contributions, since your taxable income is lowered by the amount you put in. This is the first part of reducing your tax bill. The second part? Contributing to an individual retirement account outside your job.
Depending on your income level, you can typically contribute as much as $5,500 ($6,500 if you're 50 or older) to an IRA on top of your contributions to your employee-sponsored 401(k) and deduct the contributions to a traditional IRA from your income, further cutting your tax bill. Using the previous example, if you make $50,000 per year and file a joint return, your federal tax bill will be around $8,400. If you were to contribute the maximum $5,500 to your IRA while also contributing 3% of your salary -- $1,500 -- to your 401(k) at work, you would drop your taxable income to $43,000.
That would cut your taxes by $1,700. That's an extra $140 per month that you could save, use to pay down other debts, or invest in a taxable account. If you were to reinvest the tax savings each year ($1,700, increased 2% annually based on pay increases) into an S&P 500 index fund netting 8% annualized returns, you'd have an extra $93,000 after 20 years.
Here's what the combined power of matching contributions -- even in a severely underperforming investment -- combined with the tax benefits of an IRA can mean over 20 years of saving and investing:
You'd be more than a hundred grand ahead, contributing the same amount of money. Click here for more information about online brokers and get started with an IRA of your own.
Personal financial planning takes time, but it can be easy
Striving to invest in the best assets is important, but it all starts with focusing on the things that are within your control. As time passes, your situation (kids, property, health issues, etc.) may become more complex, making a simple process even more important. Start with the three points I've spelled out here and repeat them regularly for years. Once retirement arrives, you'll find yourself in better shape than you may have expected.
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