Source: Flickr user Pictures of Money.
For many Americans, the American dream involves having enough saved for retirement that they'll never need to work or worry about money ever again.
Of course, that task is easier said than done. Practically everyone wants to become a millionaire and live the American dream, but the process of how to become a millionaire eludes most people.
Why Americans are off track
To begin with, while time is the greatest ally of the investor, a shorter-term mentality has been instilled among investors over the past two decades. Easier access to information via the Internet has made it so anyone, of any skill level, can invest in the stock market. This has led to increased periods of market volatility and a precipitous decline in the length of time investors are holding their stocks. According to data from the NYSE, the average holding period on a stock ranged from roughly four to eight years between 1940 and 1960, but by 2007, the average holding period had fallen to a meager seven months.
The other half of the coin is that far too many Americans are in the dark when it comes to understanding basic financial principles that will help them meet their retirement goals.
Source: NYSE via Facebook.
According to a five-question financial literacy quiz offered by the Financial Industry Regulatory Authority, just one out of four millennials were able to correctly answer four or five out of five questions correctly. These questions touched on basic principles such as interest, mortgages, and stock market-based risk.
A similar survey that came out earlier this year from the National Foundation for Credit Counselling found that only 59% of Americans would grade themselves at an "A" or "B" in terms of their financial knowledge. Three-quarters of those surveyed noted that they could benefit from additional advice on everyday financial questions from a professional.
How to become a millionaire using three simple strategies
By now, you're probably wondering what you can do to become a millionaire and retire comfortably. As I see it, the solution could be as simple as employing three strategies that require nothing more than discipline and a commitment to learn some basic financial principles.
Strategy No. 1: Creating a budget
The first step toward becoming a millionaire begins with the ability to save money. As the old saying goes, you need money to make money -- but it's incredibly difficult to save money if you don't understand your cash flow.
Source: Flickr user Pictures of Money.
Arguably the biggest setback most consumers face when trying to establish a budget is a lack of discipline. Either their spending isn't properly tracked, or the defined goals are simply too loose. The secret to a great budget is in setting defined lines in the sand on spending categories, such as discretionary spending or groceries, which can help you track your progress on a month-to-month basis and allow you to make adjustments on an as-needed basis.
For those of you who are classic over-spenders, or who have difficulty sticking to a budget, one possible trick is to think of each budget category (such as entertainment) as having its own bank account, or even setting up separate jars with cash inside for each budgeted category. Even though you may have plenty of money in your checking account, if the money for your entertainment account runs out two days before the end of the month, then you're out of money. Period! This little trick can help you learn to live within your means so you can start saving for retirement early and often.
Just how important is a budget? Utilizing Bankrate's return on investment calculator, if an individual began saving just $142.25 each month to put toward their investment account at age 18 and did so through their full retirement age of 67 years (so for a total of 49 years), and the stock market returned an average of 8% annually (which is its historic average), our fictitous investor should have $1 million in their investment account upon retirement. Without a budget it can be tough for some of us to scrape that $142.25 together, and it could be causing us to miss out on lucrative potential profits.
Strategy No. 2: Learn to reinvest your dividends
The second strategy involves utilizing the stock market to seek out solid businesses that pay healthy dividends. For those of you who are uncomfortable with the idea of picking out individual stocks, or who don't have the time to devote to researching individual companies, there are always electronic-traded funds, or ETFs, you can buy. As of December, there were more than 1,400 to choose from.
Source: Zack McCarthy via Flickr.
Over the long run, there is no investment vehicle that has more handily trounced inflation than the stock market. By a similar token, successful investors also understand that dividend-paying companies offer an added bonus to those gains in that they return a certain percentage of their profits to shareholders. But the smartest investors of all truly understand how to use those dividend payments to supercharge their returns.
Instead of simply pocketing a dividend payment from a company or an ETF, consider taking your dividend and buying additional shares of that company or ETF. If there is a solid business model and investment thesis behind a company, there's a good chance its dividend will remain steady or grow over time. What this means for you is the ability to buy more shares over time, which can lead to an even bigger dividend, which leads to even more shares of stock.
The result from this compounding growth can be returns that, over a 30- or 40-year period, could be double what you would have earned had you simply pocketed your dividends payments.
Strategy No. 3: Minimize or eliminate what you pay in capital gains taxes
Once you've set parameters that allow you to save, and you've set your sights on dividend stocks for the long term, the final step in the process of how to become a millionaire involves using tax-advantaged tools to your benefit.
Source: FINRA via Facebook.
Arguably, the Roth IRA is the most powerful tool the younger generation can use when investing. This is a retirement account that does have some income limitations, but if you qualify, you can contribute up to $5,500 per year ($6,500 per year for those aged 50 and up).
What makes a Roth IRA so great is that any and all capital gains over the long term are free and clear of taxation as long as you don't make any unqualified withdrawals, and you don't take any money out that was added to the account for at least five years. For instance, take our fictitious investor above as a good example. Over 49 years he or she earned around $815,000 in capital gains over what they originally put in. If this were a Traditional IRA our investor might owe as much as 20% taxes on this total when disbursements finally start. However, our Roth IRA investor gets to keep these gains free and clear of taxation, meaning that $1 million in their account is really $1 million-no strings attached, minus the one's just discussed.
Another key point, which we alluded to above, is to avoid short-term investing. Short-term investing is tough not only because timing the market is hard to replicate with any success over the long run, but primarily because it exposes you to ordinary marginal tax rates based on your income. Instead of paying a long-term capital gains tax rate of 0%, 15%, or 20%, you could be exposed to a marginal tax rate of anywhere from 10% to 39.6%!
You may not be the next Warren Buffett or Donald Trump, but if you utilize these three smart strategies, there's no reason you can't one day become a millionaire and claim your own slice of the American dream.
