Author: Chuck Saletta | August 02, 2019
Cue the fireworks
Some people live to work. They’ve found a career that’s such a perfect fit for their skills and personality that they can’t imagine doing anything else with their time. Warren Buffett is one of those people, having famously said that he plans to work as long as he is physically and mentally able to do so, despite being one of the richest people on the planet.
For the rest of us, however, work is at least somewhat a means to an end. Even if we really enjoy our jobs, at least part of the reason we work is to get paid to cover our basic costs of living and/or have the cash to cover the things we’d rather be doing with our time. If you’re in this second group, you probably dream of a day when you’re financially independent enough that you no longer have to work. If so, read on to uncover 11 steps that can help you speed up your own Financial Independence Day.
1. Track where every penny you’re spending goes
For at least a month -- maybe two if you have fairly irregular expenses -- keep track of all the money that you’re spending, down to the penny. Your rent, utilities, groceries, car payment, ride shares, insurance, bar tabs, vending machines, taxes, charitable gifts, lunches out, coffees, etc. If you have expenses that only hit a few times a year -- like car maintenance or major holiday gift-giving expenses -- estimate those costs as if they were monthly and include them in your list as well.
In this first step, you’re not focusing on cutting out any of your costs or making any sort of value judgements. All you’re doing is learning exactly where your money is going. What you’re trying to do is minimize the impact of “surprise” expenses that shouldn’t really be surprises because your spouse’s birthday happens to fall around the same time each year.
2. Color code your expenses based on your priorities
Once you know where your money is going, your next step is to figure out whether that’s exactly where you want it to be going. Take a good hard look at each of your expenses and mark it as green, yellow or red with either a highlighter or digital color coding depending on how you tracked your spending in the first place.
Green is for money that you are certain you have to keep spending as-is. For instance, if you just signed a 12-month lease, your rent payment is a green expense, at least until you get closer to being able to move or renegotiate your rent. Likewise, if you take medication that keeps you alive and have already optimized your costs for that treatment, it can stay a green expense as well.
Yellow is for money that you are spending on things that you either want or need to keep spending on, but where you may have room to lower your costs. For instance, you need to pay your electric bill, but you might be able to lower it by programming your thermostat to not run your air conditioner when your place is empty. In addition, you know it’s important to set aside some money for entertainment, but you may not have realized just how much you were spending until you wrote it down.
Red is for money that you are spending on things that really aren’t priorities for you. For instance, if you subscribed to an automatically-renewing streaming service that you no longer use but never cancelled, that charge can be flagged as red. Likewise, if find you’re absent-mindedly buying a coffee on the way to work every morning despite having decent free coffee at the office, that could be a red expense.
3. Take care of the “easy decisions” with your red and green costs
Your color coded list of expenses represent your priorities on where your money is going. Two of those groupings are easy decisions for you to make -- the red and the green. For the expenses that you marked green -- you keep paying them because they’re clearly high priority without much wiggle room.
For the ones you marked red, they’re easy to deal with too. Simply make a decision to get rid of them and either cancel the charges or change the activity leading you to spend. You yourself said that the red expenses weren’t a priority for you, so getting rid of them should be an easy way to free up some cash without really negatively affecting your life.
4. Figure out ways to optimize your yellow costs
Next, take a good, hard look at each expense that you marked as yellow and build an action plan to get those costs down. For instance, you might decide that instead of buying lunch every day at work that you’ll plan to brown bag your lunch four times a week and buy once a week. You might also decide that you’d be willing to give up cable TV in exchange for a less expensive streaming service that focuses on the channels and programs you really want to watch.
For food, you might be willing to buy more generics instead of the name brands. For clothes, you might decide to buy last season’s styles on the discount rack rather than buying the latest ones at full price. Your objective with your yellow costs is to get the best bang for your buck -- to get the most value, enjoyment, or benefit out of the least amount of spending.
5. Figure out other ways of bringing in cash
Can you work overtime at your current job or take on a second job or side hustle to bring in a few extra bucks? Do you have any stuff you no longer use or need that you can sell online or in a good old-fashioned garage sale?
In addition to the extra income, you might find that putting in the extra effort may actually help you advance faster. Your boss could see the overtime as a sign of your dedication and passion for the job, helping to give you the edge over other employees for the next raise or promotion. Alternatively, the skills you pick up on your side hustle could help you stand out at your primary job, also helping you advance.
Whether a recurring revenue stream or a one-off infusion of cash, any legal way you manage to get your hands on more money is another tool at your disposal to speed up your process of building wealth.
6. Use the cash you’ve freed up to snowball (most of) your debts away
By getting rid of your “red” costs of things you didn’t want anyway and reducing your spending to get down to what really counts from your “yellow” costs, you should have freed up some serious cash flow. That should give you a tremendous start on getting out of any debt that’s acting as an anchor holding you back from your plan to speed up your Financial Independence day. Add in the extra income you’re generating, and you should start to feel unstoppable in your quest.
Your debt holds you back for two key reasons. First, the interest accruing on it is a drag that actively moves your net worth backwards. Second, the cash flow you use to pay it every month is money that in the absence of the debt service payment, you could be using to actively build your wealth.
To snowball your debts, line them up in order from the highest interest rate to the lowest interest rate. On all your debts except your highest interest rate one, make the bare minimum payment allowed by the contract. On that highest interest one, pay every penny you can afford above and beyond that minimum. Use the money you freed up from steps 3 and 4 along with any other cash flow you may have to aggressively pay down that debt.
Once it is gone, put that entire payment against the new highest interest debt on your list. Keep repeating the process until almost all of your debts are gone. The only debts that it may be OK to keep paying the minimum on are very low interest rate debts that aren’t a major burden on your cash flows. For instance, if you have a 4% mortgage that you can easily cover each month, you can consider keeping that. Similarly, if you have an affordable, interest-free car loan, there’s no need to speedily pay it off.
7. Sock away a little bit in savings for an emergency
When you’re building long-term wealth, most of your money will be socked away in investments of some sort. Before you get too far down that path of long-term investing, you should put a little bit aside in a pretty safe and liquid account like a savings account or short-term U.S. Treasury bills. The goal there is to have a ready source of cash to access if an emergency were to happen that would otherwise temporarily send the rest of your plan off track.
A key problem with investments suitable for driving long term returns is that many of them are unreliable sources of short-term cash. Investment real estate, for instance, can be expensive to sell or take a loan out against. Stocks are volatile assets that can go down as well as up. If you’re forced to dip into long-term assets at an inopportune time to cover an emergency, it could set you back substantially.
Of course, you don’t want to have too much socked away in cash-like assets. Those types of savings plans rarely keep up with inflation after the taxes you have to pay on any income you earn on them. As a result, you’ll probably want to limit your emergency savings to somewhere in the neighborhood of three to six months’ worth of your living expenses. Much more than that, and your savings risks being a drag on your returns. Much less than that, and it’s not providing you much protection.
8. Take advantage of "free money" for your long-term investments
When you start saving for long-term future goals like retirement, some of the best tools available to you are ones that offer you some sort of free money to use them. Qualified retirement accounts like 401(k)s and IRAs bring with them those incredible benefits that make them worth your while as the first stop for your long-term investments.
Any qualified retirement account offers tax-sheltered compounding on your money. Most investments within those accounts can grow and throw off dividends, interest, and/or capital gains without exposing you to taxes along the way while the money remains in your account. That reduced friction helps your money compound for you that much more quickly while you’re saving it for your future.
In addition, in “traditional” style retirement plans, you can frequently get a tax deduction on the amount you contribute to the plan. That reduces your current taxes and thus frees up that much more money to invest. On the flip side, in “Roth” style retirement plans, you can frequently take the money out of your account in retirement completely tax-free. That makes each dollar in your account worth that much more spending cash when you need it.
As if that weren’t enough, many employers offer matching funds for employees’ contributions to the company’s sponsored 401(k) or similar retirement plan. That’s extra money your boss will pay towards your retirement on your behalf, just because you put a little bit of your own money in the plan as well. No matter how money gets into your account, once it’s in there, it can compound on your behalf, thus helping you reach your Financial Independence Day that much faster.
9. Invest your long-term money in stocks for their long-term potential
Despite the fact that the market goes up and down on a daily basis, over the long run, the U.S. stock market has delivered returns that average around 9.5% annually. That’s enough to turn $10 a day into over $2 million over the span of a 45 year career. That type of sustained compounded growth rate is incredibly difficult to find in other types of investments and make intelligent stock-oriented investments a worthwhile go-to place for your long term money.
The key, however, is that to be successful investing in stocks, you have to have a long-term focus with your money. Because the market goes up and down on a daily basis, it can get incredibly tempting to sell when the market is moving against you. That could cost you dearly, both because you’d essentially be "buying high and selling low" and because you’re at risk of missing any subsequent rebound from having your money on the sidelines.
10. Keep your investing costs low
While the market has delivered those stellar returns, many investors have found that their actual returns are much lower. A key reason for those subpar returns is that they find themselves invested in high cost, high churn, actively managed mutual funds. The average mutual fund manager will likely achieve returns that, well, are about average before considering the costs of running the fund itself.
Knock out the cost of research, the churn costs of trading, and the marketing costs the funds pay to seek out new investors, and the net returns ordinary investors see in those funds tend to be much lower. As a result, low-cost passively-managed index funds are some of the best investments you can make, despite the fact that they merely attempt to match the overall market.
With lower management costs and less trading friction, index funds assure more of the market’s returns actually find their way into the pockets of their investors. In other words, if the market manages to deliver returns in the future anywhere close to as strong as it has in the past, index funds give you a great chance of actually achieving those returns for yourself.
11. Keep adding to the money you sock away whenever you can
As you continue on your investing journey throughout your career, you will likely have several opportunities to increase the money you’re investing with no real pain to your lifestyle. For instance, if you get a raise, you can probably sock away half that raise without feeling the impact of it.
In addition, every year, tax brackets are indexed for inflation. If you were making ends meet in December, your paycheck may well be a little bigger in January due to that index. That boost can easily be saved as well. Likewise, if you wind up with a tax refund, that money is a great candidate for socking away for your retirement, since you managed to live without it throughout the year you earned it.
Also, as your life changes over time, you could very well find yourself with more money to invest. Once your kids become independent, for instance, that can feel like a substantial raise. If you pay off your car or house, that’s also more cash flow you can free up without really impacting your everyday life.
The more you’re able to invest for your future, the better your chances are of getting to your Financial Independence Day. After all, not only does increasing your savings rate increase the money working on your behalf, but it also reduces your risk of finding yourself trapped in a high-cost lifestyle by getting used to all that spending. The better you can keep your costs in check along your journey, the less you have to have saved to reach your destination, and the easier and faster you can get there.
Get on the path to your Financial Independence Day
These 11 steps provide a time-tested approach that can help you effectively build the type of nest egg it takes to become financially independent. The more aggressive you are at cutting your costs to free up money to invest, the faster you can reach that goal.
Once you are financially independent, your time truly becomes yours to do with as you please, even if, like Warren Buffett, that involves some sort of work you truly enjoy.
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