Finances 101: A Guide for Everyone

Finances (and also cookies)

In 2009, a now famous Sports Illustrated article stated that “By the time they have been retired for two years, 78% of former NFL players have gone bankrupt or are under financial stress because of joblessness or divorce.” The exact numbers are debatable, but it is hard to deny that many professional athletes have financial problems as soon as the paychecks stop coming in. Usually there are two responses to this. The first is that people find it incomprehensible. “How could they go broke with all that money?!” The other response is lifestyle criticism. “Of course they went broke, they lived like they would make that money the rest of their lives!”

Yet, how can we really blame professional athletes, or anyone really, for not understanding how to manage money? Very few people ever get any formal training on financial management beyond “put some money into a savings account every month”. While this is certainly good advice, it doesn’t truly educate anyone about financing your life. And when you don’t educate yourself, finances become mysterious and scary.

There is an entire industry that wants to make your financial matters more complicated than it needs to be. How are you possibly going to understand how to budget, invest, and save? But the majority of people don’t need a tax man or an accountant or an investment manager. Professional athletes might, but you most likely don’t.

“How could they go broke with all that money?!”

No matter how big your paycheck, it is easy to assume that is your living wage. It doesn’t matter if it is hundreds or millions. If you make $5,000 a month (slightly above average) and you spend $5,000 a month, that is actually a very risky situation to be in. If that paycheck stops, game over. When we look at professional athletes and say “This guy was making $500,000 a month! How could he go broke?” Well, he stopped making $500,000 a month, that’s how. If you are spending all that you make, you are in a precarious position. It is the same for anyone no matter how much they make.

“Of course they went broke, they lived like they would make that money the rest of their lives!”

Now you are 65 and making $5,000 a month at your job. Time to retire! Except you can’t, because your lifestyle is to spend $5,000 a month. “Yeah, but, retirement!” How much do you have in “retirement” (whatever that means)? How much per month will that give you and how long will it last? If you are 65 and just beginning to ask these question, it’s too late. The money you were making was meant to last you the rest of your life, not the rest of the month. The rule is true for everyone, not just high paid professional athletes.

The reality of finances is that they’re fairly straightforward and easy enough for the layman to understand. The hard part is not what to do with your money, it’s changing your lifestyle. Most people won’t or can’t change their lifestyle. Some people are used to living a certain life and can’t imagine changing it. Others are actually trapped into certain expenses due to poor choices or happenstance. Changing your life IS hard and there is no way around that.

I have written a couple pieces on sustainable lifestyles, but now I am going to get into some actual numbers. There are plenty of guides out there on finances so I am not reinventing the wheel. Yet, I wanted to write the Tome of Nerd Approved Financial Guide for the sake of concrete information. I speak a lot in generalities, but below is an actual step-by-step process most anyone can follow.

The obvious disclaimer is that I am just some guy telling you stuff. I am not a professional nor have I been formally trained. Albeit, that is the point I’m trying to make. You don’t have to be an expert. Use this guide as a starting point and do your own research.

The Tome of Nerd Approved Financial Guide

Step 1: Know where all your money is going

You can’t possibly get a hold of your finances until you know exactly where your money is going. Write down where every cent you make is ending up. This includes tax deductions, insurance, and retirement. This also includes that $5 work lunch. Everything.¬†Without knowing where you are at, you cannot possibly make changes.

Document this in any way that works for you. I recommend creating categories (rent, eating out, bills) and then putting the total of each month for the past 3-6 months. This isn’t something you’ll have to do every ¬†month, but you need it as a starting point. It will give you an average of how much you spend in a given month and what you spend it on.

Step 2: Get out of high interest debt

Debt is bad, but it is also sometimes necessary. For most of us, we can’t pay for a car or home in cash. The most important thing is to minimize (or preferably completely eliminate) high interest debt.

[High interest debt, for the sake of this guide, is above 4% interest. How did I arrive at this number? Common wisdom asks if you had a choice between paying off debt or investing the money, which would have a better return? If you have credit card bills racking up 25% interest, there is no way you are going to outpace that number through investments, so you need to give that debt priority. On the other hand, if you have a low interest loan at 2%, the better use of your money is to invest (versus paying extra on the loan). The 4% number I have stated is subjective. There is no guarantee that the market will outpace 4%, but generally that has been the case.]

You need to prioritize your high interest debt. There are a number of strategies for this. If you only have a few high interest debts, simply pay aggressively on the highest interest debt first. If you have a lot of different high interest debts, it may be smarter to pay off the smaller debt totals first. This will reduce the number of minimum payments you’ll have to make each month (death by a thousand cuts).

“Pay off your debts” is easier said than done, I am aware. But it should be your number one priority. High interest debt is a money hole. You need to get rid of it as soon as you can, even if that is 10 years from now. Look at your monthly spending and look for where you can divert funds to debt payment. It probably won’t be fun, but you literally owe a debt that needs to be paid. Don’t sacrifice your future for having some extra cash now.

Refinance debt if possible

If possible, refinance your high interest debt to lower interest rates, especially your large debts (mortgage, student loans). Usually the savings in interest more than makes up the cost of any refinance charges. Again, you have to think long term. Paying more towards debt now will reward you greatly in the future.

Step 3: Create an emergency fund

Your life will have unexpected expenses. You may lose your job or get in a costly accident. That furnace might die. Lots of things can happen to you and you need to have a nest egg to take care of it.

You want 3-6 months of living expenses in a high interest easy to access savings account (Ally, as of this writing, is 1.05% interest). 3-6 months is a big range, so you must decide what you are comfortable with. If 3 months worth of expenses is fine for you, then good. If you want a bigger cushion, go for it.

Step 4: Max out tax advantaged retirement accounts

This is the step where eyes begin to glaze over. 401k, Roth IRA, investing… it certainly all sounds complicated. But again, it really isn’t. Understanding a few simple things will make this step easy enough. You will also gain some benefits now and, you know, retire someday.

The first thing is to understand every retirement account available to you through your employer. Don’t worry about all the specifics, just figure out what you can participate in. You most likely have more than one option. The goal is to put every dollar you can into these accounts.

Pre-tax accounts

Pre-tax account means that your money goes in before taxes. This is usually via some employer sponsored retirement program through payroll deduction, most commonly a 401k (there are others, especially in government). A Traditional IRA also falls under this category. You pay taxes on this money when it is withdrawn (usually in retirement).

There are potentially two big advantages in using pre-tax accounts. First, the money going in means less money being taxed now. For example, if you make $50k a year, but put $18k into your 401k, your taxable income this year is $32k. Not only is your taxable income lower (thus paying fewer taxes), but that is a drop from the 25% to the 15% tax bracket.

The second possible advantage is whether or not your employer provides any matching funds to retirement contributions. Oftentimes an employer will match up to a certain contribution point. This is free money. I repeat, free money! Just by putting money into an account, your employer gives you the same amount. Look into this and at the very least contribute up to the match of the employer (if any). If you aren’t taking advantage of this, you are leaving money on the table.

Post-tax accounts

Essentially the opposite as above, in that these contributions are made after you have paid taxes. This means when you withdraw funds, you pay no taxes. Most commonly this is a Roth IRA, but you might see “Roth” applied to other accounts as well. Personally, I’m a big believer that my taxes will be lower when I retire, so I prefer pre-tax accounts, but post-tax is good too. You probably have access to pre-tax and a post-tax accounts, so use both.

Understanding contribution limits

The type of account you are contributing to will have an annual contribution limit. The most common limits as of today are $18,000 for 401ks and $5,500 for Roth IRAs. But here is where I ask you to do your research. Google the accounts available to you to fully understand how much you can contribute. The goal, again, is to contribute the max possible amount.

Investing 101

Investing does not need to be complicated. Most providers offer incredibly simple “all-in-one” target date funds for you to take advantage of. These funds are usually called something like “Retirement Goal 2045”. These funds are designed to be riskier now and slowly grow more cautious as you near retirement. For the majority of people, putting all of your money into one of these target date funds is going to be the best option. Set it and forget it.

The one thing to be aware of when investing is the fund’s expense ratio. The percentage shown is how much is being charged to manage the fund. The higher the charge, the more it is costing you. 1% might not sound like a lot, but 1% of your money over the lifetime of your investing is significant. Do your best to keep expense ratios low. If the target date funds have high expense ratios compared to your other options, no worries. Investing is still straight forward.

Most likely your retirement plan offers you a variety of funds to invest in. A common way of thinking is to have your age in bonds and the rest in stocks. If you are 30, that means 30% of your investment in bond funds and 70% in stock funds. Bonds are safer than stocks, so as you age, your investments become safer. Others simply sit at 80% stocks and 20% bonds continuously. It just depends on your risk tolerance.

In the long run, no one can consistently beat the S&P 500. And if the experts can’t, you can’t either (no offense). Don’t get fancy with stock funds. Pick one that mirrors the S&P 500 and then add a general bond fund. This will be the most consistent way to invest for the long haul. Adjust over time as need be to keep the appropriate ratios.

Appendix – Budgeting and saving

I said earlier you don’t have to budget, but you have to be aware of where your money is going. I believe that to be true. But budgeting is incredibly helpful, especially when you need to save for something. One thing that is nice about the plan above is that you don’t really need to “save” part of your money every month into a saving account. You already have your emergency cushion and you are saving heavily into retirement. You are already covered.

But what if you do actually need to save for something special? A down payment on a car, for example. It’s a lot easier to save when you have a budget. When you know what is going where, it’s easier to decide where to cut back and save. Do you spend $500 a month eating out? Well, try to cut that in half for a few months. Knowing where your money goes and having a budget empowers you to make decisions.

And while saving usually isn’t considered fun, it does provide emotional benefits. When you set aside money for entertainment and other “fun” spending, you can use that money guilt free. When you know everything else is already taken care of, there is no shame in spending the money set aside for enjoyment. Trust me, a few hundred dollars never felt as good as when I knew I could spend it guilt free.

Budgeting is a self-reinforcing tool that will help control your finances. It will help you save money and it will free you from the guilt of spending. There are tons of great apps out there these days that will make it as painless as possible.

Epilogue: Control your money, not the other way around

It’s cliche to say, but don’t let your money control you. Our culture pushes us to consume as much as possible. We are bombarded with ways to spend our money but not with ways to live responsibly. Often this leaves us feeling out of control. We don’t want to even think about our money because of how stressful it is. This makes us uneducated and lost. We must take the time to understand how our finances work, because frankly, it isn’t that hard. And once we understand, we can make informed decisions about our money and our lives. Don’t let the financial insiders and experts fool you. The hardest part is not how to best utilize the money. The hardest part is living a life that is financially responsible.

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