Pay Yourself First

Pay Yourself First
by David John Marotta | 02-28-2011

The greatest engine to generate real wealth is saving and investing. And the best way to ensure that your default is saving and investing is to automate the process. Pay yourself first, and your savings will grow exponentially.

Wealth management is based on the idea that very small changes can yield enormous gains in your family's finances. This process, both easy and simple, is worth millions. Unfortunately, only a tiny percentage of American families take advantage of the tools available to implement this automated technique.

All income should flow into your joint taxable investment account. Make saving and investing your default. Putting all of your money in this account helps ensure that you move only the money intended for some other purpose into a different account.
Automating the process of saving and investing is like damming a river to form a reservoir.

For working families this means an automatic deposit of paychecks into their joint account. Banks will try to entice you into setting up automatic payroll deposit into their checking account. They will offer you additional interest if you do so. Resist. The additional interest is not worth the failure to not only save but to save and invest. Your taxable investment account should be the default.

For retired families this means an automatic deposit of Social Security checks. It also means their required minimum distributions (RMDs) from their individual retirement accounts (IRAs) should be deposited first into this account.

From this account you can then withdraw what you need for daily expenses. Do this by setting up a regular transfer of funds from your joint investment account to your checking account. Make sure the transfer matches the amount you have allocated in your budget, ideally 65% or less of what you need to support your lifestyle. The other 35% should remain in your joint taxable account, much of it to be invested.
Gift appreciated stock from this account and leave enough cash to reinvest and replenish the value. This plants the seed for future gifting. You save on capital gains tax, and with your new purchases you can rebalance your portfolio.

Another part of what remains is the 10% you have designated for unknown unknowns. In the ideal world, this money will not be needed, but few families can anticipate every possible expense. Each stage of life presents new challenges. Having the financial margin to absorb some of life's shocks is simply wisdom and offers financial peace of mind.

Because the time horizon for this emergency money is unknown, invest it in a balanced portfolio. If unused, your emergency money will double in 7 to 10 years and provide a greater safety net for your family. If you have to dip into this fund, keep track of the amount. If it approaches the full 10% every year, you are using your emergency money to extend your budget, not simply for unanticipated expenses.
The less you use this account, the more quickly you will reach financial independence. These funds are mixed with your other taxable investment savings and continue to grow your net worth. If you are meeting all of your expenses without any major surprises, these funds can be used to purchase a home, start a business or for additional charitable giving.

Another portion of what remains in your taxable investment account will be the 5% you are specifically designating as taxable savings. Because this 5% gets mixed in with charitable giving that is being invested and your unknown expenses, the entire portfolio should be balanced. If an emergency arises, any portion of the portfolio could be sold to furnish the needed funds. Similarly, when you want to gift appreciated stock, any portion of the portfolio could be gifted.

The last portion might be the 10% for funding your retirement accounts each year. Many people put this money directly into a retirement account as part of the payroll process through a pretax deduction. If that is the situation, you don't need to flow anything through your taxable investment account. But you may want or need to fund your retirement outside of a payroll deduction. One example is funding your Roth IRA each year. In this case you may want to collect the money in your taxable investment account and then transfer it to a Roth account.

If you want to fund a Roth IRA account for the maximum $5,000 (in 2010), you could transfer the entire amount once during the year or set up a monthly transfer of $416.66. The money from your paycheck would provide the liquidity, either letting it build up throughout the year or supply the funds for each month's transfer.
Busy people forget to make the necessary transfers each year. That's why a monthly transfer is preferable. Saving and investing should be automated so it occurs regularly without any additional effort. Whatever is in your checking account you are likely to spend. Whatever is in your investments you are less likely to spend.
Automating the process of saving and investing is like damming a river to form a reservoir. The alternative is the manual process of hauling buckets of water from your stream to a water tower. You will never grow rich by hauling buckets, and it's much harder work.

No matter what income you have, you probably already have enough to grow rich. Saving and investing just $10 a day builds a million dollars over your working career at average market returns. You build wealth by what you save and invest, not by what you spend. Automating the process of saving and investing grows your wealth while you sleep.

Raising Money-Savvy Kids

Raising Money-Savvy Kids
by David John Marotta | 02-21-2011

Many people lament that schools don't teach children to be financially responsible. But studies show that book learning doesn't work when trying to teach about finances. Here is a guide for what will give your children the best chance of handling their money well.

Financial responsibility is more about self-discipline than about knowledge. Think of it like dieting or staying physically fit, not solving math problems. It isn't simply information you learn from a book, it is a skill you learn by doing.
I coached soccer for many years and was assistant coach to one of the best. Excellent coaches understand how to design exciting games that teach specific skills. They are able to motivate the players about the game and at the same time teach them the skills they need to be successful.

You learned your best life lessons by experience. You cannot teach your children to live within their means if you keep supplementing their means.

Training to be financially adept requires the same three methods needed in sports: communication, example and application.

Communication alone is the least effective. Imagine I was teaching you the proper way to kick a soccer ball. In a textbook you read, "Take aim and then look back to the soccer ball as you shoot. Approach slightly from the side. Plant your non-striking foot beside the ball. Strike the middle. Keep the knee of your kicking leg over the ball. Follow through."

If that was the end of the lesson, all players would remain abysmal once they got on the field. Head knowledge isn't enough, and it doesn't help you visualize what is possible. Also, knowing how and why is very different than actually being able to do it.

Most coaching involves simply giving players an example. You do something and you say, "Kick the ball like this." Although "like this" could mean a thousand things, children are very good at abstracting what is important. Similarly, our children can learn financial perspectives and habits simply by growing up in our homes.
Our example as parents gives them a default of what to try first. But unfortunately, most families don't provide a very good model. The average family's finances are appalling. Credit card debt averages $6,500. Half of American families have no retirement accounts. The other half have only saved $35,000.

Getting your own financial house in order is half the battle. The other half is bringing your children into your circle of trust as they mature. Most children feel they are in the dark regarding family finances. My most valuable education came from my mother, who shared every aspect of her household budget with us.

Before age 10, I knew what my father's salary was, the amount of our mortgage and the interest rate we were paying. I knew how much a week's worth of groceries cost and the value of buying term life insurance and investing the difference. Parental actions can be ambiguous, but when they are accompanied with a commentary of values and decision-making skills, they offer sage mentoring.

Communication and example are important, but practice is the key to raising financially savvy children. Given enough time to practice, even children without guidance and good examples will learn from trial and error, just like young soccer players accidentally learn that spinning balls curve.

The physics that causes a lateral deflection of a spinning object are quite complex. But with some trial and error, it is much easier just to learn to do it. Even children with no knowledge of physics can ultimately bend or curve a soccer ball around a wall of players and into the corner of the net.

To raise financially savvy children, give them as much practice time with real money as you can. Encourage your children to make spending decisions as early as possible. Let them make mistakes and learn from them. Give them practice in spending, investing and earning.

They should not be asking you for money. Let them make the tough calls about needs and wants and be forced to choose. If they are not obligated to make hard decisions, you are giving them too much money or not making them pay for enough things. You learned your best life lessons by experience. You cannot teach your children to live within their means if you keep supplementing their means.

Also, they should only be paying for things you are willing for them not to purchase. For example, if you make them pay for a school trip, you must be willing for them to decide not to go. And if they have spent all of their allowance, do not loan them money. Finding that you want to buy something but you have already spent everything is a critical lesson. Make sure your children don't miss it.
Children need experience not only saving, but saving and investing. It takes a while to understand the principle of compounded interest. I thought the lesson was essential enough to cheat and shorten the time horizon. The first time my children had $100, they were allowed to invest the money for one year with an extra 100% return on their money. They could keep whatever they earned plus an additional $100. They were young, and a year was a long time for them.

As part of our firm's quarterly reporting, clients receive a chart showing the net cumulative investment versus the portfolio value, which drives home the power of investing. Even $100 invested teaches the lessons of compounded market rates of return.

Finally, children must learn how an ethic of hard work and persistence produces a financial return. Grit is a better indicator of financial success than IQ. And running a small business requires more persistence than smarts.
My children were allowed to get jobs at age 14 and were eager to do so. That year they also started funding their Roth IRAs and took over more of their everyday spending. They had been prepared and were able to assume much of their own financial independence.

At every age of your children's lives, think through how you can communicate, be an example and give them real-world practice, first at budgeting, then at investing and finally at running a business that provides real value.

If you'd like to further your children's financial education, come to this month's NAPFA Consumer Education Foundation meeting. This Wednesday, February 23, my topic will be "How to Raise Money-Savvy Kids" at the Charlottesville Northside Library Meeting Room from 7:00 to 8:00pm. The talk is intended for parents and teenage children, although younger children are welcome.

For Valentine's Day, Work on a Budget Together

For Valentine's Day, Work on a Budget Together
by David John Marotta | 02-14-2011


An overwhelming number of people in failed marriages cite financial troubles as a major factor in their breakup. It's not surprising because the way we use our time and money reflects our values. Without a strong set of shared values, marriages may founder. But dealing with finances together can bring a couple closer. Developing and remaining faithful to a budget is probably the best way to build both your wealth and your marriage.

You may think financial planning is unromantic, but marriage is so much more than gazing into each other's eyes. It is as much a business merger as any corporate contract. And nothing is more romantic than planning how to realize your shared hopes and dreams for the future.

Finances tend to be a taboo subject. Often engaged couples do not know what their prospective mates earn or how much savings or debt they have accumulated. Most couples have deeply conditioned emotions and expectations about financial matters that they unconsciously project onto others. So in addition to selecting a china pattern and the floral arrangements for your big day, make sure your marriage has the financial footing and monetary habits to meet life's challenges.
Couples who have worked together on a budget already agree on the big picture. Once they make the hard decisions about what will help further the family's values, specific purchases in each category are much less critical.

Planning for financial security helps engender a loving environment of shared goals, respect and communication within which romance can flourish. If you can't share details about your finances, it doesn't bode well for your relationship. A professional may help facilitate the necessary discussions. An advisor can ask sensitive questions without judgment, listen to each person's goals and make recommendations to which the couple can respond without any hurt feelings.
I especially enjoy working with young families. Wealth management is all about small changes that produce large results over an extended period. And young couples have enough time to grow richer year by year as they age gracefully together.
Many new couples mistakenly believe they are doing well if they live within their means. This is a common misconception. Couples should keep daily expenses within 65% of take-home pay and reserve the other 35% for very specific purposes.

Ten percent should fund your retirement accounts, and an additional 5% funds your taxable savings. Set aside another 10% for large unexpected purchases. Without budgeting for these large emergencies, anything could swamp your finances. The roof might leak, the car could require major repairs or you could need to fly home for a family emergency. And finally, you may decide to put aside an additional 10% for charity and gifting.

If you add these values up, 35% of your regular take-home pay can't be spent on daily living expenses, leaving only 65% that can. Without this foresight, your finances or savings will be deluged by the regular large waves of unexpected immediate needs. This might be the single choice separating those who will grow their finances and those who won't.

Having a budget gives you more freedom, not less. Couples without one often fight about every dollar they spend. Each purchase becomes a battleground where values and priorities clash. And there are always impulsive purchases that provide fodder for an argument.

Disputes about how to spend money can be ongoing in families that are struggling to make ends meet. But a spending plan should never be exploited as a weapon. It can only be used as a tool for couples who are working together toward a common goal.
Most people occasionally buy something that their spouse considers frivolous. The way to contain the havoc these purchases wreak on a budget and a marriage is to set a boundary within which they can be enjoyed and beyond which they will not threaten other financial goals.

We recommend that couples make a line item in their budget for a husband's frivolous purchases and a wife's frivolous purchases. I suggest 1% total or half of 1% for each spouse. So long as spending stays within the budget, there should be no arguments.

Couples who have worked together on a budget already agree on the big picture. Once they make the hard decisions about what will help further the family's values, specific purchases in each category are much less critical.
When people follow a carefully constructed household budget, they do not need to worry about spending until a category exceeds the prescribed amount. Having decided how much money the family can afford to spend on clothes for him and for her, for example, it doesn't matter if he prefers lots of inexpensive clothes and she prefers a few more expensive outfits. A budget allows a certain degree of freedom that forestalls any controversy.

And when a family does overspend one category, they can decide in a monthly budget meeting how the category allocations might be adjusted going forward. There may still be disagreements, but at least with a budget there won't be petty discussions about every dollar or even an attempt to figure out where the money was spent.
As we grow older we can enjoy great peace of mind if we have resolved our money issues together. For Valentine's Day, work on a budget together. It is a calorie-free way of building lasting harmony.

Save Your Social Security Payroll Tax Cut

Save Your Social Security Payroll Tax Cut
by David John Marotta | 02-07-2011

This year the government reduced Social Security taxes by 2%. More than 150 million workers will receive up to $2,136 each. The assumption is we can spend our way out of unemployment. You should boost your savings rate by 2% to ensure you don't fall behind on your retirement savings.

We can't spend our way out of economic trouble as a country any more than we can grow taller by pulling on our shoestrings. Increased spending is an indicator of economic health only when it follows increased production and earnings. Rich people generally spend more. But that certainly is not what makes them rich.

A far better scenario would be if we as a country tried to save and invest our way out of a recession. Imagine if everyone invested their rebate by creating new businesses or building factories. Then we as a nation would produce more. Increased annual production could be sold, which would increase our gross domestic product.
Consuming more goods doesn't really help our economy when half the stuff we buy comes from China anyway. In fact, deferred consumption is the definition of capital and would allow us to use that money to build more productive companies. It would lower unemployment and reduce inflation.

President Bush tried the exact same gimmick in May 2008, issuing tax rebates in the form of stimulus checks.I respondedjust as vehemently that the rebate was a cheap insult directed at the American people and free markets. Every time the government bureaucracy engages in centralized spending plans, the economy is weakened. They believe they are better off, butworkers will actually be poorerif the check increases their spending habits by even a penny.

Average workers earning about $50,000 a year will see their take-home pay rise by 2%, or $1,000. Normally their standard of living after taxes and savings might be $37,000. By age 50 they should have saved about 10 times their standard of living, or $370,000. But if they spend an additional $1,000, they increase their annual lifestyle to $38,000. They will fall $10,000 behind on funding their retirement.
The United Auto Workers supports the idea of the payroll tax cut. They claim, "Working families will likely spend this money in their local communities, creating jobs and stimulating overall growth." Anyone who spends more than 4% actually loses ground in saving toward retirement. Thwart the UAW's advice and start saving and investing an additional 2% of your income this year.

To replace your income and be financially independent at a reasonable age, you should be saving 15% of your take-home pay toward your retirement. I received the following reply to that advice from one of my readers. She wrote, "Few people I know, except for well-paid professionals, can save 15% of their income for long-term retirement goals. . . . Sorry, but most people don't live in this author's rosy world."

No matter what your salary, there are people living comfortably off 15% less money and still managing to save 15% of their smaller salary. We could easily begin to ask uncomfortable questions about this reader's lifestyle. We might find at least 15% in discretionary spending that more frugal people could easily eliminate. My reader would have made a more convincing argument if she said we are already being taxed more than 15%, which ought to be enough.
Most workers don't know how much they are taxed for Social Security. The correct figure is 12.4% for Social Security plus an additional 2.9% for Medicare, a total of 15.3%.

Of the 12.4% for Social Security, 6.2% is deducted from the employee's paycheck. The other 6.2% is withheld by the employer, who reduces salaries accordingly. In truth, without these government-imposed taxes, the labor market would settle at paying employees 15.3% higher wages. Management doesn't care whose share it comes out of. Either way employees bear the burden of the entire tax.
Saving 15.3% over a working career ought to provide all employees with a retirement income at or greater than their wage during their working years. Instead, the return on Social Security investment is minuscule if you are a rich white woman and negative if you are a poor black man. Nonworking spouses, who never contributed anything to Social Security, are the only group that can claim to have won in the exchange.

White House economic adviser Jason Furman said, "The payroll tax cut has absolutely no effect on the solvency of Social Security." Only in Washington do they pretend the emperor is clothed. How can collecting $112 billion less in Social Security taxes have no effect?

The Treasury Department has been instructed to replenish Social Security with additional borrowed money against Treasury bills. The entire Social Security fund is a stack of IOUs written against future tax collection. So I guess adding a few more without first squandering and spending revenue doesn't really change the solvency. In other words, the system is bankrupt either way.
Take ownership of your own financial securityand increase the rate you are saving and investing by at least the 2% Social Security tax cut.