Phase 0: You Have a Choice

You’ve got a choice.  The proverbial red pill versus blue pill.

Choose the red pill and build wealth.

Photo by W.carter.

Take the blue pill, skim through these posts, and continue life as you have–paycheck-to-paycheck, never ahead, and worried that you’re one layoff away from financial meltdown.  You’ll retire when you’re 67, that is, as long as social security is still around to help support you.  You may need to work the door at Walmart, but that’s a good opportunity for socializing right?  Life is now.  You’ve got to enjoy it.  Live like no tomorrow!  You’ll make more money when you’re older.

or…

You take the red pill.  You take this stuff to heart and realize that you don’t have to live paycheck-to-paycheck anymore.  Retirement comes earlier and is not just sitting around, but the opportunity to do other “stuff”.  You’ll have a legacy to pass on to your children, be able to fund your grandchildren’s education, and best of all, you won’t have to work the door at Walmart.  You will build wealth.

A common misconception is that financial success comes when you earn a significant amount of money and have a nice house.  Maybe it’s when you’re driving a shiny new BMW.  So many people use a six-fig salary as a measure of true financial success, but they’re often living paycheck-to-paycheck just like somebody that’s making $40,000 per year.  When people imagine making more money, they imagine being able to have a little more breathing room; not worrying about when the next paycheck is coming.  But living paycheck-to-paycheck feels the exact same no matter how much money you’re making.

In fact, financial success isn’t completely reliant on being successful from an income standpoint.  It hinges on being organized and disciplined more than anything else.  If you’ve ever read The Millionaire Next Door, you know what I’m talking about.  It is totally possible for normal people to be abnormally successful with their money if they just steer their financial ship with self-discipline.


Now that you’ve (hopefully) decided to pull the trigger, where the heck are you supposed to start?  The following is a list of what to do with your money.  If you finish Phase 1, move to Phase 2, and so on.  I’m tempted to say that these are ordered from the most important to the least important but they are all important.  Think of it more as a To Do List.  If you get past Phase 6 you’re doing well.  If you make it to Phase 7, you’re kicking some serious butt.  At Phase 8?  You’re in Legendary mode.

Here is your order of operations:

  1. Build and stick to a lean budget
  2. Have an emergency fund of a minimum 3 month’s expenses.
  3. Get that 401(k) match
  4. Pay off all debt (excluding a mortgage if you have one)
  5. Max out contributions to a Roth IRA
  6. Bump your 401(k) contributions to a minimum of 10%
  7. Contribute to a brokerage account for your long term goals
  8. Pay down your mortgage

Let’s get a quick run-down of the phases (we’ll cover them in more detail later).

The Phases

Phase 1 – Your Lean Budget

You’ll notice that Phase 1 is different from all of the other steps.  Unlike the other steps, Phase 1 isn’t telling you where to park your dough, but it lays the framework for you to be able to accomplish the remaining steps.  The key part of Phase 1 is making your budget lean. What does lean mean?  If you’re not brown-bagging lunch 90% of the time, your budget ain’t lean!  Having a car payment ain’t lean!  Be ready to make some changes here.  They may seem huge at first, but humans are amazingly capable of adaptation.

Phase 2 – Emergency Fund

After you make sure your budget is squared away, you need to get an emergency fund up and running.  This is a lump of cash that is there for you should you get laid off, make an unexpected visit to the ER, or rear-end that dude in the Mercedes.  Emergency funds will always, always, always be held in a high-yield savings account.  Why?  It makes it a little trickier, though not difficult, to access and it earns a little bit of interest while it’s parked.  Make no mistake, this is not an investment.  In fact, it’s almost guaranteed to be outpaced by inflation.  The purpose of this isn’t to make you money–it is to save you from financial ruin.  Three month’s actual living expenses is a requirement.  Six months is preferred.  You’ll be happy you have it when the proverbial poop hits the propeller.

Phase 3 – 401(k) Match

The Society for Human Resource Management reports that the most common 401(k) match is dollar-for-dollar up to 6% of an employee’s salary.  It is closely followed by a 50% match up to 6% of an employee’s salary.  Not contributing 6%?  If you make $40,000/year, you’re missing out on $2,400 (dollar for dollar up to 6%) per year!  If you’re just starting out your career, that means your retirement nest egg will be a quarter-million dollars smaller when you’re ready to cash out (annualized 6% return for 35 years).

Phase 4 – Paying Off Debt

Credit card, student-loan, and car debt is going to kill you.  Your mission is to kill it first.  Mr. Hardcore himself, General George Patton said, “Attack rapidly, ruthlessly, viciously, without rest, however tired and hungry you may be, the enemy will be more tired, more hungry. Keep punching.”  This will be your mantra. If you’ve got a $3,000 credit card bill, have a 15% APR, and make the minimum payments, you’ll pay more than $400/year in credit card interest.

Maybe $400 over a year doesn’t sound like a lot, but what if that $3,000 TV rang up on the register as $3,400?  You would be talking to the manager at Best Buy.

Phase 5 – Maxing Your Roth IRA

A Roth IRA is a tax-advantaged account used for retirement savings.  A 401(k) is tax deductible now, but you’ll be taxed on withdrawals later.  A Roth is the exact opposite: you pay taxes now, but you don’t pay taxes later.  If for some reason, you have a Chernobyl-like financial meltdown, you can withdraw funds from a Roth without penalty (more on this later). You can’t do that with a 401(k).  Imagine not having to pay taxes when you retire.  The 2015 maximum contribution limit is $5,500 if you’re under 55.  Guess what?  If you put in $5,500/year from age 25 until age 59-1/2, you’d have a whopping $628,000 (6% for 35 years).

You may have a Roth 401(k) at work.  Not to fear.  We will go into detail about this when we cover Step 5 in detail.

Phase 6 – Bump Up Your 401(k) to 10%

Now that your Roth is maxed out, bump your 401(k) up to 10%.  If you’ve got plenty of cash left over, then contribute even more.  Between a 10% 401(k) contribution, your employer’s match, and maxed-out Roth IRA contributions, you’re going to have a solid retirement plan.

In case you were wondering, if you make $50,000/year and plow 10% of your paycheck (plus your employer’s 3% match) into your 401(k), this comes out to $767,785 at retirement age.

Phase 7 – Save Outside of Retirement Accounts

After your retirement accounts are getting a nice monthly check, start thinking about pre-retirement, long-term savings needs.

You need to setup a nice stash of dough to help out with future expenses. Whether it’s a rental property, early retirement, or a new (but used!) car, big purchases are a part of life. Be prepared.

Phase 8 – Pay Down Your Mortgage

The freedom that comes with no mortgage is unlike any other. You can do it faster than you think. Some people prioritize this over Step 7, which is ok.

Summary

My hope is that this blog can give you a sense of direction.  A financial compass.  It’s geared to the normal people out there.  We are not going to be “flipping houses using other people’s money” or saying that you can “retire in your 20’s by spending $20,000/year”.  The end goal is a solid financial plan which will allow you to live and retire comfortably by building wealth.

Work towards these goals and you’ll be enjoying a life much different and more prosperous than your colleagues.

P.S. if you made $50,000/year and followed steps 1 through 6 above, you’d be sitting on a $1.4 million retirement fund.  At the “safe” withdrawal rate of 4% per year, your retirement salary would be more than $55k annually.  You’re making more in retirement than you did while working!

5 thoughts on “Phase 0: You Have a Choice

  1. Ginger

    I’m not sure I like your step order. My Roth and emergency fund are one and the same except for about a month cash that is in a regular savings. I also never would give up a match, even if I did not have an emergency fund. Plus, sometimes a 401k with a match is better with tax credits like the saver’s credit and EITC than a Roth.

    1. Will Post author

      Thanks for the thoughtful comment, Ginger. I place a pretty high priority on having an emergency fund before anything else. My thought with getting the e-fund going before the match is that it should take very little time to do so. If you have a crisis without an e-fund, it could result in some pretty significant consequences. As you pointed out though, you can always do two things at once!

      It’s pretty widely accepted to have your e-fund separate from your retirement accounts so that you’re not forced to sell at a loss to fund a personal emergency. It also prevents any issues with penalties that you could encounter. Your retirement savings shouldn’t have to take a hit because you rear-ended a Benz.

  2. Tiffany

    Hi Will, I found your blog bc you kindly responded to a question I posted on [name removed by Will] forum. I’ve been reading [name removed by Will] blog for a while but I still can’t seem to figure out how exactly I should set up my Roth. I was lucky enough to to be able to max it out this past year, but all it has done is lose money. I know it goes up and down, but I can’t seem to grasp how I can expect and plan for a 6% return when all I see is my losses. Could you shed a little light on this? You may have a post on it- I just haven’t seen it yet.
    Thanks so much!

    1. Will Post author

      Hi Tiffany. Thanks for checking out the blog. You’ve got pretty good timing–I’m working on a post right now that talks about timing and returns. Volatility is a normal and expected thing with the stock market (that doesn’t make it any more pleasant though). When I had finally saved up $3k to invest in an S&P 500 index fund, it was the summer of 2006 and the S&P was at ~1,300 points. I felt proud of myself for actually becoming an “investor”. Flash forward to 2009; my portfolio had lost half of its value. Was I bummed? Absolutely. Did I question whether investing was a good idea? A little bit. But I hung in there and trusted the wise words of Warren Buffet, mostly because I had no alternative. So what happened? The market eventually recovered from (hopefully) the worst financial downturn I’ll ever witness in my life. My portfolio that had lost half of its value after 3 years had an average annual return of 11% when I last looked.

      My point is this: market volatility happens. Really the only thing you can do is to wait it out and see what happens. Reward necessarily comes with risk, but over the long run you’re likely to come out ahead. Just keep investing a consistent amount each month and make sure your dividends are being reinvested. Chec kout Dominate Your Savings With Automation–it can help make contributing consistently much easier.

      If you subscribe to the blog, you’ll get a notification when I publish the article on market timing, volatility, and returns. I hope you like it!

      1. tiffany

        Thanks Will! I’ve got my Roth set up with Betterment, so my dividends are reinvested automatically. I was just questioning my allocation and set up, I guess! It’s hard to see your money go down and down and down :) thanks again!

Leave a Reply

Your email address will not be published. Required fields are marked *