Building wealth from income is a challenge. Wealth is best described as the value of what you own minus what you owe, which is also known as your net worth. To be financially successful, you need to think in terms of this wealth - not cars, not carrying a balance on your credit cards, or buying $600 shoes. The only way to build wealth from income is to start taking part of today's income and investing it to accomplish future life goals. Put simply, it means limiting today's spending.
We have all heard the adage "pay yourself first" as a way to make setting aside money for the future a priority. That raises the question, how much to set aside? I recommend striking a balance using the “33-1/3 percent solution.”
Assume that 1/3 of your income goes to housing costs (mortgage or rent, insurance, maintenance). Assume that another 1/3 of income goes to the government in the form of different taxes paid - from income tax, capital gains tax, property tax, sales tax and employment taxes like Social Security and Medicare. That leaves the remaining third of your income available to meet both current consumption needs and to invest for your future.
My suggestion is to start with the 33-1/3 percent solution and adjust the percentages accordingly depending on your overall tax burden, and the percentage of your income you spend for shelter.
Take a look at last year's state and federal tax returns. They show your gross income, income taxes paid, FICA taxes paid, and the deductions you took for property taxes and other deductible items, like business expense. What it misses, unless you are deducting them, is how much you have paid in sales taxes. (You can deduct state income tax, or state sales tax, but not both.)
Put your total taxes over your gross income and you've got the tax weight. Not 33-1/3 percent? It doesn't matter; just subtract that percentage weight from 100 percent. That is what you have available for the other two categories.
Next is shelter. If you escrow homeowner's insurance and property taxes, your monthly mortgage payment covers PITI - principal, interest, taxes, and insurance. You do not want to double count property taxes. If you count them here, do not count them in the tax weight. Power, water, sewer, and a line item for maintenance can go in this grouping too. Renters have it a bit easier in estimating their costs for shelter. Once you have calculated the percentage of gross income you spend on shelter, you have your second weighting. Subtract that weight plus the tax weight from 100 percent and you have arrived at the percentage of your income you spend on current consumption or invest for your future.
33-1/3 is a good estimate for the consumption/investing piece. You may find out that you are spending 40 percent of your gross income on shelter and 35 percent on taxes. That leaves you with just 25 percent of your gross income to finance current spending and investing. The lower the percent, the harder it will be to accomplish your future goals.
So how do you pay yourself first?
Take advantage of the "no pain" approach. There is a lot of truth to a savings approach that assumes out of sight, out of mind. A 401(k) plan is one of those. Not only does the money go directly to the plan before you can spend it, if your company matches any part of your 401(k) contributions, you are that much better off. At a minimum, you should contribute up to the limit of the company match to the 401(k) plan. With a typical plan, the company will contribute 50 cents to every dollar you contribute up to you contributing 6% of salary. That 3% company match allows you to save 9% annually towards retirement.
Is that enough? Probably not, but it is a start and the sooner you begin, the easier it will be to reach your retirement goals. Contribute 6% of salary and you now only have 27-1/3% of that last third to allocate between other investments and current consumption.
Work backwards to prioritize
There are plenty of other life goals besides retirement; like financing some or all of your children's college costs, buying a second home, traveling, philanthropy, or leaving an estate to your heirs.
Before you prioritize those goals, you need to budget out of current income money to pay your bills for food, clothing, and other necessities. Keep in mind that housing is already coming out of the other third. Fold in a component for what you enjoy doing: entertainment, exercise, or vacations, because life is not all about delayed gratification. That gives you the percentage of the consumption/investment wedge that you are allocating towards consumption. What you are shooting for is living within your means while investing for your future wants.
You have just created a spending plan, allocating your income to desired spending. After meeting your current consumption needs, what percentage of the income pie is left to pay yourself first? If what is left for investing is zero or negative, then you should redo your budget and try to cut expenses. In general, you do not want to finance current consumption with future income. What is clear in all this is that you do not have money to waste in credit card interest, overdraft fees, ATM fees, and other unnecessary fees.
Once you determine the percent available for investing, it is good to set up a plan to make those savings happen automatically. Don't forget about the need for liquidity in an emergency fund. You don't want all of your money tied up in your retirement accounts. Once you have your emergency fund, then you can invest more for your future.
Regardless of where you plan to retire, the number one factor in ensuring that you can retire on your terms is your 401(k). Make sure that your 401(k) is maximizing its potential with this free analysis that checks your fees, fund mix, and other factors to help you hit your retirement goals.