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Pay Yourself FIRST - Build the Personal Finance Ladder

In my previous article I have provided a list of books and resources to help you learn more about personal finance. This article will primarily focus on creating and managing banking and investment accounts and provide a summary of investment account options available and how we would want to prioritize them to get the most bang for our buck!

Note that, there is no perfect answer for this topic and the accounts that you may want to create and what's available to you can vary widely from one individual to another. You should assess your financial needs and check what makes the most sense to you.

If you want to strive to achieve financial independence early in your life you should develop the habit of paying yourself first! As soon as you receive your paycheck every month, make sure you save and invest before you decide to make other purchases. Many articles and literature suggest saving at least 15% to 20% of your gross income for retirement. If you save more and invest your hard earned dollars early, you will be much better off in the long run. Check out my article on the power of compounding and ways to save on monthly expenses.

As you pay yourself first, try to get rid of your non-mortgage debt and at least pay off high interest rate credit cards. Save enough so that you are not stuck in reverse gear because of high interest rate debt. Pay your credit cards in full each month or at least pay the statement balance every month. Staying debt free will enable and empower you to save and invest more. Now let's discuss the various accounts that you may want to open and contribute to to achieve financial independence.

Personal Finance Ladder

Emergency Fund - as you master the art of managing and eliminating your debt, the very first thing you should focus on, is to save enough for the rainy day. Save at least 3 to 6 months of your monthly expenses. You can save more given your needs. It is good to have these funds liquid and saved in a high-yield savings account (HYSA) so that you can access it easily. Lot of online banks provide higher interest rates compared to brick-n-mortar banks. If your monthly expense is $5,000, you should save at least $15,000 to $30,000 in your emergency fund.

Employer sponsored 401(k), 403(b), 457, Thrift Savings Plans - these are retirement accounts offered by employers where an eligible employee can make contribution on pre-tax basis. The amount contribution amount is deducted from paychecks. Most employers also match employee contribution up to a certain percentage. For e.g., employers will match up to 3% dollar for dollar. Let's say your base salary is $65,000/year. This will result in bi-weekly payments of $2,500. So, if you contribute $75 (3% of 2,500) biweekly, your employer will match that amount and also contribute $75 to your 401(k) account bi-weekly. That is $1,950 just from the employer on annual basis. Make sure you at least contribute so that you get the fill employer match. That's free money! The amount that you and your employer contributes is invested in a curated list of mutual funds that are part of the 401(k) plans. The money grows tax deferred and withdrawals are subject to income taxes since you did not pay any taxes on your contributions. The employee contribution to 401(k) and Roth 401(k) cannot exceed the limits set by the IRS and any other plan limits that may exists. Refer to IRS' website to learn more about contribution limits, age limit for withdrawals and catch up-contribution limit.

Roth 401(k) - Some employer sponsored retirement plans may also offer a Roth option in addition to pre-tax 401(k). The amount is contributed after tax to a Roth 401(k). However, earnings grow tax deferred and withdrawals are tax free. So if you expect that you will be in a higher tax bracket later in life, a Roth option can be more appealing to you. The employee contribution to 401(k) and Roth 401(k) cannot exceed the limits set by the IRS and any other plan limits that may exists. Refer to IRS' website to learn more about contribution limits, age limit for withdrawals and catch up-contribution limit.

After you have your emergency fund set up, prioritize contributing enough to a 401(k) and/or Roth 401(k) so that you are at least getting the full employer match.

Health Savings Account (HSA) - this is a triple tax-advantaged account where your contributions are done on pre-tax basis, the money grows tax-deferred and the withdrawals are tax free for qualified medical expenses. Note, you need to be eligible to be able to contribute to a HSA. Refer to IRS's website to learn more about the eligibility and annual contribution limit. Some employers offer HSA accounts where the contributions are deducted from your paycheck. However, if your employer does not offer an HSA and you are eligible, you can open a HSA account by yourself.

If you are contributing enough to your employer sponsored retirement plans to get full employer match, the next account you may want to consider is a HSA.

Individual Retirement Arrangements/Accounts (IRA) - these are retirement accounts that provide tax advantages that you can open yourself with any brokerage firm of your choosing. Unlike employer sponsored retirement plans, an IRA has more investing options and you select stocks/mutual funds that you want to invest in. Generally, there are two widely known IRAs. Refer to IRS's website to learn more about contribution, income, age limits and required minimum distribution and also a comparison between different IRAs.

• Traditional IRA - you can contribute to a traditional IRA if you have taxable compensation. Contributions you make to a traditional IRA may be fully or partially deductible as determined by your tax filing status. The amount in this account grows tax deferred and generally the money is not taxed until you take a distribution. If you think your tax rate is high now and you will be in a lower income tax bracket in your retirement, then contributing to a traditional IRA can be appealing to you.

• Roth IRA - This is different from Roth 401(k)! You can contribute to a Roth IRA if you have taxable compensation. Contributions you make to a Roth IRA are not deductible. The amount in this account grows tax deferred and qualified distributions are tax free. If you think your tax rate will be higher later in life, then contributing to a traditional IRA can be appealing to you. Unlike 401(k) plans and traditional IRA, you are not required to start withdrawing from your Roth IRA once your reach a certain age. So, the amount in your Roth IRA account can grow tax-deferred forever and you enjoy tax free qualified distributions.

If you are contributing enough to your employer sponsored retirement plans to get a full employer match and have maxed out your HSA, consider contributing to a Traditional and/or Roth IRA.

529 Plans - if you are planning to save for your child's education, a 529 plan is a tax-advantaged savings plan that is designed to help pay for qualified educational expenses. You can also use this amount in this plan to pay for K-12 education expenses. The savings grow tax deferred and withdrawals are tax free for qualified educational expenses.

Once you have maxed out your HSA and IRA contributions, consider maxing out your contributions to 401(k) and/or Roth 401(k) and contribute to a 529 Plan, if needed.

Taxable Brokerage Account - if you have additional savings left to invest after you have leveraged all the aforementioned accounts to its full potential, you can open a taxable brokerage account at a financial institution/brokerage firm of your choosing. You fund this account using the money that has already been taxed. Any earnings resulted from sale of investments is subject to income taxes. You would pay short term or long term capital gains tax depending on how long you had held your investments.

Fund this account after you have taken advantage of all above mentioned tax advantaged accounts.

After-Tax 401(k) - Now what the heck is this? Feeling perplexed and dizzy? I wouldn't be surprised! Some employer sponsored plans also offer this option in addition to pre-tax 401(k) and Roth 401(k). If this source is available to you, you can contribute to this source in addition to total limit set by IRS for pre-tax 401(k) and Roth 401(k) combined. As the name suggests, the contributions are deducted from your paycheck on after-tax basis. The amount grows tax deferred and any earnings are subject to income tax on withdrawals. Your employer sponsored 401(k) plan may also allow for "In-Plan" Roth conversion of after-tax 401(k) or may allow you to rollover your after-tax 401(k) to your Roth IRA account.

These are some of the investment accounts that may be available and you may be eligible to contribute to. The goal of this article is to present you with some options that you need to be aware of. Please refer to IRS' website for more details and contact your HR representative at your firm to see if you qualify for any retirement plans. My intention is to provide you a gist of what's out there and how you may want to strategize and leverage several tax advantaged accounts. If you are curious, you may also want to check other accounts like SEP IRA, SIMPLE IRA, UGMA/UTMA accounts and see if you qualify for any of those. Sky is the limit!

The key takeaway is to get good handle on managing and leveraging various investment accounts and contribute enough given the target time horizon and target goal you have in mind for your retirement. So, do your homework, save enough and start investing early. Consistently saving and investing even small dollar amounts can help you accumulate enough wealth in the long run. Every cent counts! Every Cent you put to a good use, has a ton of Potential to grow!

The Eight Wonder of the World and the Power of Small Numbers

 “Compound interest is the eight wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” - Sir Albert Einstein.

In simple words, compounding earns you interest on interest. Let’s say you have $100 and you invested it in a stock or a mutual fund that earns you 10% interest. Now you have $110 at the end of Year 1. For Year 2, you will earn 10% on $110, not on $100. Now you have $121 at the end of Year 2. In approximately 7.2 years, you would have doubled your $100 investment and in 10 years you would end up with roughly $259.37

So how can I apply compounding to my own advantage and grow my wealth? 

Let's say you buy coffee from your local café five days a week. This can cost you roughly $100 a month assuming coffee/snacks costs $5. Now you decide to purchase coffee only four days a week instead of five and invest the remaining amount in a low cost, index mutual fund. At this point, you are investing $20 per month. The table below shows you the amount of money you would have, given the average rate of return, in 10 years and 45 years if you invested small amounts of money monthly. This is power of compounding! Small amounts of money invested over longer periods of time can turn in huge pile of cash. The sooner you start, the better!

To put this into perspective, just think of an expense that you can save and select a multiplier from the table below. You will get a sense of how much money you can save by just eliminating the expense you no longer need to indulge in. You can play with the compound interest calculator here and estimate the amount for a different time frame.

Key Takeaways - 

• You do not need a huge sum of money to being investing. Do NOT underestimate the power of small numbers!
• If you do not have enough savings to begin investing, start small. But most importantly, start EARLY. Time is the key!
• A tiny change in an average rate of return over a long period of time can make a huge difference.
• Your savings rate, annual rate of return and investing time horizon are the key parameters.

So eliminate redundant, unnecessary expenses. Below are few tips that will help think of ways you can save money, some of which, I too, have implemented.

• Cell Phone Service - Consider switching to a Mobile Virtual Network Operator (MVNO) for your cell service. MVNOs do not own the infrastructure that the big cell carriers need to maintain and thus are able to offer services at very low rates. Switching to an MVNO has helped me save over $50/month (that's $600/year, which you can invest). Some MVNOs offer plans for as low as $15/month.
• Local Laundromat - If you do not have access to washers and dryers in your apartment, consider trying out your local laundromat. Renting washers and dryers can cost you around $45/month to $55/month. Plus they increase your electricity and water usage and bills.
• Auto/Renters Insurance - Consider increasing your deductible. This, in most cases, will reduce the premium you are paying.
• Electricity Provider - Contact your local utility to see if you qualify for their energy efficiency program offering. Utilities offer energy savings kits that include free LEDs, showerheads, advanced power strips, aerators and other weatherization measures that can save electricity and reduce your monthly electricity bill.
• Learn to Cook - try cooking once in a while at home if you tend to eat daily outside. See if it affects your lifestyle significantly and becomes a positive reinforcement. Cooking is happiness :)
• Subscriptions - revisit your monthly channel/magazine/TV/media/wholesale club subscriptions and cancel the ones you do not use.
• Learn to Negotiate - If you do not negotiate and ask for a better deal, you won't get it! It doesn't hurt to ask. Negotiate your monthly internet bill/insurance bill. Get a quote from other providers and switch if you are not satisfied. Negotiate with banks on fees you may be paying. Most banks will waive off late fees if you have had a good history of paying your credit card bills on time. So always call and ask.
• Do your Homework - if you are planning to make an important purchase (for e.g., car), always do you homework on the price that you should be paying. Most salesman/dealers will try to convince you on buying that extra feature or a plan that you may not need. Take a step back and assess the need. If you have done your research, you will be able to ask the right question to the salesman/dealer and that person will not be able to sway you into making an unnecessary purchase.

These are just a few tips. Once you start implementing these saving habits in your life, you will soon realize how quickly the small numbers add up. And then put those hard earned and well saved dollars to work for you by investing them. You may realize that these decisions you make, do not affect or change your standard of living significantly or that you are not sacrificing your happiness in a big way. Instead, you are able to make the most from less and are investing the rest. The money will compound and will work for you. So, think how you can maximize your savings, and in turn, your happiness. Keep saving and investing for a better future and let compounding do all the magic!

If you have additional tips on ways to maximize savings, feel free to drop a comment. And remember... Every Cent you invest, has a ton of Potential to grow!

Books, Blogs and Podcasts on Personal Finance and Investing

Books are human's best friends! The first step before you get started with investing is to educate yourself. Don't rush and don't skip this step! You do not need to shop ten different books on personal finance. Check out your local public library and you can borrow books for free. Pro tip - you can borrow and read ebooks and audiobooks from your local public library for free using The Libby App by OverDrive.

The books/podcasts/blogs mentioned in this article share one thing in common - they help you develop a long term, equity-oriented, well diversified, low-cost, simple investing strategy. Take a moment and think about those five key words. Investing does not have to be complicated. Developing a systematic and disciplined mindset and sticking to the plan is the tough thing to do! So believe in yourselves and begin your journey to financial independence. Enough of pep talk... Here are few resources that I have found extremely helpful. The authors have done a commendable job of explaining basic concepts of personal finance and investing in the most simplest terms. The topics are well organized and easy to digest.

Books

The Simple Path to Wealth by J L Collins - in my opinion, this is the simplest book out there on investing. Collins wrote series of letters in 2011 to his daughter about money and investing. He later started a blog www.jlcollinsnh.com and created Stock Series to discuss topics on sound investing.

Retire before Mom and Dad by Rob Berger - in this book Rob beautifully explains the power of compound interest and discusses The 7 Levels of Financial Freedom and how to achieve it. The message in the book encourages you to change the way you look at money and use the money to buy your financial freedom instead of buying things you don't need, with the money you don't have, to impress the people you don't like.

I Will Teach You To Be Rich by Ramit Sethi - Ramit directly cuts to the chase and nails every topic from optimizing your credit cards and bank accounts to investing and automating your finances. He also offers tips and scripts on how to negotiate your salary/raise, pay less in fees by negotiating with your bank and credit card companies. Ramit explains that all of us can live our rich lives by spending extravagantly on things we love by ruthlessly reducing our expenses on things we do not need.

The Little Book of Common Sense Investing by John C. Bogle - Mr. Bogle, the founder and former chairman of The Vanguard Group, created the first index fund in 1975 that started index investing revolution. In this book, Mr. Bogle explains how investing in index funds can effectively guarantee your fair share of stock market returns. Index funds are low cost investing vehicles compared to many actively managed funds that charge high fees whose managers are seldom able to beat the market consistently over a longer horizon. To emphasize the genius of Mr. Bogle, I would like to quote Warren Buffet who supports index investing and said this about Mr. Bogle: "If statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle."

A Random Walk Down Wall Street by Burton G. Malkiel - in this book the author underscores that passively invested portfolio of low-cost, well diversified index of securities is still likely to exceed the performance of actively managed funds. Mr. Malkiel also talks about the recent bubble in cryptocurrencies like bitcoin. In addition, he explains how you can leverage other investing vehicles like money market accounts, real estate investment trusts (REITs), insurance, home ownership, gold and collectibles and use tax-loss harvesting to your advantage.

The Intelligent Investor by Benjamin Graham - This is a Classic! The book discusses the philosophy of "value investing". The book was first published in 1949. This is one book you don't was to miss reading! Graham's investing principles are still current in today's modern world. Doing your due-diligence of the company and its underlying businesses, shielding yourselves from big losses and aspiring for adequate returns are Graham's key principles on investing.

Your Money or Your Life by Vicki Robin and Joe Dominguez - What is your relationship with money? How much of your life's energy do you trade for money? Are you at peace with your money? These are some of the deep questions that the authors address in their book. Our beliefs, habits, play an important role in the way we manage our money. This books presents tools/lessons to achieve four FIs: Financial Intelligence, Financial Integrity, Financial Independence and Financial Interdependence.

Blogs and Podcasts

There are a lot of blogs out there with good saving, investing and money management advice. Some of these folks have retired early in their life to dedicate their time and energy to share knowledge and help others achieve financial independence.

Mr. Money Mustache - blog by Peter Adeney. There is also an app

Afford Anything - blog and podcast by Paula Pant

The Dough Roller Money Podcast - podcast by Rob Berger

madfientist.com

jlcollinsnh.com

bogleheads.org

Other Books

If this topic has spiked your interest and you would like to explore more, here are some additional books that you may want to read:

1. Unconventional Success: A Fundamental Approach to Personal Investment by David F. Swensen
2. The Bogleheads' Guide to Investing - by Taylor Larimore, Mel Lindauer, Michael LeBoeuf
3. When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein
4. The Millionaire Next Door by Thomas J. Stanley, William D. Danko

Once you take the first step to read and learn basics of personal finance, you will know where to start and will feel in control. Next time when you hear words like portfolio, bull/bear market, equity, risk/return, diversification, asset allocation you won't be puzzled. Instead, you will know enough to have meaningful conversations with your friends and family. Also, if you have hired a financial manager, you will be able to ask the "right" questions and make sure your financial manager is working in your best interest. So Read On...! And remember... Every Cent you put to good use, has a ton of Potential to grow.

Welcome to CentPotential!

This is a blog on personal finance! Think of it as a blog on Financial Literacy 101, which to my knowledge, is not taught in most schools at an early stage in life. Having born in an Indian family I learnt the benefits of frugal living growing up. What I didn't learn and wasn't made aware of was how to put the money that's sitting under the mattress to good use. Saving money is good. Investing it, is much better!

I moved to the United States in Fall 2011 to pursue my graduate studies. Pursuing a Masters degree in the United States is a costly endeavor! During the initial few months, I was able to take care of my living expenses via a Grading Assistantship. I was relentlessly searching for an on-campus job so that I do not have to pay full tuition fees out of pocket. After lot of searching, networking and applying to various jobs, I finally bagged a Fellowship and a Graduate Research Assistantship (RA). This fully took care of my tuition fees and it helped me save ~$30,000 in annual tuition expenses.

While trying to make ends meet on a meager RA stipend, I didn't have the luxury to indulge in comfort purchases like car and gifts. The stipend provided me enough money to pay for rent and monthly groceries. Childhood lessons on frugality came in handy and I felt I was ready to make the most from less! Graduate school was not easy. I knew that there was going to be a lot of struggle in life from here on but I felt motivated and in control.

First step was to make sure I get my finances in order. I picked up few books, talked with friends and started learning about personal finance. I was good at saving money, I just did not know how to put that money to work for me. Over past few years, I have learnt a lot about personal finance. I wish I knew more about it when I was a teenager and want to help others who are in the same boat. Taking control of my finances not only instilled a lot of confidence in me but it helped me focus on other things and provided me with options on what I would like to accomplish in future. I did not want to get up one day with a feeling that, "Damn! My life would have been much better if I had started doing this 20 years ago!"

Through this blog I aim to share my personal finance lessons and encourage you to develop a systematic and disciplined long term investing approach. I do NOT indulge in frequent short term trading, speculative investing and gambling with money. My goal is to write short articles to discuss topics on personal finance, investing, money management and retirement. My plan is to give you a gist of what's out there and what you need to know to get better at managing finances so that you know where to start, do your own due diligence and dive deep into topics that interest you.

Are you wondering how to get started with investing?

How do I educate myself?

Which accounts should I open?

How to optimize retirement accounts?

This is my first stint at blogging and I am excited to begin the journey to Financial Independence with you all! All of us can help each other and stay the course. If you would like to share your lessons that have helped you, feel free to drop a comment. And, until next time remember.... "Every Cent you put to good use, has a lot of Potential to grow"!