Tuesday, February 24, 2009

I'm All Right Jack

There are two stages to getting your financial house in order. The first is bedrock - ensuring that you earn more than you spend. The early part of this series has attempted to describe how to do that. The second stage is foundation - organizing your finances to provide security, so that even if an unexpected emergency occurs, you won't fall apart. This entry talks about the priorities you should look at, after you have worked out your income/expense picture, but before you start looking at serious investment.

In rough order of importance, then, here's what you should try to do.

1. Get insured.

What? If you don't already, get car insurance, renter's or homeowner's insurance, and medical insurance. If your job offers it, sign up for long-term disability insurance. Other types of insurance are optional, depending on your situation - for example, you can skip life insurance if you're single with no kids.

How? When you can get insurance through your work, do so - it may feel expensive, but it is much cheaper than buying it as an individual, and infinitely cheaper than getting stuck without it. For things like auto and renter's insurance, talk with friends and family to see if they can recommend an agent. If you're already with a particular company, don't immediately switch unless you're unhappy; many offer loyalty bonuses if you stick with them for several years, and if you're a long-time customer, they may occasionally give you a break.

Why? It's incredibly important. Odds are that you already have this stuff, but if not, get it as soon as you can. Without renter's insurance, if there's a fire in your place, you will lose everything you own; with it, they'll pay to replace your bed, your TV, your computer, everything. Premiums are not the place to save money, so don't skip them!

2. Set up an emergency fund.

What? Experts recommend keeping enough money here to cover between 3 and 6 months of expenses - think of rent, utilities, debts, insurance, food, etc. I recommend that you keep track of all your expenses for one month, subtract any truly unusual items (like plane tickets), then multiply by 3.

How? You will automatically be accumulating this fund as part of your checking and savings account. Any money that isn't being spent becomes part of this fund. Eventually, you might want to move this money to a high-interest online savings account - more details on that in a future session. Even if you keep it in your normal bank, you might want to consider creating a separate account for it, so you recognize that this is "special" money that isn't available for spending. Any time you have to withdraw money from the account, re-filling it should become your top priority again.

Why? Bad things can happen to any of us, but this fund will provide a buffer that keeps "bad" from meaning "catastrophic". If you have no savings, then you can only respond to financial emergencies by taking out loans, which probably carry high interest rates. You can spend years digging yourself out from under there. The emergency fund can be tapped to, for example, pay a medical or car insurance premium if you get in an accident. Also, if you lose your job, the fund will support you during the time you look for new work; without it, you could be forced to take the first job you find, just to make ends meet.

3. Pay off high-interest debt.

What? This category includes your credit cards, store charge cards, and anything else with a high interest rate. The definition of "high" fluctuates over time; right now I'd consider this anything over 5%.

How? Ideally, you want to pay off all such debt in full every month. Whenever you get a statement, check to make sure you have enough money in checking to cover it, then pay the whole thing off, either online or by writing a check. If you don't have enough to cover everything, then make sure you pay the minimum on everything, and as much as you can to the highest-interest item. After that's paid off, move to the next-highest, and repeat.

Why? This will keep you from getting charged that high interest - interest takes money out of your pocket in return for nothing, so it's bad no matter what your goals are. Even though this is listed as #3, in practice it might be #2 for some people. If you have a usurious credit card rate of 33%, it will be very hard to build up your savings account while accumulating interest, so in that case you should pay off the card at the same time that you're setting a little aside for your savings.

4. Sign up for a retirement plan.

What? If you work for a medium- or large-sized organization, you probably have access to a 401(k) plan, 403(b), or something similar. Open an account if you don't already have one and start saving.

How? Talk with your HR representative or manager if you need to open an account or need information on how it works. You will generally specify a percentage of your paycheck to put into the account. Some organizations offer a match - for example, they might match 50% of the first 6% that you contribute. You should contribute at least enough to get the match - in this case, 6%. If you have more money available, consider saving even more. You'll have a choice of funds to invest in; we'll look at these in more detail in a later session, but for now, just sign up and start contributing.

Why? The "employer match" is free money. You'll never be able to find another investment with a guaranteed 50% return, so grab it! Another great benefit is that your contributions are tax-free. Suppose that you earn $50,000 a year, and contribute 10% to your 401(k). Now, you'll only be taxed as if you earned $45,000 that year - extra money in your pocket! 401(k)s can go up and down over time - mainly down this year - but over the long term, you can earn much more money here than in other investments, so it's the fastest path to retirement.

5. Consider other retirement savings.

What? In addition to the 401(k) and similar programs, you can also save money in an IRA or a Roth IRA.

How? Open an account with an investment company - I like Vanguard, but you can also use T. Rowe Price, Fidelity, or other companies. Your bank may also offer these types of accounts. You can instruct the company to automatically transfer money from your checking account into this retirement account at certain times, or manually move it over yourself. Note that there are income limits on the accounts, a maximum amount that you can contribute each year, and you often can't contribute to a traditional IRA if you're also contributing to a 401(k).

Why? The traditional IRA and Roth IRA offer other ways to save for retirement and save money on taxes. There's no match, but the Roth IRA has the advantage of letting your money grow tax-free - unlike the 401(k), you won't need to pay any taxes when you withdraw money from the account. These accounts can be a little complicated, so make sure you understand them, but like the 401(k) they are a great long-term vehicle to retirement.

6. Save for financial goals.

What? If you have a big purchase coming up, like a car or a house or a vacation, set money aside to buy it.

How? We'll cover this in more detail in the investment sessions ahead. Briefly, though, it depends on how long it will be until you plan on purchasing. If it's less than a year, just keep it in your online savings account. If it's between one year and five years, you can use your online savings account or a Certificate of Deposit. If it's more than five years, a mutual fund might be a good idea.

Why? Whenever possible, you want to own things, not borrow them. If you take out a loan to get a new car, you're really just borrowing the car - the lender actually owns it. By saving up to make these big purchases, you're taking charge of your financial future. You're in the driver's seat, and can direct money towards reaching your personal goals.

7. Enjoy!

What? If you are debt-free, on track for retirement, and own everything that you want, then congratulations! You're in a wonderful position. Enjoy it. Don't let yourself get obsessed with making more money, and stay focused on your personal goals. Practice contentment.

How? If you have a surplus, then look to your goals to see how to spend it. Maybe you will become a philanthropist in your city. Perhaps you'll donate to your college so they can build a new laboratory. It might be time to start up a new company. Or take that trip around the world. Or run for office - nah, skip that step and just buy a Senate seat!

Why? Remember, the point of these exercises isn't to become the richest person on the planet. It's to identify what's important to you and fulfill your potential. Money can be an important tool for getting there, but once you've arrived, keep your focus on what's important, and not the sum in your bank account.

The above priorities will probably take you from now through retirement. I've glossed over some details, though. The remainder of this series will look in more detail at how these various things work, starting with debt and credit cards, and going through the various types of investments.

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