When we first incur financial responsibilities — perhaps college tuition, apartment rent, or a down payment on a used car — we tend to focus on two things: keeping our expenses down and increasing our incomes. Those are good goals for anyone who’s starting out.
To achieve financial independence, however, the uncomfortable truth is that we need to think bigger. How can we increase our assets and decrease our liabilities? In other words, how can we increase our net worth?
A solid approach is to take action in four areas:
Establish budget priorities
Many if not most of us struggle to set a household budget and stick to it — if we ever try at all.
The steps to create a budget are pretty straightforward, measuring income against necessary and discretionary expenses, then looking at savings opportunities. (Related: How to make a budget)
But there is typically some angst in creating a budget. You have to comb through your bank and credit card statements to see where your money goes. Then you might beat yourself up for overspending on takeout meals. You end up whittling down fun expenses and trying to guess at future income. And after all that, you realize that you have to track everything going forward. The chore can be tedious, time consuming, and stressful.
And really, you probably already know what you’re spending money on that isn’t important, isn’t increasing your quality of life, or is causing you financial pain. Budgeting is like dieting: no one wants to do it, and you don’t need to log everything you eat to know that your afternoon candy habit might be increasing your waistline.
The solution? Identifying your motivation.
“Sometimes people think they need to do something because someone told them to,” said Marcus Leung, a financial professional with MassMutual Northern California in San Francisco. “But why do you think you should?”
Are your parents relying on you for their retirement plan? Do you want to raise your kids in a home where their parents don’t argue about money like yours did? Dig down into your earliest money memories, into the emotions you feel around money.
What does success look like to you? Is it being close to your family? Leaving a legacy?
“Bring the future into the present,” Leung said. “Think about yourself at 85 and what you’ll need to have done up to that point to feel good about what you’ll leave behind.”
Examining these things can help you figure out the real reason why you want to manage your finances differently.
Having these insights makes it much easier to establish budget priorities and savings goals. Then make sure you put money toward those items first, each time you get paid. What’s left can go toward the fun stuff. (Budget calculator)
Learn to invest
Saving money, however, will only get you so far. It can help you cover an unexpected car repair, but with inflation constantly siphoning the value of your cash, you’ll need to learn how to keep up — and get ahead. That usually means purchasing some combination of savings and investment vehicles, like certificates of deposit, bonds, stocks, and perhaps real estate. (Related: How to build wealth)
Someone who stuffed $10,000 in cash in a safe deposit box in 2002 would still have $10,000 after two decades, but due to inflation would need almost $16,000 to have the same buying power. Someone who invested $10,000 in an S&P 500 index fund in the same year would have nearly $41,000.
Exact returns will depend on which dates you look at, of course. Pick different years and that $10,000 investment will decline in value. When you buy and sell matters. (See: Beware retirement’s overlooked risk: Sequence of returns)
Still, the underlying lesson has historically held true: Stock market returns tend to outpace inflation over time and help people grow their net worth in the long run. (Related: Winning with a steady investment strategy)
Learning to invest may be easier than you think, and you can always work with a financial professional if you need help. The prospect of taking a risk with money you’ve worked hard for can be scary, and failure is a real possibility. But you’ll have more ability to take a calculated risk with your investments — or with changing jobs or starting a business — if you’ve established protection buckets.
Protect your future
“There is a fine balance between protection and growth,” Leung said. “As your assets grow, the protection generally needs to increase as well.”
However, most of us focus so much on the accumulation phase that we don’t think enough about what will happen once we reach retirement. Leung said we should focus more on the distribution phase, or our retirement income. What will your net income after taxes be? How will your portfolio be permanently impacted if you have to draw income from your nest egg during a down market?
Think about your working years as hiking up a mountain and your retirement years as the descent. What gear do you need to pack to face the various challenges that might arise on the downward slope?
“We don’t know what terrain, weather conditions, setbacks, or detours we might face in our journey — only that we need a wide enough selection of gear to brace ourselves,” Leung said.
We might encounter changes in tax laws, our health, and market performance along the way, to name a few potential challenges. If we’ve diversified our “gear” into other options such as Roth IRAs, life insurance with cash value not tied to the market, home equity lines of credit, and long-term care insurance, we may be better prepared.
For example, instead of deferring taxes until retirement via traditional IRA, 401(k), and 403(b) plans, it may be prudent to pay taxes now on at least some of your nest egg. Shifting contributions to Roth accounts can help protect against changes in tax rates during retirement.
Further, Roth accounts aren’t subject to required minimum distributions that force you to draw down your assets and may push you into a higher tax bracket.
“RMDs can come at a time when you have few tax deductions, as your children may no longer be dependents, your home is paid off, and you have no 401(k) or traditional IRA to fund,” Leung said.
Whole life insurance, which is guaranteed to grow regardless of market conditions, can provide a volatility buffer in years when your stock investments are down. Rather than having to sell investments at a loss because you need the income, you can borrow against the cash value of your permanent life insurance policy.
Leung suggests working with a financial professional who can help create a road map and find a balance between equity positions and cash value products. Growing both at the same time is ideal. (Related: How whole life insurance can help through life)
It may also be important to carry disability insurance to protect your income, term life insurance to protect your family’s standard of living, an umbrella policy to protect against lawsuits, and long-term care insurance to improve your care options and preserve your savings.
“You might have fewer assets when you get to the top of the mountain because you paid more taxes or bought more insurance, but you may have more income in retirement because you have these options,” Leung said.
Reduce your tax liability
Regardless of your feelings about how government spends your tax dollars, it’s a fact that how much you pay in taxes has a direct impact on your net worth. Understanding how your actions affect your tax liabilities is the first step toward legally minimizing what you owe.
After all, your paycheck already reflects a substantial tax bite. When you earn income from working, whether it’s an hourly wage or an annual salary, you’re hit with multiple levels of taxes: Federal income tax, state and local income tax (depending on where you live), and Social Security and Medicare tax (FICA). High-income earners can also be subject to the net investment income tax and additional Medicare tax. (See: How to avoid moving into a higher tax bracket)
Beyond that, regular savings are subject to ordinary income taxes as are direct investments in a personal portfolio, which are generally subject to capital gains taxes as well.
So, you may want to consider whether shifting some of your taxable savings and investments into tax-preferred options makes sense. There are a range of financial options that are subject to different tax treatment that retirement savers may want to take advantage of.
Certain types of retirement investment accounts, as mentioned earlier, offer advantages like tax-deferred growth. Other types of financial instruments, like whole life insurance, can also offer beneficial tax features, as well as protection. (Related: Income tax diversification)
And there are additional strategies like investing within 529 savings plans for your children’s college costs, doing Roth IRA conversions, and taking advantage of flexible spending accounts and health savings accounts.
A long-run strategy for increasing your net worth is about far more than growing your income and socking more money away.
Through establishing budget priorities, learning to invest, protecting your future, and reducing your tax liability, you may be able to achieve far greater financial security than you ever imagined.
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