Monthly Archives: November 2018

Getting (and Sticking to) a Budget

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savings-2789112_640Developing a budget is a crucial first step on your road to financial wealth.  The goal is not only to figure out where you’re money is going, but maybe even more importantly what you can afford to save.  If I ask you today, without a budget, can you put away $1000 a month? More?  Less?  You really don’t have a good idea.  At the same time, a budget enforces that your money should be allocated in a way you consciously decide, not just spent until the wallet is empty.  There are a number of personal finance software packages out there to get you started, but I’ve generally found them more of an obstacle than a help.  Personally, a spreadsheet has always done the trick for me.

The first thing you need to do is come up with your spending categories.  Many of these are easy: food, housing, etc but some may be particular for you.  There’s a funny Office episode where Michael is questioned for his money spent on magic sets.  Hey, no judgement.  If it’s important to you and within your budget, go for it.  Magic aside, here an example monthly budget for a person with a yearly salary of $72,000

 

Let’s look at a few of these. Some expenses can be tricky.  I know you probably aren’t going on $300 vacations every month, the idea is to set aside money in your budget so when you want to take that vacation, the money has been saved.  Other expenses like things for your home might have occasional big purchases and some months where you need to spend nothing.   Again, this is just an average so you are ready to replace that washing machine when it craps out.  For the car, I know loans are common, but I really can’t stand borrowing money for a depreciating asset.   It’s a double whammy. I understand you usually need a car to work and sometimes a car loan is unavoidable, but try to avoid it if you can.  Instead, think of some of this money as saving for the car you pay for with cash.  I also have a category here called mad money and I that needs some explaining.  My wife and I set up three bank accounts. One joint, one that’s hers, one that’s mine.  Most bills are paid from the joint account and each month our “mad money” is transferred from the joint account into our personal accounts. Our rule is we aren’t allowed to question each other on what we spend from our personal accounts.  It has really protected me from being ridiculous and headed off at least 1000 potential disagreements.

Estimating your after tax income is not very difficult especially if you are using the standard deduction.  See here for an example.

Once you have your food, car, magic, and whatever other categories for your situation you need to estimate your monthly expenses in each category.  You can do this by tracking your actual expenses for a while, bu don’t be afraid to challenge yourself.  If your spend $500 at the bar every month you’re reaction shouldn’t be “well I guess that’s my bar budget”.  It should be…”holy crap, I’m literally drinking away my future!” The example budget I show above leaves room for fun, in addition to saving almost 15% of the pretax income.

Hopefully when you figure out your budget the monthly income exceeds the total monthly expenses and you can plug in a significant amount for savings.  If not, you have to make some cuts. I know it’s painful, but saving for your future is just as important as food and shelter.  It’s literally your future food, shelter, and medical care. If that means a few less nights out, that seems like a small thing to ask.  Future You says thanks, by the way.

Let’s Get Started

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rocket-launch-67723_1280I starting writing this blog mostly as an advice column for my kids.  I’ve taken what opportunities I’ve had with them to sit down and explain the importance of budgeting, investing for the long run, and making smart decisions, but those conversations are not as thrilling as they sound.  It’s really, really tough for a teenager to look away from a YouTube compilation of people doing crazy things to hurt themselves so you can explain the beauty of index funds.  And I get it–I don’t think my YouTube channel called “Successes” would get nearly the number of hits.  They indulge me and they are great listeners, but this blog will always be sitting patiently, here when they need it.

Always a lover of math puzzles, I’ve made personal finance a bit of an obsession.   As I’ve gotten older I’m constantly amazed at the amount of bad advice out there, and how financial salespeople feed people’s fear of math and investing know-how into making decisions that really only makes the sales person rich.  I’d like to try to fix that.  The math isn’t scary–I’ve worked through all of what you’ll need that I’ll readily share–and the knowledge required is amazingly simple.

Often what people are looking for is what are those “magic” investments that pay insanely high returns with almost no risk. Somehow there is a belief that there are people out there in the know, working their way through the system, hopefully legally, to get richer.  I still hear infomercials on the radio using lots of words like ‘smarter strategy’ basically implying they have found that low risk/high return investment to get you rich with almost no capital.  I’ll write a separate blog post on the ridiculousness of this argument, if there are loopholes of return without risk, they are quickly closed.  But people hear this and think, man, I need to be part of that action if I ever want to be financially secure. Thankfully, cheaters and scammers aside, there really isn’t a shortcut, and furthermore, you can get there without a shortcut.

So what to do? First of all, the mega return on investment is not that necessary, boring and average is just fine.  What is really important is DISCIPLINE. The discipline to automatically and consistently save money, month after month, year after year.  The discipline to not keep up with the Jones’ and not satisfy every wish and desire at the expense of your financial freedom. You need to save as much as your budget can stomach. Very few young people (or old people) get this. If you get it, you will grow your nest egg. Yes, hopefully you are investing smartly, and I do have some advice for this, but the most important thing is to invest consistently.  Don’t sweat too much trying to find that ultimate return year after year.  Even professionals can’t do it, though many claim they can.

The next question is, how much do I save every month?  That is where a good budget comes in.  You need ruthlessly adhere to a budget, and coming up with a budget is not difficult, I’ll show that in my next post.  You can’t really know what you can afford to save unless you know what you really need to spend.  Hopefully the money budgeted on expenses is less than the money coming in.  If not, you need to make some cuts.  Painful if need be, but you cannot support a lifestyle by going further into debt or stealing from savings.  Lots of young people fight this because they figure they are young, shouldn’t this be the time they are living it up?   Well, yes, but that can’t be at the expense of your future, which will only lead to greater stress in your life.  So allow some money in your budget for fun, but if you really want to set yourself up for your future, you need to save early and as much as you can.

All of this is really about freedom (this is another rant coming, prepare yourself).  As long as we NEED to work, all of us are servants to some degree, we are never truly free.  Hopefully you like your job, but few of us would continue coming in if the little pieces of paper that come every two weeks stopped.  Having complete financial freedom is about having options, where money does not have to be part of the equation in your decisions.  So you can keep doing that job you love if you’d like until you’re 90 and that is your choice.  Or, with a big enough pile of cash, you can do what you want, when you want, as much as you want.  That is freedom.

I’ll touch on a these topics in more detail in later posts, but this hopefully gets you fired up to save some cash!  Well maybe not fired up, that’s just me.  Slightly motivated?  I’ll take it.

Monte Carlo Analysis

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For those interested in how I got the probability numbers for reaching retirement goals, a little fun with excel.

I used the random number generator =RAND() for each possible outcome to simulate the randomness of the return of our investments for both stocks and bonds.  My example used a 30 year old in 2018, investing for 35 years until age 65 (year 2053).  Stock and bond returns for each year are generated based on our random number and the mean and standard deviation we have chosen to use, using the excel function =NORM.INV(A1, 10.4, 18.3) and NORM.INV(B1, 4.0, 2.8) assuming the random number for stocks and bonds is in cell A1 and B1 respectively, and you are using the 10 year averages for mean and standard deviation I mentioned in an earlier post for stocks and bonds.

I used an allocation following my recommended asset allocation based on age.  The overall return for stocks and bonds is calculated by using the randomly assigned returns from above and adding in our deposits made that year.  I also rebalanced at the end of the year to get us back into the proper allocation for the upcoming year and use that value when calculating my return for the next year.  This is repeated for every year until retirement.

Running this calculation once represents one potential future, or one run of the Monte Carlo simulation.  We really want to run 1000’s of simulations, but for this case, I’ve just run 100 for simplicity.  Each time I recalculate the sheet (hint, press F9), I record that bottom line number.  Note, you want to copy and paste the value of this cell into another cell, not just do a strict copy and paste, otherwise all your numbers will be changing.  For 100 runs, I got the following results:

monte carlo runs

For our purposes, these represent the universe of outcomes.  The randomness of returns keeps things far from guaranteed, but we can get a sense of how good or bad things can be.  I then use this list and the COUNTIF function in excel to determine how many “futures” get above certain thresholds.  For example if the data above is in cells M1 to M100 and I’m looking for how many cases were above $1.2M, that is =COUNTIF(M1:M100, “>1200000”).  For various thresholds, the results are below

monte carlo summary

There are still a bunch of assumptions here, most notably that the return for stocks and bonds for the next 35 years will look a lot like the past 10, but this philosophy gives some insight for making decisions in a very unsure world.  For instance, from the above you can feel good, but not great, about getting to at least $1.2M, but if you’re counting on $4M, you better be a very lucky person.  I know, Han Solo said “Never tell me the odds!”  I’m guessing Han had a substandard retirement plan.  You want to know the odds.

Calculating Taxes

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Estimating your tax burden isn’t very difficult, especially if you take the standard deduction.  The first step is to calculate your taxable income:

Taxable Income  = Salary – Standard Deduction – 401(k) – Health Insurance

For a single person the standard deduction is $12,000 and for married people filing together this is $24,000.  Let’s assume we are married (congrats!) and use our budget from earlier, the taxable income is

$72,000-$24,000-$7,200-$1,200 = $39,600

Payroll taxes for Social Security and Medicare (FICA on your paystub) are calculated based on your pay regardless of any 401k contribution.  I know.  The 401k is only sort of deductible.  This is why on your W2 at the end of the year there is a different amount for Wages (Box 1), Social Security Wages (Box 3), and Medicare Wages (Box 5).  Really annoying.  Typically employers will report your wages on your W2 at the end of the year already taking out health insurance premiums you have paid, so

Payroll Taxes = 7.65% x (Salary – Health Insurance)

For our example, this is

Payroll Taxes = 0.0765 ($72,000– $1,200) = $5,416

One more caveat, if you make over the social security limit ($128,400 in 2018 and if you make more than this, good for you) the social security taxes are capped, you don’t pay any more than 6.2% of $128,400 ($7960.80). So for a person making $128,400 or more, the payroll taxes are

Payroll Taxes = $7960.80 + 0.0145 (Salary – Health Insurance)

Sorry, I started this whole post saying how the taxes were simple, and just hit you with a bunch of ridiculous rules.  Blame Congress.

State taxes vary by state–duh–but let’s just estimate 5% of taxable income.  You should estimate this based on your state, but most states are something around this, unless you’re in California, in which case, sorry, that perfect weather doesn’t come cheap

State taxes = ~5% x Taxable Income = 0.05($39,600) = $1,980

Federal taxes are based on a progressive system, and a lot of people don’t quite get this.  The money you earn is taxed at different rates, and the more you earn, the higher the rate.  People debate the merits of this, but I think this makes sense.  $1000 has a very different value to a person making $20,000 a year (yay, we can pay our heating bill!) vs a person making $10 Million (lets gold-plate our bathroom faucet!).  To account for this, the tax code is set up with different brackets, where the first few bucks you earned aren’t taxed very hard, but after you start earning a bunch more (the Government gets to decide what is a “bunch”) they crank up the rate.  That doesn’t mean rich people pay a higher rate on all their income, just the higher income.  For example, everybody (rich and not-so-rich) pays 10% on the first $19K of taxable income.  The tax brackets are shown below

For our example, this would be

Federal Taxes = 10% x $19,050 + 12% x ($39,600-$19,050) = $4,371

If you have kids there is a nice credit of $2k per kid that you get to apply directly to this amount of tax owed, you get to take it right off the top.  Though fair warning, if you have kids to save money, you’re in for a massive disappointment.  There are other little deductions and credits too, but less common, as Homer Simpson pointed out:

Okay, Marge, if anyone asks: You require 24-hour nursing care, Lisa’s a clergyman, Maggie is seven people, and Bart was wounded in Vietnam

–Homer S.

In the end, we add them all up and we have $11,767 per year or $981 per month.  In our budget example, I rounded up to $1000, maybe we’ll get a small refund?