Personal Finance in Your 20s & 30s For Dummies. Eric Tyson
that amount every year — some years it will be less and some years it will be more. The following table shows how much you’d have after 40 years if you got a 3 percent annual return versus an 8 percent annual return.
| Investment | 3% Annual Return over 40 Years | 8% Annual Return over 40 Years |
|---|---|---|
| One-time $1,000 saved | $3,260 | $21,720 |
| $1,000 saved annually | $75,400 | $259,060 |
When you combine regular saving with more-aggressive yet sensible investing, you end up with lots more money.
Saving $1,000 yearly and getting just an average 8 percent annual return results in a nest egg of $259,060 in 40 years compared to ending up with just $3,260 if you invest $1,000 one time at a 3 percent return over the same time period. And remember, if you can save more — such as $5,000 or $10,000 annually — you can multiply these numbers by 5 or 10.
With historic annual inflation running at about 3 percent, you’re basically treading water if you’re only earning a 3 percent investment return. In other words, your investments may be worth more, but the cost of other things will have increased as well, so the overall purchasing power of your money won’t have increased. As I discuss in Chapter 10, the goal of long-term investors is to grow the purchasing power of their portfolio, and that’s where investments (such as stocks and bonds) with expected higher returns play a part.
Budgeting and Boosting Your Savings
When most people hear the word budgeting, they think unpleasant thoughts, like those associated with dieting, and rightfully so. Who wants to count calories or dollars and pennies? But budgeting — planning your future spending — can help you move from knowing how much you spend on various things to reducing your spending.
The following process breaks down budgeting in simple steps:
1 Analyze how and where you’re currently spending.Chapter 5 explains how to conduct your spending analysis.
2 Calculate how much more you want to save each month.Everyone has different goals. This book can help you develop yours and figure how much you should be saving to accomplish them.
3 Determine where to make cuts in your spending.Where you decide to make reductions is a personal decision. While many people need to save more (and spend less) to accomplish their goals, it’s possible you may not need to reduce your spending. In Chapter 5, I provide plenty of ideas for how and where to make reductions if you’re among the many who want to save a greater portion of your current earnings.
Suppose you’re currently not saving any of your monthly income and you want to save 10 percent for retirement. If you can save and invest through a tax-sheltered retirement account — such as a 401(k), 403(b), SEP-IRA, and so forth (see the section “Valuing retirement accounts and financial independence” later in this chapter) — then you don’t actually need to cut your spending by 10 percent to reach a savings goal of 10 percent of your gross income.
When you contribute money to a tax-deductible retirement account, you generally reduce your federal and state income taxes. If you’re a moderate-income earner paying approximately 30 percent in federal and state taxes on your marginal income (see Chapter 6), you actually need to reduce your spending by only 7 percent to save 10 percent. The other 3 percent of the savings comes from the lowering of your taxes. (The higher your tax bracket, the less you need to cut your spending to reach a particular savings goal.)
So to boost your savings rate to 10 percent, you simply need to go through your current spending, category by category, until you come up with enough proposed cuts to reduce your overall spending by 7 percent. Make your cuts in areas that are the least painful and in areas where you’re getting the least value from your current level of spending.
CONSIDERING ANOTHER BUDGETING METHOD
Another method of budgeting involves starting completely from scratch rather than examining your current expenses and making cuts from that starting point. Ask yourself how much you’d like to spend on different areas (such as rent, meals out, and so on). This is called zero-based budgeting.
The advantage of this approach is that it doesn’t allow your current spending levels to constrain your thinking. Just because your current rent is $1,500 per month doesn’t mean that it needs to remain there. When your current lease expires, you could change your housing arrangements and perhaps find a nice rental you can share with others. I did this in my early years after college, and doing so enabled me to keep my rent low and save more money.
You’ll likely be amazed at the discrepancies between what you think you should be spending and what you actually are spending in certain categories. Take going out to eat, to bars, and to concerts, for example. You may think that spending $150 per month is reasonable and then discover that you’ve been averaging $250 per month in this category. Thus, you’d need to slash your spending here by 40 percent to get to your target.
Setting and Prioritizing Your Savings Goals
You probably have some financial goals. If you don’t, you should begin thinking about some personal and financial goals you want to reach. Because everyone is unique, you surely have different goals than your parents, friends, neighbors, and siblings. Although goals may differ from person to person, accomplishing personal and financial goals almost always requires saving money. In this section, I discuss common financial goals and how to work toward them.
Identifying common goals of accomplished savers
As a result of my experience counseling and teaching people about better personal financial management, I can share with you the common traits among folks who accomplish their goals. No matter how much money they made, the people I worked with who were the most successful were the ones who identified reasonable goals and worked toward them.
Among the common goals for young adults with whom I’ve worked are the following:
Making major purchases: You need to plan for major purchases. So if you have a future purchase in mind for a car, living-room furniture, the newest smartphone, vacations, and so on, you should save toward that.
Owning a business: Many people want to pursue the dream of starting and running their own business. The primary reason that most people continue just to dream is that they lack the money (and a specific plan) to leave their job. Although many businesses don’t require gobs of start-up cash, almost all require that you withstand a substantial reduction