There are many different paths that lead to financial freedom and independence, but as we laid out in our blog post on The Misperception of Wealth, the majority of individuals who have accumulated wealth have taken a very similar approach which entails beginning to invest early in life, prioritizing saving, taking advantage of their employer retirement plan, and sticking with a sound investment plan for decades.
This may sound simple but knowing where to start and having the long-term commitment can be difficult.
While many of our clients have already achieved financial freedom and independence for themselves, they have children who are leaving home and beginning their own journey. With this transition, children often ask their parents for advice on what they should be doing to make wise decisions from the beginning.
This blog post is designed to assist our clients in having a conversation with their children about how to get off to the right start with their finances.
Everyone’s situation is different, but following the steps below will be a great starting point to create a future of financial freedom and independence for your child.
Step One: Establish an Emergency Fund
We all will have unplanned expenses or financial emergencies from time to time such as unexpected medical bills, a car repair, or loss of income for a few months. We never know when these expenses will arise; so it is important to always be prepared so they don’t have a large impact on our financial situation.
An emergency fund is a cash reserve set aside specifically for these unplanned expenses. How much is necessary for an emergency fund depends on each person’s situation and their own comfort level, but typically we recommend having an emergency fund that covers at least three to six months of living expenses.
An important thing to consider with your emergency fund is where to keep the funds. You will want your emergency fund to be safe and accessible, but it is also important that it generates a competitive rate of return. The traditional savings account satisfies two of these requirements as it provides FDIC insurance and you can typically transfer funds between your checking and savings account instantly. The downside is that the average interest rate on a savings account is only 0.45% APY (October 28, 2024).
Another option individuals often consider for their emergency fund is purchasing a certificate of deposit (CD) in order to increase the interest earned. CDs also qualify for FDIC insurance, and one-year CDs are currently paying between 4.00% APY and 4.42% APY (October 28, 2024). The downside to this option is that CDs have a maturity date, and if you withdraw money from a CD before the maturity date there is often an early withdrawal penalty. The early withdrawal penalty typically results in forfeiting 3 to 6 months of interest.
This is why we recommend keeping your emergency fund in a high yield savings account. A high yield savings account qualifies for FDIC insurance, provides easy access to the funds whenever you need them, and currently offers interest rates between 4.00% and 4.50% (October 28, 2024). The interest rates are variable with high yield savings accounts so you aren’t guaranteed to receive a specific interest rate for a set time period, but there are no penalties to withdraw the funds from a high yield savings account if necessary to cover an unexpected expense.
As we mentioned in our previous blog post covering the banking crisis in 2023, we recommend a cash solution for our clients called Flourish Cash. Flourish Cash has partnered with many different banks, and they allocate their customers’ funds across these partner banks to maximize FDIC insurance coverage while also ensuring their customers receive attractive interest rates on their deposits (as of October 28, 2024 Flourish Cash is paying up to 4.50%).
Key Takeaway:
Establish an emergency fund that covers between three to six months of expenses and invest the funds in a high yield savings account.
Step Two: Pay Down Your Debt Balances
Once an emergency fund has been established that can cover between three and six months of expenses, the next step is to begin aggressively paying down debt – excluding any mortgage debt.
Ramsey Solutions broke down the average American debt and found that the average nonmortgage debt (Student Loans, Auto Loans, Credit Card Debt, and Other Debt) for someone in their 20’s was $13,122 and the average nonmortgage debt for someone in their 30’s was $26,888 at the end of 2023.
For individuals who have large debt balances, monthly payments and high interest rates eat away at their income and restrict their ability to save and grow their assets for the future. By eliminating these debt balances, individuals allow themselves to take advantage of their greatest financial tool, which is their income.
There are two major approaches to paying off debt. These approaches include the debt avalanche strategy and the debt snowball strategy. The debt avalanche strategy is the more economical approach to paying off debt, as it targets the debt with the highest interest rate first. Mathematically, this approach pays off debt the fastest.
Alternatively, the debt snowball strategy targets the debt with the smallest remaining balance first, which allows the individual to pay off the small balances very quickly and then use the extra cash flow to target the remaining balances.
If each person was simply a mechanical robot, the debt avalanche approach would be best, but since we are human, it is often the debt snowball approach that has the best results because it harnesses the psychological benefits of seeing progress early on which creates commitment that can only come by experiencing success.
To show how each strategy works let’s assume an individual has the following nonmortgage debt balances and has $500 of monthly cash flow available to pay down their debt:
If this individual uses the debt avalanche strategy, they will start by using any excess cash flow to pay off their credit card since it has the highest interest rate. Once the credit card debt is eliminated, they would shift their focus to their auto loan given it has the second highest interest rate and apply all the cash flow that was going toward the credit card debt toward the auto loan.
By starting with credit card debt, this individual would essentially be locking in a 20% rate of return on any principal payments they make as they will no longer be charged 20% interest on the amount they pay down.
While this strategy is focused on saving interest expense by knocking out the debt with the highest interest rate first, it can also be difficult to stick with since the highest interest rate loan may be one of the loans with a larger balance. In that case, it may take a long time to pay it off which often results in reduced long-term commitment since little progress is experienced in the early stages. Accordingly, many individuals choose to use a debt snowball strategy.
A debt snowball strategy starts by using any excess cash flow to pay off the smallest loan first. In our example, this would be the auto loan. Once that loan is paid off, they would shift their focus to the next lowest balance which would be the credit card debt and so on.
The following graph compares the two strategies in the example above and shows how long it would take for each strategy to fully repay the debt.
While the debt snowball strategy takes one additional month to extinguish all the debt, it does allow the individual to eliminate one debt entirely after just 17 months whereas the avalanche strategy doesn’t eliminate an entire debt for three full years. Accordingly, many individuals are more successful at implementing a debt snowball strategy given they feel the psychological rewards of success earlier.
The ultimate goal of both the debt snowball strategy and debt avalanche strategy is the same (eliminating debt); so when trying to decide which strategy is best for you, focus on which one will be easier to stick with for the long haul.
Paying off debt doesn’t happen overnight, but sticking to a strategy over time will ensure debt is eliminated and cash flow is freed up for investing and growing assets in the future.
Key Takeaway:
By sticking to a plan and eliminating your debt, less of your income goes toward debt payments providing the opportunity to save and invest which will ultimately lead to financial freedom.
Step Three: Take Advantage of Employer Sponsored Retirement Plans
After non-mortgage debt is eliminated, the next step is to take advantage of the cash flow created by paying off debt and use that cash flow to save and invest for the future. Often retirement isn’t the top priority for young individuals who are just entering the workforce as this is often 40+ years down the road. However, starting to invest early can be very powerful, and the benefits are often boosted by the opportunity to receive an employer match for funds contributed to their workplace retirement account.
An employer match is the amount your employer contributes to your retirement plan on your behalf to “match” your own contributions. The formulas for employer matches can vary from company to company.
To understand how an employer match works, let’s assume your employer offers a 401k plan with a full employer match of up to 3% of your salary. This means if you contribute 3% of your salary to your 401k, your employer will match that contribution dollar for dollar.
So if your salary is $100,000 and you contribute 3% to your 401k, your contribution will be $3,000 and your employer will match that by contributing an additional $3,000 to your 401k. This is essentially free money that can be invested and can grow in a tax advantaged retirement account for 40+ years until you need it in retirement.
To fully grasp the value of these contributions, it’s important to understand compound interest and the value of a long time horizon. Conceptually compound interest is the idea that investment earnings are reinvested and begin to produce income on top of the money you originally contributed. As this process continues, your money begins to grow exponentially. While growth may be slow at the beginning, the compounding effect makes a huge difference over time.
A simple tool that can be used to show the value of compounding is the “Rule of 72”. The Rule of 72 is a formula to estimate the amount of time it will take to double your money at a specific annual rate of return. To use the rule, you simply divide 72 by your expected rate of return.
For example, if an individual has $100,000 invested currently and expects to receive a 9% annual rate of return, their money will double approximately every eight years (72 / 9 = 8 years). So after eight years the individual’s investment would be worth approximately $200,000, and after 16 years it would double again to approximately $400,000 and so on.
The Rule of 72 is not a precise calculation, but it is a great way to quickly conceptualize the value of compounding over time. To demonstrate the value of compound growth, consider the following example where an individual contributes $3,000 to their 401k annually and receives an employer match of $3,000. As you can see after 40 years the individual’s portfolio grows to between $928,572 and $2,655,555 depending on the rate of return they receive over that period of time.
While the individual and their employer only contributed a combined amount of $240,000 over the 40 year period, compound growth turned those contributions into a substantial portfolio. This is why it is so important to start investing early. With time on your side and many years for the money to grow, even relatively small contributions can lead to significant balances that create long-term financial freedom.
Key Takeaway:
Contributing to an employer sponsored retirement plan and taking advantage of an employer match allows young individuals to leverage one of their biggest assets, compound interest over a long-term investment time horizon.
Step Four: Begin Investing for the Future
After taking advantage of any employer sponsored retirement plans and receiving the full employer match, the next two items to think about are how much to save and which accounts to allocate those savings into.
Most individuals need between 55% and 80% of their preretirement income to maintain their lifestyle in retirement. Typically individuals don’t rely completely on their investment portfolio to provide this income, as some income may come from other sources such as Social Security.
However, to ensure you reach this desired level of retirement income, a general rule of thumb for a young individual is to save 15% of their income for retirement. For those later in life who haven’t been saving as aggressively, this percentage may need to be higher in order to catch up.
After establishing an appropriate savings rate the next step is to determine which accounts to contribute to first. The first place to begin allocating excess cash flow is an employer retirement plan to ensure you receive the maximum employer match as discussed previously.
After ensuring you receive any available employer match, additional contributions should go to the most tax advantaged account that is available. Typically, if an individual is eligible to contribute to a Health Savings Account (HSA) this would be the best place to start.
An HSA is a tax advantaged account that allows individuals to save for medical expenses. To be eligible to contribute to an HSA, an individual must be covered by a High Deductible Health Plan (HDHP). Those who are eligible to contribute to an HSA can make a contribution of $4,150 if they are covered under an individual HDHP or $8,300 if they are covered under a family HDHP in 2024. Those age 55 and older can make an additional catch-up contribution of $1,000.
Maxing out these contributions annually and taking advantage of the triple tax savings of an HSA can add significant value over the course of a lifetime. The triple tax savings of an HSA include the tax deduction received for the amount contributed to the HSA, tax free growth while the funds are in the HSA, and tax free distributions from the HSA as long as they are used for qualified medical expenses.
Even though individuals can use their HSA to pay for medical expenses immediately as they are incurred; one strategy to maximize the triple tax savings of an HSA is to pay the expenses out of pocket and save the receipts. This allows the funds in the HSA grow, and as long as the receipts are saved, those expenses can be reimbursed from the HSA in the future. For more details on this strategy, check out our blog post or listen to our podcast on the Triple Tax Savings With Health Savings Accounts.
For those who aren’t eligible for an HSA or still have additional cash flow to allocate after maxing out their HSA, the next option is contributing to a Traditional IRA or a Roth IRA.
When deciding between contributing to a Roth IRA or a Traditional IRA, it is important to consider your current tax bracket versus your expected future tax bracket. The reason is that contributions to a Traditional IRA reduce your taxable income now by the amount of the contribution, but all withdrawals are taxable in retirement. On the other hand, contributions to a Roth account do not reduce your taxable income now, but all withdrawals are generally tax-free in retirement.
If your future tax bracket is expected to be higher than your current tax bracket, it typically make sense to contribute to a Roth IRA and pay taxes now. Whereas, if your future tax bracket is expected to be lower, it typically makes sense to contribute to a Traditional IRA and defer taxes to future years.
Because most of our clients’ children are just entering the workforce, it generally makes sense for them to start contributing to a Roth IRA instead of a Traditional IRA.
Contributions to a Roth IRA account are made with after-tax money. Funds in the Roth IRA grow tax free for life and any qualified distributions in the future are also tax free. The contribution limit for a Roth IRA in 2024 is $7,000 and those age 50 and older can make an additional $1,000 catch up contribution. Eligibility to make direct Roth IRA contributions can be phased out depending on total income. Those who have income over the limit may be eligible to make back-door Roth IRA contributions depending on their specific facts and circumstances.
Back-door Roth IRA contributions are a loophole in the tax law allowing high income earning individuals to make Roth IRA contributions despite having income over the limit for direct Roth IRA contributions. Before making back-door Roth IRA contributions, it is important to understand the related rules and restrictions. For more information and to see the value that annual back-door Roth IRA contributions can add, consider reading our blog post or listening to our podcast on Tax Free Growth With Back-Door Roth IRA Contributions.
After receiving your employer match, maxing out your HSA, and contributing to a Traditional or Roth IRA, the next step for any remaining cash flow is to return to your employer plan (i.e. 401k, 403b, etc.) and max out the rest of the available contribution limit. For 2024 the maximum amount an employee can contribute to their 401k is $23,000, and those that are age 50 or older can make an additional catch up contribution of $7,500.
With many employer plans, individuals have the option to choose between Roth 401k contributions or Traditional 401k contributions. The logic of deciding between Traditional (i.e. pre-tax) and Roth contributions is the same as discussed above for a Traditional IRA or a Roth IRA.
Maxing out these tax advantaged accounts will allow individuals to save and grow their assets for the future while at the same time substantially reducing the taxes paid over the course of their lifetime.
Key Takeaway:
A general rule of thumb for young individuals is to save 15% of income for retirement and to do so in the most tax advantaged accounts available.
Step Five: Create an Appropriate Investment Allocation
After making sufficient retirement contributions, it is important to make sure the money is invested appropriately. This can look different for each individual depending on their risk tolerance and time horizon.
For those starting out with many decades until retirement, we typically recommend creating a diversified portfolio using index funds. A diversified portfolio to us means being allocated to multiple different asset classes, large, medium, and small companies, U.S. and international markets, and various different business sectors.
Index funds are a great way to implement a diversified portfolio because they track a specific benchmark or index (i.e. S&P 500 for U.S. large companies) and have low expenses.
As individuals progress in their careers, their portfolios become more complex, and the financial impact of each decision grows. When that occurs, we recommend beginning to look for a financial advisor to assist you. When you begin your search for an advisor, we recommend finding a fiduciary, fee-only, independent advisor who can help coordinate all areas of your financial life.
Key Takeaway:
After making retirement contributions, it is important to make sure the money is invested appropriately. For those starting out with many decades until retirement, typically a diversified portfolio using low cost index funds is the best approach.
Step Six: Automate Your Finances
Finally, the last step is Automate, Automate, Automate! While managing finances requires discipline, individuals are typically far more successful if they can automate many of the difficult decisions.
For example, whether it is paying down debt or setting aside 15% of their income for investing, it works best if those funds are automatically deducted from an individual’s paycheck or bank account on a recurring basis.
By automating the appropriate behavior, individuals are not tempted month by month to spend the money on something new or talk themselves out of the plan they established. Automating the process removes many of the pitfalls that cause individuals to abandon a plan along the way.
Key Takeaway:
Automate, Automate, Automate! Automation allows you to stay on track with your financial plan.
The Psychology of Money
While finances can be a daunting topic for many, having a simple framework through which to view money and finances will make all the difference in achieving long term success.
For individuals who are interested in reading more about what works and leads to financial freedom and success, we recommend reading The Psychology of Money by Morgan Housel.
The Psychology of Money provides valuable lessons about money through short stories that illustrate the financial concepts that will provide an invaluable framework for individuals as they are beginning their own financial journey.
Key Takeaway:
We recommend reading The Psychology of Money by Morgan Housel to help form an appropriate perspective about money and finances.
Conclusion
For parents who have children leaving home, it can be an exciting and challenging time. Ensuring they have the knowledge necessary to make wise financial choices from the start can help them avoid a lifetime of financial challenges.
The six steps we covered throughout this post provide a pathway to get started on the right track. Each step along the way isn’t going to look the same for everyone, but those who stick to a plan can begin moving in a direction that will ultimately lead to financial freedom and independence.
For families who are interested in not only establishing their own financial freedom and independence, but also want to ensure their children are making wise financial decisions as they begin their own journey toward financial independence, we would love to connect to see if what we do is right for you.
