Paying for Your Future First

Question of the week:I know I should be saving, but times are tough right now and there never seems to be enough money left over to put any away. Saving just seems impossible--is there any hope for me? --A Wannabe Saver

Dear Wannabe,

If it's any help, you've got plenty of company. According to the U.S. Department of Commerce, Americans aren't doing a very good job of saving. Recent statistics show that we're saving on average just a tad under four percent of our personal disposable incomes.

However, there's no shortage of ideas out there for how to reduce expenses and save more. When we asked members of the Armchair Millionaire community to tell us their methods for how they save, we heard dozens of great ideas. Here are just a few:

Just say no to new cars. "We've easily saved over $150,000 by driving used cars over the past 35 years. Repairs, insurance, and the original cost of the cars and interest on the savings invested well all add up. Plus you don't worry about drinking coffee in the old car or scratching it in the parking lot." --GM

Don't carry lots of cash. "I keep less than $10 with me, so if I want something more than that, I have to write a check, and that stops me from buying things I don't really need, because I don't want them bad enough to write a check." --Dayna

Buy carefully. "We never buy anything big (such as a car, boat or house) unless we think we'll be able to sell it for as much or more than we paid (and we usually do)." --A.

The savings technique that I personally recommend above all others is paying yourself first--stashing a portion of your net income in a separate account before you have a chance to spend it. Sound complicated? It isn't. My guide will get you started.

The Armchair Millionaire Guide to Paying Yourself First

• Save automatically. The easiest way to save automatically is to set up an automatic investment plan with your broker or mutual fund company--or wherever you decide to save and invest your money. This will enable a set amount of money to be automatically withdrawn from your checking account each month and automatically placed into the investment of your choice. This service is nearly always free. The best thing about it is that it's painless--the money is gone before you know it, so you never really miss it.
• Save enough. To make a real difference in your long-term financial health, you need to sock away a substantial part of your income. I recommend saving at least 10 percent of your take-home pay. If you absolutely can't do 10 percent right now, start at 3 or 5 percent, but commit to increasing it as soon as you can. If think this is impossible, just think back to a time (it probably wasn't too long ago) when you earned less than now. You still found a way to make ends meet, didn't you?
• Do the math. Little will do more to motivate you than knowing how much your "pay yourself first" money can grow over time. Let's assume that you bring home $3,500 a month and that you decides to save 10 percent, or $350 a month, over the next 20 years. Assuming an average annual growth rate of 9 percent--historically, an extremely realistic number--your money would grow to over $235,000.
• Start now. Without a doubt, saving that first month's amount can be difficult. But starting is the only hard part--once you get started, it's all downhill from there. You'll not only get used to saving money, you may even forget that it's happening.

THE BOTTOM LINE: If you combine it with other wise financial moves (like fully funding your retirement account), your monthly "pay yourself first" contribution to your long-term savings will make you wealthy over time. Best of all, it will grow your nest egg while sparing you the hassle of dealing with a budget.

The Little Things That Mean a Lot

Question of the week:I recently received a small raise in pay and am wondering about the best thing to do with it. It isn't very much--about $1,000 per year--but I want to make the most of it. What do you suggest doing with this extra money? --MBL

Dear MBL,

Dear MBL,

The fact that you are so deliberate with how to use this money sets you apart from most people, who simply absorb extra cash into their daily finances and never make a clear plan for getting something substantial from it.

When we asked recently members of the Armchair Millionaire community about how they use extra money that comes their way, their responses showed your same level of thoughtfulness. Here are two examples:

"Any extra money I get is divided in thirds: 1/3 to debts (if any for that month), 1/3 to savings (Roth IRA and emergency fund), and a 1/3 to myself. (Hey, I earned it!)" --Paula

"I take every dollar and split it into buckets: 75 cents to retirement savings and 25 cents to regular savings, which I eventually use to reward myself with a purchase or vacation." --Ian S.

The most important thing is not how much money you have, but whether or not you deliberately choose to save a portion and then follow through on your plan. My checklist has a range of ideas for turning your small trickle of money into a torrent.

The Armchair Millionaire Checklist to Making a Lot Out of a Little

• Ensure a wealthy retirement. If you stash away that thousand dollars each year in your 401(k), it will grow to just under $181,000 over the next 30 years at an average annual growth of 10 percent. Not only will you put yourself on a fast and painless savings track, you'll a get a nice tax break, to boot. If your employer offers a match on your contributions (as many do), then you'll leverage that money even more. If you don't have a 401(k), set up an IRA.

• Build your emergency fund. Nothing comes in so handy as cold hard cash when you face a real emergency, like the loss of your job or a major house repair. I recommend keeping about three months' worth of expenses in a liquid account.

• Save for college. An annual contribution of $1,000 to a college fund earning an average return of 10 percent will grow to nearly $35,000 in 15 years. There's a nice range of college savings programs now available, most of them offering substantial tax advantages.

• Join an investment club. Investment clubs are a great way to learn common sense investing techniques while establishing a solid core holding of stocks. Most require minimum monthly contributions of just $20 to $50.

• Pay off your mortgage early. Want to get out from under the mortgage burden? An extra $1,000 payment each year on a $150,000 30-year mortgage with seven percent interest will knock off six years.

  By enrolling in a dividend reinvestment plan (available from most major companies), you can bypass the broker and purchase stock directly from the company. These plans require only small monthly investments (which can be set up as automatic withdrawals from your checking account) and will automatically reinvest any dividends for you.

• Build a stock portfolio.

THE BOTTOM LINE: Don't assume that a small amount of money won't do a lot. With patience and a clear plan, small amounts can achieve big goals.

Stockpiling for the Short Term

Question of the week:I just got my first real job and I'm starting to save big time. I want to buy a new car within the next year, have enough for a down payment on a house in five years and save for retirement! Right now this money is just sitting in a savings account earning dismal interest. Are there better choices? --Blaine

Dear Blaine,

Congratulations on your ambitious savings goals. Now you just need to get that money in the right places, and you do have options beyond the very popular savings account.

The main thing that will help you decide where to put your money is how much time you have before needing that money. Split your goals into either short term--everything you will need (or might need, like for an emergency), in the next five years--or long term, everything more than five years out.

I believe that most money set aside for long-term goals, like retirement, should be in vehicles that will significantly grow your capital over time, like stocks or stock funds. (For me, this five-year line is what distinguishes "savings" from "investments.")

As for short-term savings, we recently asked Armchair Millionaire community members where they're keeping their money. Here's a sampling of what we heard:

"My main short-term goal is to have six months worth of living expenses in a very liquid account. I use a money market account since the interest rate is a little higher." --Bryan J.

"My short-term goal is to have enough money for a car. I keep this cash in an Internet savings account that pays 3 percent interest." --Miller

"We're saving for the short-term for travel and house renovation and medium-term for a replacement car and rainy day fund. These savings are in CDs and savings accounts." --Simplicity

For your short-term goals, you want your money safe and liquid so you can easily access it when you need it. My checklist has your major choices, with the pros and cons for each.

The Armchair Millionaire's Checklist for Stockpiling Your Savings

• Certificates of deposit. CDs are issued by banks, savings and loans and credit unions and are federally guaranteed. When you buy a CD, you commit to leaving the money untouched for a fixed amount of time (anywhere from 30 days to five years or more). The longer the term, the higher interest rate, but if you withdraw your money early, you'll pay a penalty.

• Money market deposit accounts. Federally guaranteed and available from banks, credit unions and S&Ls, these accounts are much like regular checking accounts, but pay a bit of interest. They typically limit the number of checks you can write each month, so a money market account probably can't take the place of your checking account. Accounts paying higher interest may require a high minimum balance.

• Money market funds. These are a type of mutual fund and are available from fund companies and brokerages. They invest in high-quality, short-term debt instruments, so while they're not federally guaranteed, they are very safe. They offer check writing, usually with fewer restrictions than money market deposit accounts.

• I bonds. These are a nifty kind of savings bond offered by the U.S. Treasury with an interest rate adjusted periodically to keep up with inflation. Interest is exempt from state and local taxes, but you'll pay a small penalty if you redeem one before owning it for five years. I bonds are available from banks or directly from Uncle Sam at www.treasurydirect.gov.

• Bond mutual funds. These funds purchase government bonds, municipal bonds, corporate bonds or some combination of the three. They're convenient and give you instant diversification with a lot of different bonds, but they carry no guarantees. Different funds carry different levels of risk, and not all are appropriate for short-term savings, so look closely before buying.

THE BOTTOM LINE: The more security and liquidity you need for your savings, the lower the interest rate you'll have to accept. But when you balance this out with the rewards of long-term investing, you'll have the best of all worlds.

Transform Yourself Into an X-Treme Saver

Question of the week: My New Year's Resolution this year was to save 20 percent of my paycheck. So far, I've failed dismally--there's never enough left at the end of the month to save! How can I make my savings plan work? --Striving to Save

Dear Striving,

Congratulations on your ambition to join the ranks of the x-treme savers--people who are aggressively stashing away a substantial portion of their earnings each month in order to achieve their dream of financial freedom. When we asked members of the Armchair Millionaire community about their savings habits, we found that there are plenty of people who are regularly saving 20, 30, or 40 percent of their income. A few are saving even more.

But as you've discovered, this sort of x-treme saving doesn't just happen. Here is a sampling of the good advice we got from the community on reducing spending and increasing savings.

Tax yourself. "Upon depositing my paycheck, I 'tax' myself by peeling off an extra 20 percent and sticking it in a separate account. Every two or three months I use my 'tax' account to fund a larger investment." --Ray

Live on one salary. "When my wife and I were first married, we decided to live only on my salary and save hers. This way, when we decided to have children, there wouldn't be much of a financial disruption and we wouldn't be dependent upon us both working forever." --Bryan J.

Make a lot out of a little. "I've never made a lot of money but I do manage to put away about 25 percent of my salary each month when you include 401k/IRAs. My trick? I guess I decided long ago how I want to live (simply) and I just don't need the extra money. So I save it." --Polly T.

Anyone can do it. "Something I have learned along the road to financial education is it takes planning and discipline--and I should know--10 years ago I declared chapter 7!" --Paula

These ideas will just get you started. My checklist has more tips that will help turn you into an x-treme saver.

The Armchair Millionaire's Checklist for Painless X-Treme Saving

• Pay yourself first, automatically. Arrange to have money automatically regularly deposited into a savings or investment account, either directly from your paycheck--as with a 401(k)--or from your checking account. Either way, this money will be safely tucked away before you miss it.

• Save your next raise. Most people just tend to spend any increase in their income. Instead, whenever you get a raise, commit to saving that amount.

• Remind yourself. Leverage technology to send yourself regular reminders about saving. You can set up an email reminder, program your Palm, or schedule an automatic transaction in your personal finance software.

• Re-direct debt payments. Whenever you pay off any loan, send the payments you were making into your savings. Same goes for the amount you save by refinancing your mortgage.

• Ignore the Joneses. Keeping up with the spending habits of your neighbors or friends is a dead-end street. Live below your means and save the difference.

THE BOTTOM LINE: There are few things that will bring you to financial independence more quickly than x-treme saving. While you may find it difficult to get started, you'll soon find that it's one of the most rewarding--and addicting--things you can do.

The Math Behind Stashing Your Cash

Question of the week:  I'm finally working at a job that offers a 401(k) plan and I want to start saving for my retirement. My problem is I'm not making a lot of money and I seem to spend what I have. How much should I be saving? —LD Dear LD, Even with a modest salary, you can ensure a better retirement if start saving as soon as you have the opportunity. Unfortunately, most people squander their chance to make the most of the time and the savings tools available to them because they're afraid they won't be able to live with a smaller paycheck It's easy to underestimate the advantages of tax-deferred savings. But did you know that when you save in a tax-deferred account, such as a 401(k), a traditional IRA or other tax-advantaged savings plan, you get a big chunk of your money back in the form of tax savings? Depending on your income tax rate, stashing one dollar in a tax-deferred plan saves you anywhere from 10 to 40 cents in taxes. That's like getting a guaranteed 10 to 40 percent return on your money—something you sure won't get any other way. The members of the Armchair Millionaire community have discovered this little bit of math and now they love to stash their cash into their tax-advantaged savings plans. Here's how some members of the Armchair Millionaire community are going about it: Put it on autopilot. "My wife and I both contribute to 401(k)s, and our employers add a match. We find that the automatic payroll deduction works wonderfully to instill discipline." —Yorgos Max out your tax-deferred possibilities. "I save 15 percent of my gross income and my husband saves 20 percent of his. Both go into our 401(k)s, which save us taxes, and we both contribute the maximum allowable by law. On top of that, we fully fund our Roth IRAs every year." —Georgia P. Add on savings in taxable accounts. "Besides maxing out my 401(k), I save an additional 15 percent of my income in a diversified taxable mutual fund portfolio." —Tony G. Your timing is good because you can now put away more than ever in tax-deferred accounts. Worried that Americans aren't saving enough for retirement, Congress approved some changes last year in our retirement plan savings limits that are designed to help you take more control of your retirement planning and rely less on Social Security. Here's a look at the most important changes. The Armchair Millionaire Summary of New Retirement Rules Higher 401(k) limits. The pre-tax maximum you can put into your 401(k) goes up to $11,000 this year, and up by another $1,000 each year until it hits $15,000 in 2006. (Remember that, depending on your employer's plan, you might be subject to other limits. Be sure to check with your company's HR department for details.) Higher IRA limits. Starting this year you can put $3,000 a year into your Roth or traditional individual retirement account, up from the paltry $2,000 limit we've had for so many years. Even better, the annual cap rises to $4,000 in 2005 and $5,000 in 2008. Catch up provisions for both 401(k)s and IRAs. To help procrastinators catch up, there's a special rule for taxpayers 50 years of age and older. These folks can salt away an additional $1,000 a year in their 401(k)s for the next few years, and an extra $5,000 a year starting in 2006. For IRAs, the rules allow an extra $500 a year now with an additional $1,000 starting in 2006. The BOTTOM LINE: Combining the powerful effect of compounding returns over time with the benefits of tax deferral makes for a potent savings recipe. Apply a strong dose of common sense investment planning and you'll be on a smooth road to retirement.