“You do not rise to the level of your goals. You fall to the level of your systems. Your goal is your desired outcome. Your system is the collection of daily habits that will get you there.” – James Clear
Getting your Financial House in order is paramount to achieving your Financial Goals. However, as the quote above from James Clear states we fall to the level of our systems. I believe how this applies in Personal Finance is through automation.
Automation
Even the most well-intentioned and organized person is still going to fail from time to time to accomplish a repetitive task. For this reason alone, that is why computers are incredibly powerful. As long as they are programmed appropriately they continue to repeat their tasks without fail.
We should seek to leverage this power to achieve our financial goals. In steps the system of automation. Instead of manually paying our bills, choosing how much to put into our savings, investments, or short-term buckets we should make this decision once and let our “employee”, the computer, handle the task.
Many people struggle to save money. What I contest is the easiest way to do this is by making that decision once and letting the computer handle the burden.
Okay, so you’ve convinced me that I should automate saving for my Financial Goals. But how do I do that? What should I prioritize?
Wealth Waterfall
Now, I’ll be the first to admit that I don’t know everyone’s scenario and your case could certainly be different, but I’ll provide the steps I take in my own life.
1. High-Interest Debt
The best way to put yourself in a better financial state than you are currently in is by eliminating any high-interest personal debt. What is considered a high interest you might ask?
Personally, as mentioned back in my previous post, 5 Levels of FI – Demystifying the Noise, I expect to draw somewhere near 4% of my nest egg in retirement. Therefore, any debt above 4% is a debt I absolutely want to remove.
However, a lot of consumer debt likely falls into this category such as credit cards, car loans, student loans, etc. Not all of these are created equal. For this Wealth Waterfall, I’ll consider any debt that is higher than mortgage and student loan rates to be considered high-interest and will likely fall near 8-9%.
2. Health Savings Account (HSA)
As Brandon at the MadFientist writes in his great article, HSA – The Ultimate Retirement Account, an HSA has tremendous benefits. The money that is added to an HSA is tax-free upon contribution, has tax-free gains, and has tax-free withdrawals.
Money that is added here can be pulled out for any eligible expense tax and penalty-free. Still, the best value is to try and not touch this account until age 65 because at that point it can be treated like a Traditional IRA (eligible expenses are still tax-free, but all other expenses are treated as regular income) and is not subject to the 20% penalty if you were to pay for an expense that is not health-related.
In 2024, the annual contribution limit for Health Savings Accounts is $4150 for an individual under 55 or $5150 for individuals 55 and older. For families, the amount is doubled at $8300.
3. Traditional 401K/Roth 401K/403B/457B Contribution to get full employer match
What would you think if I offered you free money?
I’m guessing you’d take me up on the offer, but that is what is happening today when employers offer their employees a 401K match, yet there are still employees who opt to not take their employers up on this offer.
I want to make this clear. If you are offered this benefit, IT IS PART OF YOUR COMPENSATION. Please take it. Your employer is trying to compensate you for you doing your part in saving for your retirement. The price for you to receive this free money is you saving the required portion (typically between 3-6%) in a 401K/403B/457B.
4. IRA (Roth or Traditional)
The IRA, or Individual Retirement Account, is exactly as it sounds. It is an account where you can set investment elections based on your financial institution’s offerings.
Additionally, there are tax implications based on whether you decide upon a Traditional or Roth account.
You may ask yourself, why would I contribute to a 401K/403B/457B and an IRA? Don’t they do the same thing?
The short answer is no.
While they are both retirement accounts, there are differences in the amounts you can contribute each tax year and the flexibility that each account provides you.
In 2024, the annual contribution limit for an IRA is $7,000 for those under 50 and $8000 for those 50 or older. It should also be noted the contribution limit is for the combination of both a Roth IRA and a Traditional IRA (i.e. you could contribute $3500 to each if under 50, but not $7000 to both).
Flexibility
In a 401K/403B/457B, you are limited to the investment options that your employer has available in your plan. Unfortunately, this could come with sub-optimal options or high fees (as expressed as a high expense ratio).
A quick note about expense ratios. Expense Ratios are the fees that are charged for a particular investment option. The FI community and I advocate for investment in low-cost index funds.
Low-cost Index Funds and Fees
What the heck is a low-cost index fund?
It is a mutual fund or ETF that tracks a particular benchmark. Because the fund is trying to match a benchmark it typically does not require active portfolio management and therefore has lower fees.
VTSAX, Vanguard’s Total Stock Market Index Fund, which JL Collins, author of The Simple Path to Wealth, commonly endorses has an expense ratio of .04% or 4 basis points (bps).
For example, on an investment of $1000 and a rate of return of 6% after year 1, you’d have a gross amount of $1060 and a net amount (after fees) of $1059.60 after year 1. This means you paid a total of $0.40 in fees for 1 year of management.
I bring this up as it’s not uncommon to have mutual funds with an expense ratio of 1% for an actively managed account. In the example above, that means you’d end year 1 with a net of $1050 and fees totaling $10. You may be saying, big whoop it’s $10, but that is 25 TIMES more in fees. Many studies have shown that actively managed funds often underperform their non-actively managed counterparts. Therefore, not only are you getting less return on your money on the specific investment you are also being charged more money for the privilege. THIS IS A BIG DEAL!
Traditional IRA
In a Traditional IRA, your contributions funded with pre-tax dollars, grow tax-free, but taxed at withdrawal (as regular income in that tax year).
Roth IRA
Conversely, in a Roth IRA, your contributions are funded with after-tax dollars, grow tax-free, but are tax-free at withdrawal.
5. Traditional 401K/Roth 401K/403B/457B (Maxed)
Next, after you’ve maxed out your IRA, it is time to max out your retirement account offered by your employer (Traditional 401K/Roth 401K/403B/457B).
In 2024, the contribution limit for 401Ks/403Bs/457Bs is $23000 per year for employees. Employees 50 or over can contribute an additional $7500 for a total employee contribution amount of $30500.
6. Post-Tax 401K Contributions
While not available to all, if your employer offers an After-tax 401K, this is another way to stash away funds for retirement to the tune of $69000 or $76500 if 50 or older. There are certainly benefits here if your employer allows for in-service withdrawals as these could be converted to a Roth IRA.
7. Taxable Contributions (Brokerage Account)
Finally, there are taxable accounts. You might hear that term and think what is that?
Well, in short, it’s an account where the normal IRS tax rules apply. Some examples of taxable accounts include checking, savings, money market, and brokerage accounts.
These accounts will not offer you tax benefits but will give you flexibility. One such benefit is no limit on the amount of money that you can contribute to these accounts in a given tax year.
However, you pay interest, dividends, and capital gains in the year that you earn them in these accounts. Depending on how long you’ve owned an asset, the sale could change whether it is taxed at a short-term (normal income tax rate) or long-term capital gains rate (reduced rate based upon your income level)
Fall to the level of our Systems
Remember that quote at the beginning of the article? Well, I need to put this to practice and will promise to be better to you. It’s taken me nearly 2.5 weeks to get this out and being a perfectionist has delayed me hitting the publish button. I need to rely more on the Pareto Principle and deliver more frequent byte-sized articles to you. I hope you stick with me on my own journey in order to help add a new voice to the community and help some people on their own path.
I’m headed to EconoMe for the first time ever this year. If you’re going to be around and want to meet face to face drop a note and I’ll look to try and make it happen!