The number of Americans living paycheck to paycheck was shockingly high prior to the pandemic and the virus would not have been kind to any of those people. If better financial habits are part of your 2021 resolution, start with my post on nailing down the basics here. For anyone that wants to have a sound financial future, the most important consideration should be the utility of that money. Essentially, every dollar needs to have a purpose assigned to it before it hits your bank account. The way to achieve this is creating a budget which I have written about in a past article here.
Now most of us understand the concept of bills, leisure spending, savings and retirement. When we get paid, we think about the bills we need to pay. Most employers provide a retirement plan like a 401(k) which we contribute to for retirement savings. We never see the retirement contributions because they are usually taken out of our paychecks before the money hits the account making it a great way to secure our money for when we are old. Once we pay the bills, we think about leisure expenses like shopping and entertainment. Then, we hope that there is something left for savings which will stay in the account until the next paycheck arrives. This isn’t quite the right prescription for a sound financial future. Experts invariably say you need to pay yourself first. Meaning, as soon as the paycheck hits, savings should be taken out first. Then, pay the bills and if something is left over, you indulge in leisure spending. This way, you never miss your savings goal.
Now assuming you are building some savings, you need to think about what those savings are for. As I said, every dollar should have a purpose. Depending on where you are in your financial freedom journey and the amount of money you have saved up, every individual should have 4 different accounts and how much money is in each account is driven by when you may need to spend that money.
- Checking Account – This is the account where you get the portion of your paycheck that you will use to pay bills and spend on leisure. You can then use the debit card associated with this checking account to do both of these activities. Most of us have this so I won’t say much about this one. The thing to remember is that your entire paycheck need not go in here. Pay yourself first by splitting you paycheck and deposit it in this next account below.
- High Yield Savings or Money Market Account – This is the account that contains your emergency fund (3 – 6 months of bills and expenses) and any other money that you may plan on spending in the next 1-2 years. For example, if you are saving for a down payment on a house or saving cash to buy a car that you plan to buy in the next 12 – 24 months, put that money in this account. It is earning more interest than the checking account and is pretty much entirely protected from the fluctuations of financial markets. This way, you can withdraw this money whenever you need it – whether for emergencies or the down payments.
- Brokerage Account – Once you have a fully funded emergency fund and you don’t have any big plans of spending money in the next 2 years, anything you may want working for you for 2 years or longer, goes into a brokerage account. A brokerage account lets you purchase stock in different companies, mutual funds, Bonds and Exchange Traded Funds (ETFs). I will go into details of these financial instruments at a later time but in essence, the brokerage account allows you to actively invest and trade in the financial markets. I recommend not investing any money you may need in the next 2 years in any of these investments because these investments are vulnerable to market fluctuations and you don’t want to have to withdraw in a down market and incur a significant loss. In the long run, prudent and diversified investments will invariably do well so be smart and don’t try to get cute with the financial markets and gamble with your money. The money in this account can also be used for early retirement since there are no limitations/penalties for withdrawals. You will have to pay taxes on your profits though, so do not spend all your profits before tax season or be ready for the fury of Uncle Sam.
- Retirement Accounts – Whether 401(k), 403(b) (if you work for a non-profit) or IRA (If you are self employed). They are all in essence similar. Tax sheltered accounts where you can contribute pre-tax money that will be invested in financial market funds of your choosing to grow until you hit 59.5 years of age which is when you can start drawing out from them. You will pay taxes when you take money out however. In essence, it is a great way to shelter some of your earnings today from Uncle Sam in return for an IOU. There are also Roth versions of these accounts. These are accounts where you contribute post tax dollars (basically, you pay taxes now and then put the money in) and they are invested the same way. The kicker is that all the profits from investment are yours to keep when you withdraw them in retirement. The profits are not taxed. That is the primary difference between Regular and Roth retirement accounts. There are some other differences – the most notable being that there are mandatory minimum distributions after 72 years of age for regular accounts so you have to start drawing money. There are no such requirements for Roth accounts making them an excellent inheritance tool. If you plan on leaving money for your children when you pass, you may want to consider Roth accounts today.
Overall, anyone who wants to structure their finances can do so by having these 4 simple but effective accounts and leveraging them for the benefits they provide.
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