Step 1: Acquire a job.
Money comes from hard work. There is no way around that. You should learn a good work ethic as early as possible. Before you can let your money work for you, you need to work to earn the money.
“No one does anything hard willingly,” says Barbara Sher, author of Wishcraft and I Could Do Anything If I Only Knew What It Was. We need to make “a conscious decision to win the lifelong battle against procrastination and laziness.”
Step 2: Choose an investment custodian.
The ideal custodian would have:
- No maintenance fees or financial hooks.
- No or low minimum account balances.
- Access to Buy List investments.
- No or low transaction costs for Buy List investments.
- Excellent customer service.
- Easy web interface for most tasks.
- A toll-free phone number.
If you plan on implementing our Gone Fishing Portfolio, we recommend Vanguard as a custodian. Vanguard has no maintenance fees and no minimum account balance. Furthermore, when buying Vanguard ETFs (a large part of the Gone Fishing Portfolio) in a Vanguard account, there are no transaction costs.
Step 3: Open accounts.
You will want to open the following account types:
1. Roth IRA (one for each family member)
Roth IRAs are tax-advantaged accounts. Although the math can be complicated, the benefits of funding a Roth IRA over other retirement accounts are often millions of dollars.
IRAs have contribution limits and rules for when you can access the money. Such restrictions make them preferred for retirement savings but not for other types of savings.
2. Savings account (Joint or Individual, your choice)
This type of account goes by many names (savings account, brokerage account, investment account), but it is simply an account that is capable of holding investments.
This will be home to your Unknown Fund, big purchase savings, and additional retirement savings beyond the IRA contribution limits. Ideally, you will rarely need to draw money from this fund, but this account can also house your emergency fund.
3. Checking account (either through a local bank or the custodian, if offered)
This account will hold the funds to support your standard living expenses. It will essentially just enable you to deposit checks, access your cash savings with a debit card, and pay regular bills.
As a result, a local bank account is often easiest. When choosing a local bank for a checking account, the ideal bank would have:
- No account fees.
- No or low minimum account balances.
- Access to free checks and debit card.
- Short commute from your home or work.
- Excellent customer service.
- Easy web interface for most tasks.
- A toll-free phone number.
(Although Vanguard does not offer checking, we do have a guide for how to open the Roth or savings accounts at Vanguard.)
4. Employment related retirement account (401(k) or 403(b))
You cannot open this account on your own, but you can choose to participate in a plan if your employer sponsors one. Asking Human Resources if they have a 401(k) or how the plan works is a good place to begin.
Many employers encourage savings by matching your contributions to the firm’s retirement plan (called an “employer match”). A typical match is dollar for dollar for the first 3% of your salary and 50 cents per dollar for the next 2% of your salary. Thus, contributing 5% of your salary results in your firm adding an additional 4% to your account.
To you, this is as good as free money. An immediate 80% return on your money is impossible to receive elsewhere and should not be overlooked.
The best employer sponsored retirement plans have:
- An employer match.
- A Roth option for your contributions (which you should probably select).
- A variety of fund choices adequate to produce a well balanced portfolio.
- Funds with low fees and expenses.
- A vesting period for the match shorter than your planned employment time.
You don’t often get to choose these details. However, if you have a particularly bad employer sponsored plan, consider sending your boss ideas for how to make it better.
Step 4: Determine how much to save.
Your future self deserves savings. Rather than spending all your money now, there are three types of savings you need:
1. Retirement Savings (15%)
If you start saving for retirement in your early twenties (see “The Benefits of Saving and Investing Early” if you need convincing that you should save in your twenties), your annual retirement savings should be 15% of your take-home pay. If you earn $50,000 after-tax, this means minimally saving $7,500 for retirement.
Ideally, you should be able to fund your Roth IRA up to the contribution limit (currently $5,500 for those under 50) and then save the rest in your savings account.
If you are starting to save later in life, you will have to save more and need to calculate how much. We have an article called “How Much Should I Save Toward Retirement If I’m Starting Late?” which should help determine how much more than 15% you should be saving.
2. Unknown savings (10%)
Many expenditures you cannot anticipate. “Like what?” you might ask. The point is that we don’t know all the details of what it could be like for you. If you knew the answer to that question, you should budget for it in known savings. That being said, job loss, medical emergency, or weather events are some common major surprise expenses.
Each stage of life has new surprises. We recommend you save at least 10% of your take-home pay towards such unknown budget items.
3. Known savings (variable)
Many expenditures are not surprises. You can see them coming and you can plan for them. Every expenditure you can anticipate is easier to meet if you either budget for it or remove the need to spend money on it.
There are large expenditures — like a house down payment, appliance repairs, or vacations — and small expenditures — like haircuts, new clothes, and movie tickets.
The money for small expenditures can go straight into your checking account. Large expenditures are better regularly putting aside money in your savings account.
If you need help calculating how much to save for a large upcoming expense, you can use a simple online calculator.
Step 5: Implement your savings plan with Human Resources.
If your employer offers direct deposit, then they are able to place your paycheck or a portion of your paycheck directly into one or more accounts. This is the first trick to automating your savings.
Ask your Human Resources department for the direct deposit form and fill out the paperwork to accomplish the following goals:
1. Deposit long term savings (retirement, unknown, or large known savings) into your savings account.
If you are earning $50,000 after tax, this means saving at least $12,500 annually ($7,500 or 15% retirement savings + $5,000 or 10% unknown savings). That is $1,041 monthly. You may save even more if you are, for example, saving for any known expenses like a down payment.
Normally, payroll will need the following information to deposit a portion of your pay into a non-checking account:
- Name of Institution
- Account Number (this is normally your 8-digit number plus additional institution-specific numbers on the front)
- Routing Number
- Account Type
The easiest way to get this information is simply to call your custodian and ask for it. Say, “I’m filling out a direct deposit form for my savings account. I need some information for the form. Can you provide me that information?”
2. Deposit your short term expenses (living expenses) into your checking account.
Sum your known monthly expenses and deposit that amount (perhaps rounded up) into your checking account each month. This provides easy access to the cash that you use to pay for groceries, bills, etc.
To fill out the forms for a checking account, you normally just need to provide your employer with a voided check (a check you have written the word “VOID” big and large across the middle).
Step 5: Implement your savings plan with your custodian.
In the last step, we placed all your retirement savings in your savings account, but we want a portion of that money up to the contribution limits to go into your Roth.
You can set up the direct deposit to go directly into the Roth, but if you’re trying to save the maximum amount ($5,500) there is no easy way to divide that into a monthly amount. Some H.R. departments are capable of doing the unique months required to contribute a precise non-multiple of 12 into an account. If yours is, by all means, set up that portion of your paycheck to go straight into your Roth.
If they can’t, you can set up with your custodian a recurring distribution. You pick a frequency (quarterly, for example) and a dollar amount ($1,375, if quarterly) and set a standing order to move that amount from your savings account to your Roth IRA.
Step 6: Generate your investment plan.
Now that you have all the money going to the correct places, we need to determine how the money in each account will be invested.
Your checking account will obviously remain all in cash.
Your Roth account should be invested entirely in stocks. For simplicity, we recommend investing everything in your Roth in Vanguard Total World Stock Index Fund Investor Shares (VTWSX). That fund includes nearly every publicly traded company in the world, comprising the United States, developed foreign markets, and emerging markets.
Your employer-sponsored retirement plan will have a finite number of options, but should be invested similarly to your Roth IRA, in a diversified selection of stock funds. You will have to shop your plan’s fund options to meet that goal.
If you are under 35 years of age and don’t anticipate needing the savings in the next 3 years, you could also invest your savings account in VTWSX.
If you do anticipate needing the money in the next three years, a bond allocation will lower returns in the short run but increase your chance of meeting all your withdrawal needs.
If you need a bond allocation, Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) can be used for liquidity and the remaining stock portion can be invested in Vanguard Total World Stock Index Fund Investor Shares (VTWSX). If you are over 35 years, you can consider using one of Vanguard’s Target Retirement funds, like the Vanguard Target Retirement 2060 Fund (VTTSX). This will be effectively an asset allocation which will gradually and automatically drift more conservative over the next 50 years.
If you want a more sophisticated age-appropriate asset allocation, we recommend our gone fishing portfolio. If you are using Vanguard, we have created a gone fishing portfolio using only low-cost Vanguard mutual funds to help save money on transaction costs.
Step 7: Automate your investment plan.
Investment plans can be difficult to implement if they require that you remember to log on after deposits and execute trades. Luckily, here is where the second trick of automation comes in.
Most brokers have the option of implementing what is called “dollar cost averaging.” It was invented to reduce risk, but effectively allows you to automate subsequent periodic purchases of a particular fund.
This requires a few steps.
- Allow both your Roth and your brokerage account to be funded with enough money to meet your selected fund(s) minimum investments.
- Invest the money in your selected funds.
- Set-up automatic subsequent period purchases of these funds in line with your paycheck deposits using your brokerage firm’s dollar-cost averaging program.
This means that, first you purchase VTWSX in your savings account. If your paycheck is deposited around the 1st of a month, then you set up a dollar cost averaging standing order to purchase more VTWSX monthly on the 15th for the amount being deposited in your savings account which is staying in your savings account.
Carrying our example through, this would mean your standing orders may be, if your paycheck deposits on the 1st of a month for example:
- Savings Account: schedule a purchase of $583 of VTWSX on the 15th
- Roth IRA: schedule a purchase of $1,375 of VTWSX quarterly (after recurring distribution)
Step 8: Rebalance twice a year.
Regular rebalancing is an important part of your investment strategy. Automating that rebalancing helps remove both the hurdles of emotion and inertia. Vanguard supports automatic fund rebalancing. If possible, we recommend rebalancing twice a year in May and October.
After automating your entire investment plan, your default will be to grow rich by living well below your means and saving and investing the difference. A little bit of planning will reward your future self with the riches of automatic prudent behaviors.
Photo used here under Flickr Creative Commons.