7 Essential Steps to Build Wealth
A Step-by-Step Guide
So you want to live with Gusto? You want to live with Financial Gusto? You want to live on your terms? Perhaps you want to be able to have the (financial) freedom to do some pretty amazing things, like live abroad for a while, or take a mini-retirement, or retire outright and move to Florida! Whatever it is, you’re ready to do with Gusto.
But, how are you going to do it?
What follows are 7 Essential Steps to Build Wealth that if followed will set you up so that you’re building your financial house on solid ground, not unstable sand. To live with Financial Gusto you need to make sure that certain areas of your life are set, like money. Moving to Barcelona for a year requires a little forethought (future posts to come, specifically on how to pull this off). Retiring to the beaches of Florida requires forethought too (future post to come on this topic too…).
Follow these steps, ‘Step-by-Step’ and you’ll be well on your way towards living with financial gusto!
This article is a bedrock piece. Consider what follows as a base reference point for many of the articles or blog posts to come. I’m often asked by potential financial planning clients, “Where do I start?” Or someone may meet me and comment, “I’d like to start investing in XYZ stock.” “How do I take a mini-retirement and travel Europe?” Or another might say, “I want to retire at 65, can I?” Or, “How do I make sure I retire someday?!” My usual response is to ask them a few questions to get better understand their situation, and exactly how I can help. Often, after asking a series of questions, I begin to learn that some of the very basic financial planning steps were skipped, usually because they simply didn’t know them! Not necessarily their fault, they just hadn’t been exposed to a post like this! ☺
You see, it’s fun to start thinking about investing, retiring to the beach, or saving for your child’s college (okay, maybe that last one isn’t as fun to think about). But in general, thinking about investing or long term wealth-building is fun.
Much like a house built on sand, which is unsteady and unreliable, jumping to the last few steps without completing the first steps, can be unsteady and ultimately cause more harm than good. In short, from a prudent financial planning perspective, starting with Step 1 and sequentially moving through them, will allow a much more successful financial journey and set you on the right course to live YOUR version of Financial Gusto. Here we go….
*** One note, before getting into it*** There are variations of these steps out there (sometimes appearing as a pyramid), and they may vary depending upon the type of product that the organization is trying to sell. Luckily, I’m not selling anything here, so rest assured these steps are solid.
So, to build wealth on solid foundation (whatever that means to you and your family), one should first cover the very first step. If needed, seek help to in accomplishing these steps. There are qualified people that can help you accomplish each one of these steps.
***Okay ONE MORE IMPORTANT NOTE *** There’s one step that probably should be listed as an actual step, but it’s not. It’s really, really important and leads to tremendous success for the people that implement it.
Before we officially get into the steps, create a budget first. I like using technology, like an iPhone app, to help with this, but an excel spreadsheet works too! You have to find the method that works best for you. Sit down with your spouse, friend, mother, or Schwans guy, and create your monthly budget. Doing this with your partner or someone who can keep you accountable also leads to quicker and more positive success. Check in with them regularly and have “Money Meetings.” My wife and I do this regularly and try to make it fun at times. However you accomplish it, JUST DO IT! It’s so important and will set you up for real success and will allow you to live with Gusto (see what I did there ☺ )
Here are a few budgeting resources to help you.
- EveryDollar.com iPhone/Android App * I currently use this.
- budgetsaresexy.com – downloadable spreadsheet
- moneypeach.com – downloadable spreadsheet
Now that your budget is set…
Let’s get into it:
Step 1: Emergency Fund
Perhaps the most overlooked and under-recommended step. Why?
They’re so not sexy… but I often find that the important things in life are not “sexy,” except my beautiful wife 🙂 (brownie points)
Also, typical financial advisors don’t make any money on an emergency fund, so they tend not to spend adequate, if any, time discussing them. Pro tip: they’re probably not actually advisors, but brokers. I digress.
The emergency fund is your very first step (aside from the budget). It should be a separate bank account from your everyday checking. Most online banking providers will allow you to re-name your accounts. I’d recommend doing this. Actually re-name your separate savings account “Emergency Fund.” This should really help you avoid tapping it for your next vacation or car purchase.
How much should I have in my emergency fund?
I generally recommend that your emergency fund be big enough to cover 6-9 months of your living expenses. So, this implies that you know how much money it takes to pay all of your bills (expenses) per month. Bu you DO, because you’ve already created your budget, right!? For example, if your monthly expense budget is $3,000. (So it takes $3,000 to pay your mortgage, utilities, cell phone, gas, groceries, etc… ) Then a healthy emergency fund should be between $18,000 – $27,000.
I know that may sound like a lot… IT IS! You may hear other people/brokers/advisors telling you that you’re missing out on growth by having that money in cash and not invested. They’re correct… in theory. But, theory doesn’t work when you’re car breaks down, the furnace goes out and someone loses their job and needs to come up with cash quickly! Having the ability to draw cash in an emergency, when REAL LIFE happens, far outweighs any opportunity cost of not having that money invested.
For your emergency fund
CASH IS KING
Step 2: Debt Reduction
After building an emergency fund, the next and prudent step, BEFORE JUMPING AHEAD, is to tackle and eliminate debt (except your home). This step is so important, that I’m often inclined to recommend that a person sacrifice building all the way to a 6-9 months emergency fund, for the sake of eliminating bad debt, especially credit card debt.
What that means is, if you’re starting from scratch, first thing is to establish a small emergency fund. Start with $1,000 -$2,000. Once you have saved that initial amount, instead of putting 100% of your extra dollars towards building your full emergency fund to 6-9 months of expenses, take a portion of what you were putting away to the emergency fund, and now put it towards extra payments towards debt. That way, once the base $1,000-$2,000 emergency fund is built, you continue putting some money towards it, but you then take a portion of those contributions and put them towards debt.
The reason for this is simply personal opinion. Some may recommend you wait to pay debt until you have amassed a full emergency fund, and some may recommend you forgo it until 100% of your debt is gone. I think there’s a happy medium there. You should also be very aware of how you “feel” about debt. Is it causing you to lose sleep? Are you worried about it? If the emotional reaction towards it is affecting you, then that’s probably a good indicator that you should get aggressive in eliminating it.
Pro tip: In general, the people that I’ve seen build a beginner emergency fund, then get crazy about eliminating all of their debt (other than their home), then go back to building the full emergency fund, tend to accomplish their goals quicker. Laser focus and sacrifice goes a long way. Either way, decide what you’re going to do before you start, then do it!
Here are resources to check out so you can make a plan to Get Out of Debt. My #1 choice for debt reduction resources and the method that actually works to pay of your debt, is Dave Ramsey and his Debt Snowball method.
You can read all about it, and actually create your plan to tackle your debt, HERE.
Chris Peach with MoneyPeach.com paid off $52,000 of debt in 7 months. Read all about his journey and even download the actual budget he used to do it. Learn more about him, HERE.
Moving right along step by step, we’re now on to Step 3. By now, the budget is dialed in, you’ve got some type of emergency fund (either your beginner one, or fully funded, and you’ve crushed your debt. You’re ready to move on.
Step 3: Insurance
a.k.a Risk Management
a.k.a The Thing Nobody Likes Talking About But Is SO Important
Let’s talk about insurance.
Again, not a very sexy topic… but important… Remember what I said above, about Emergency Funds?
Life insurance – Disability insurance – Auto & Home insurance
First, life insurance: most people should look for cheap term insurance. Of course, the amount and term should be specific to you and your situation. In general, here are a few reasons why people should consider some amount of insurance: replace needed income if income earner passes away, cover debt & pay off house, pay for children’s college, allow widowed spouse to take time off work, and the list goes on. Remember the acronym: DIME. These represent four areas that should be considered when thinking about how much life insurance to get. D=debt, I=income, M=mortgage, E=education. You can read much more about life insurance, and how to calculate how much you need, HERE.
As a general starting point, consider looking at an amount of 10-15 times your annual income. You may decide you need more or less than that, but it’s a good starting point. As for the term, consider your family situation or an amount of time that someone is counting on you. Whether that’s children or a cousin you provide for, or perhaps your parents relying on you to pay them back the “loan” they gave you, you need to determine when it’s okay for that insurance to “run out.”
Generally term insurance will be issued at 5, 10, 15, 20 and 30 year terms. After that time period, your insurance is finished. Or, you may consider “laddering” term policies. For example, if you have 2 children 5 years apart (one is 5 and one is a newborn), perhaps a 15 year term and a 20 year term are appropriate. Many people want insurance while their children are in the house and want it to last until their children are through college.
With this strategy, one of the policies falls off in 15 years, while the other remains for another 5 years to see the newborn through college. Discuss your overall life insurance needs with a qualified, independent advisor or insurance professional. Independent professionals can run your personal demographics through their software and instantly get quotes from dozens of insurance providers.
Disability Insurance: You are twice as likely to experience a disability, taking you away from work (loss of income), than dying prematurely. So, disability insurance is a type of insurance that you may want to consider, especially if you have a high income and/or your occupation is specialized (like a Dentist, Doctor, Business Owner). For many, their group short or long-term disability policies through their employer will suffice for base coverage, but the specialty occupations will often need additional private disability insurance. Often employers will pay for short-term and offer long-term disability for an extra cost. For many, picking up the extra employer long-term disability coverage is well worth the added, albeit little cost.
In all, private disability insurance is a risk management technique that should be considered. If cash flow is tight, I usually recommend forgoing PRIVATE disability insurance over private life insurance. So that means, it usually make sense to carry some form of disability insurance through your employer, and looking for cheap term insurance in an amount and term appropriate for you. If cash flow is tight, and you need to decide between picking up PRIVATE (non-employer based) disability insurance or PRIVATE life insurance, it might make sense to just stick with the employer disability insurance and pickup private life insurance instead of private disability (because of its higher cost). Often employer based life insurance is available, but not adequate according to the “rules of thumb” listed above.
You can read more about disability insurance HERE.
Auto & Home Insurance: Find a good insurance agent whom you trust and whom you know won’t just try to sell you the most amount of coverage they can. They should ask you plenty of questions, get to know you and your needs and then work with you to develop an insurance plan that is low cost, and designed around your life.
One item to make sure you discuss with them, is an un-insured/underinsured liability umbrella policy.
These can usually be added, inexpensive options that can provide extra liability in the event that you have a negative encounter with someone who is un-insured or underinsured (think: accident at your home during neighborhood party…), and they find out that you have a high income, so you probably have significant assets, and they want to go after more money after said accident. This umbrella policy can come in handy and provide a higher level of coverage protection.
As for finding an agent that you trust, I generally recommend independent agents who can use lots of different insurance companies to find the right coverage for you, and who aren’t obligated to use one company over another. However, I have found that good, quality agents who are captive (think State Farm, Farmers, American Family) can offer very competitive rates as well, and are certainly worth a look, especially if you trust them and have been recommended by someone you trust.
Step 4: Take Full Advantage of Employer Retirement Savings Benefits
Take Advantage of Your 401(k)
Take advantage of the benefits your employer offers you!
Okay, now we’ve moved on to the FUN stuff. This is the 4th step and one where we begin to see forward progress.
I don’t know how many times I’ve sat across from someone who is interested in investing in the stock market, and again, after a series of questions, I find out that they are employed and not participating in their company’s 401(k) plan and the company matches contributions!
Let me explain:
People generally like skipping the basic steps. They like skipping the “blocking & tackling,” of a solid financial foundation. When looking at these Financial Planning/Wealth Building steps, one usually wants to jump up to the “Sexy Investing Step,” because it seems much more fun. But please, don’t do that especially when your company offers a solid 401(k) plan, with low-costs, and they match contributions.
Matching contributions are FREE MONEY! Many companies that offer a 401(k) provide something like a dollar-for-dollar match, up to 3% of your contribution. So if you make $80,000/year, and you contribute 3% to your 401(k) = $2,400, your employer will put in $2,400 for you! Some employers then take it a little further, and say they’ll do dollar-for-dollar up to 3% then after that, they’ll do $.50-for-every-dollar, up to 6%. So, using the same example, above, if you contribute 6% of your pay to the 401(k), you contribute $4,800, and your employer contributes $3,600 ($2,400 dollar-for-dollar up to 3%, then $1,200, $0.50-for-every-dollar, between 3% up to 6% of pay.
Then if that money is invested well, in stock & bond mutual funds (diversified, low-cost, rebalanced), and you take a long-term perspective with it, the odds are VERY GOOD that you’ll have a nice sized portfolio over a long-period of time.
At this point, once you’ve decided to at least contribute up to the matching point of your 401(k), you are left with a couple of scenarios, based on cash-flow and how much of your NET paycheck you need to pay your bills. If you contribute at least 3% to get that maximum match, and then have nothing extra from your paycheck, that’s okay, you’re making progress. Continue doing what you’re doing and perhaps income increases.
If you do have money left over after contributing to your 401(k) plan from each paycheck, the next logical place to put more away, is more towards your 401(k). So why not continue to bump up your contribution to 6%? More on this later.
Did you know that you can put up to $18,000 per year into a 401(k) (for 2016), and $24,000 per year if you are age 50 or older? Another option, other than bumping your 401(k) contribution up to the max, and if you have extra money to save, is to look to save that extra money in an Individual Retirement Account.
Step 5: Use a Roth IRA or Traditional IRA
Rome wasn’t built in a day. Building your long-term wealth likely won’t be either. Getting the first 3 steps nailed down and participating your 401(k) plan at least up to the match in Step 4, leads us to Step 5; using Roth or Traditional IRAs. Roth IRAs and Traditional IRAs are Individual Retirement Accounts (IRAs.) You can read much more about them HERE and determine which, or both, is right for you.
Roth IRAs and Traditional IRAs are retirement plans that you set up and own. 401(k) plans are retirement plans that your company sets up, and you participate in. One is an ‘Individual’ (IRA) account; meaning it’s yours. The other (401k) is a company plan that you put money into.
In general, it’s only after the first 3 steps have been taken care of, that we move on to the Retirement Accounts (401(k), Roth IRA, etc…). Now, I’m a big advocate for defining YOUR version of retirement. If beaches and mojitos are your thing, then great; let’s make a savings and investing plan for that. Frankly, it seems like the millennial generations (and to some extent Gen Xers) are looking to redefine retirement. (More about ‘Redefining Retirement’ to come on this blog.) It’s at Step 4 that one should begin to establish regular, long-term savings goals. These are individual RETIREMENT accounts, after all. Inside the IRA you can begin investing. How do I typically recommend people invest in IRAs?
What does that mean?
It’s a broad term to describe investing solutions that are built on the science of financial markets, not hunches, whims or emotions. Evidence-based investing could be using low-cost index funds (and it often does include these), or other mutual funds designed to capture extra return through exposure to certain pockets of markets that the research has shown to having good odds of producing excess returns. How’s that for a mouthful? There are very specific funds, and a short list of fund families that accomplish this approach. I will have plenty of future posts about investing this way. Here is an article I wrote introducing readers to what the data says on active, high-cost money management vs. passive, low-cost investing. You can read it HERE.
At Step 4, aside from investing for the possibility of future growth, it’s all about tax benefits. IRAs were designed to encourage retirement savings, which you’ve already read all about. The money inside IRAs, whether Roth or Traditional, grows tax-deferred, which is a huge benefit.
Roth IRA vs. Traditional IRA – Quick Summary
With Roth IRAs you make after-tax contributions to them, (if eligible)(up to $5,500/year)($6,500/year if over age 50), invest in what you’d like (I’d recommend an evidence based approach), the money grows tax-deferred, and then pull the money out, in retirement, TAX FREE. There are income limits, meaning if you or your household income is above a certain amount, you won’t be eligible to contribute. HERE is a great resource to determine how much you might be eligible to contribute.
With Traditional IRAs, you make before-tax contributions to the IRA and may be able to deduct these contributions on your taxes ($5,500/year)($6,500/year if over age 50). There are income limits for being eligible to take full deductions on your Traditional IRA contributions. Check this resource for more information: on Traditional IRAs. You can invest inside of Traditional IRAS in mutual funds, stocks or, bonds or other investments (I usually recommend an evidence-based approach using mutual funds). Inside of the IRA, the investments grow tax-deferred. Then when you are retired and ready to take money out, you have to pay taxes on your withdrawal at your income tax rate.
Distributions from both types of plans before age 59 1/2 may be subject to a 10% early withdrawal penalty.
IRAs can often be coordinated with your employer 401(k) plan. Meaning, if you contribute up to that 3% matching amount, but your employer doesn’t match anything further, and you have extra dollars to save towards retirement (assuming a healthy emergency fund & no debt), then doing both, (portion to 401(k) and portion to IRA), may make sense for you. It all really depends on your situation, cash flow, and overall goals.
Over time, work to max out these tax-advantaged plans. That tax deferred growth can really add up. As for choosing a Roth vs. Traditional; I’m generally a big fan of Roth IRAs, but I’m a bigger fan of hedging one’s tax bet and considering both. You need to work with a qualified tax advisor or financial planner to determine your best strategy, but I often find that creating multiple buckets of money, with different tax statuses, not only creates a sense of preparedness but also achieves a tax hedge allowing you to decide which bucket of money to draw on for retirement income based upon your tax situation at that the time.
Step 6: Non-IRA Investing & Saving
Investing in the stock market
Remember, we’ve moved through these steps sequentially, for the most part. Meaning, don’t go to step 4 unless steps 1, 2 and 3 have been addressed. After the first few steps are covered, and you’ve begun saving for retirement with a 401(k) and investing in IRAs, you then can move on to what I’ll generally call, ‘Investing.’ This investing step can potentially be paired with steps 1-3, only if your individual goals require it, and you’re not neglecting FREE MONEY from your employer, in the form a 401(k) match. Remember, you are ‘Investing’ when you save money in a 401(k), and in an IRA (hopefully)… this step is moving beyond those retirement focused accounts.
Here’s what I mean by potentially pairing this ‘Investing’ step with septs, 4 and 5. As I see it, there are again a couple of scenarios here:
Scenario one would be if someone has addressed steps 1-5 to the max. Meaning, they’ve got a healthy emergency fund, little-to-no-debt, they have term-life insurance, some disability insurance (if it makes sense for them) and are well covered on home & auto, they are participating in their 401(k), and maxing it out ($18,000/year in 2016), AND they are maxing out Roth IRAs, ($5,500/year in 2016), and they still have money left over to start saving. These are our high-income earners (or very low-expense people.) They then move on to finding other ways to put money away and invest.
Either look to invest in a brokerage account and invest in mutual funds, stocks, bonds or something else, or they put their money in a low-cost, fee-based investment only annuity (typically has tax-advantages), or they buy an insurance policy and over-fund it to try to achieve cash value growth. I’ll have more on these strategies another time.
Scenario two is someone who has steps 1-3 dialed in, but can’t quite afford to fully max out their 401(k) but they are contributing at least up to the match point (3%). They also may have some time of very specific short-term goal, like buying a house in 7 years. Where do they save for that? They can allocate dollars to a non-IRA account, and still invest if they desire. I typically wouldn’t recommend investing short-term (under 10 years) dollars because of the volatility and associated risk, but hypothetically it’s an option.
Another sub-step that needs mentioning in Step 7, is what I’ll label as “Other Investing.”
Real Estate Investing
Perhaps it is your goal to begin investing in actual real-estate like single family or multi-unit buildings, renting them out, and using them as “passive income.” I label this type of investing here, simply because of its nature. There definitely are certain tax benefits to investing in real-estate but much different that the straight forward tax-deferral of an IRA. I’m not going to go into detail about investing in real-estate. If you’d like to learn more about investing in real-estate, I’d encourage you to DO YOUR HOMEWORK and take it slow. Use as much cash as you can and did I mention, do your homework and take it slow?
Click HERE to read more about real-estate investing and what to avoid.
Step 7: Wealth Accumulation
The final step is Wealth Accumulation. Doing each of these steps with diligence is living with financial gusto! You’re accomplishing YOUR GOALS by following these steps.
Working Toward YOUR GOALS = FINANCIAL GUSTO
You’ve done most of the little things well. You’ve been doing them generally in a productive order, and you haven’t gotten in over your head. Now, the key to long-term wealth accumulation and becoming established in your wealth, is two-fold.
1.) Emotionally separate yourself from the ups and downs of your money fluctuating; ignore the noise
2.) Emotionally allow yourself to enjoy your life and use your wealth for what makes you happy.
Now that’s a winning combination and what I call, living with Financial Gusto!
Continue to hold solid and globally diversified funds that are low-cost and have a great track record (again, using an evidence-based approach).
Believe me, WHILE you are accomplishing these steps, you CAN live with Financial Gusto. Of course, at the end, you definitely can. But don’t wait to the end to live this way. Financial Gusto is a state of mind. A belief that you’ve got one life to live, that it generally takes money to live your life, and that living with financial gusto is so much better than coasting, waiting for life to happen.
Use this step-by-step guide to help you accomplish your version of Financial Gusto.
This is living,
Bonus Steps (Topics):
Of course there are plenty of topics that are not covered above, and make for great future blog posts. For example, at a certain point, tax strategies need to be considered. Naturally, the first steps would likely have to happen prior to needing to work on tax strategies, but in many cases it’s a combination of the sound tax plan and following the steps that leads to wealth accumulation.
Other topics that aren’t listed above but generally need attention at some point:
- Estate Planning: what happens if/when you pass away
- Education/College Planning: is it your goal to help children pay for college
“Your kids can take out a loan to pay for college but you can’t take out a loan for retirement!”
- Behavior Management: learning how to get clear about what you can control, and what you can’t
I hope this article has helped you identify the steps to building and maintaining a solid financial life. Whether you are just getting started establishing your own wealth, or you are well established, there is plenty of “financial gold” here to help you on your journey.
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