The start of a new year can be a great time to take stock of your finances and make a plan for the year.
Spending less and saving more is obviously a common resolution. Deciding what to do with your hard-earned money can be complicated. Everyone’s situation is different, and your resolutions should be personalized. To that end, here’s a framework my wife and I use to think about our personal finances. Hopefully, it is helpful as you think about your own.
For us, we break our personal finances into a few parts:
1) Retirement savings
2) Our daughter’s college fund
3) Month-to-month budgeting
4) Paying off student loan debt
5) Extra savings and investments – not just for emergencies, but also so that we can purchase a home one day.
In my personal finances, I always try to think about the long-term over the short-term. When thinking about personal finances, we choose to put as much savings into tax advantaged investment accounts as possible. This may be counterintuitive to start with savings instead of your monthly budget and debts, but I believe it’s best to start with the long-term and then make as many sacrifices as necessary to fit the rest of our lives into our remaining monthly budget. Plus, the annual tax advantages are limited to each year, so you really want to try and maximize the full benefit while you can. Obviously everyone needs to take their own personal situation into account and only save as much as appropriate after paying their bills on time. Other people have additional frameworks to think about saving and you need to find the one which works for you.
In our house, we start each year by transferring the full limit into our IRA accounts, for most individuals this is $5500 in 2015. We do this right at the beginning of the year to start that compounding as early as possible. That said if you have not made your 2014 contribution yet, you still have time – you can set aside 2014 IRA contributions before the IRS tax deadline of April 15th.
In addition, and in order to fully take advantage of the tax benefits of 401Ks, we set the contribution limit for our paychecks each month in order to max out investing in our 401K plans over the whole year. This is even more important if your employer matches your contributions.
For our family’s financial planning there is one other very important tax advantaged investment vehicle — a 529 education savings accounts — that we set up for our daughter’s college fund. Some states such as New York offer additional tax benefits by investing in that state’s 529 plan. However in California, where we live, there are no additional state tax benefits, so we chose to go with a very low cost 529 account managed by Vanguard.
After all this saving we look at what is left and calculate our remaining monthly income. From this we subtract rent, car payments, insurance, utilities, student loan payments, and other essentials like food and childcare. We try to keep this budget to the bare essentials, then look at what is remaining for fun, discretionary expenses, like travel or weekend activities, as well as additional savings (like for a future home or also be used in an emergency if needed).
As a result of how we do our own budgeting and optimizing for long-term retirement, we look to keep our debt payments as low as possible. To do this we refinanced all our student loan debt at a very low fixed rate for 10 years. Some people may choose to pay their debt sooner, especially if it is at a high interest rate, but because of the very low rates being offered right now we chose to pay our loans off over a longer time period so that we could have additional budget for savings.
So as you think about your financial resolutions for 2015, I would encourage you to not only try to save more and spend less, but to also prioritize the long-term. Your future self will thank you.
Remember to make every penny count this year!
Happy new year and be Earnest!