Pay yourself first! What do you mean?

I have to confess. It’s serious and I hope you will support me. I have been living in the States for almost 4 years and I still don’t understand the concept of “Your mama” jokes. I mean, I understand them and sometimes they are funny, but I still can’t use them appropriate and in time.

There are a lot of things I either don’t understand or don’t know where and how to use them. Being an immigrant with pure poor English I can tell you a lot of funny stories that have happened with me; as I call them “lost in translation” stories. But today I would like to talk about one figure of speech all of us have heard bazillion times.

Pay Yourself First

I couldn’t grasp the meaning of this saying for a long time. I was asking myself, “What do they mean by saying this?” When I got a paycheck I was making sure that I am taking care about four walls of necessities first:

  • Groceries – you can’t leave without food
  • Utilities – you need water and electricity in your house
  • Rent/Mortgage – you need a place to live
  • Transportation – you need to go to and from work. We realized really quick that public transportation sucks. At least in our area.

After covering these expenses I was trying to set aside as much for investment as possible:

  • Roth IRAs – We were aiming to maxing out two Roth IRA in 2017 year.
  • Kids 529 accounts – $175 for each kid goes directly to 529 account
  • Taxable Investment – Saving for a house was and still is a big priority for us; $25,000 saved so far.

And only after doing these I was covering other expenses. And every month, I am not exaggerating here, every month preparing a budget I was thinking about this holy grail of personal finance – pay yourself first. Until the last week, when it hit on my regular afternoon walk.

Pre-tax investments/withdrawals

As a Christian and US-Resident I believe that our duty is to make sure we pay as less taxes as possible. And of course I am talking about legal ways only. My main responsibility is to make sure Uncle Sam gets less money from me and I and my family get more.

Do you know why don’t people bother a lot about how much taxes they pay? Because they don’t see this money.

When you get your paycheck your employer already sent a portion of YOUR money to KGB IRS.

Just imagine this, every Friday you get a paycheck without any withdrawals, and every Friday you have write a check and send it to IRS. Boy I tell you this, the new revolution would rise really quick. But some smart person came up with this painless and genius idea of taking your money before you get it. This is a perfect example of paying yourself first, in this case though IRS pays itself first.

As i mentioned above, I was walking my regular afternoon walk and it hit me, “For every dollar I invest in pre-tax accounts I can save $0.25-0.28. Isn’t it grate?!” Mrs. FR and I both have access to tradition 401(k) accounts at our work. And we both can contribute $18,000 each, which is $36,000 a year.  In addition to that we can contribute $5,000 of our pretax money to HSA-account and $2,600 to FSA-account.

Juts by doing this we can “hide” $43,600 from taxation and save $9,000 in taxes. I don’t know about you, but in the place we came from, it’s a lot of money.  You can add $2,000 or $166 per month and max out two Roth IRA accounts as well. That will give us  $47,000 invested in the retirement accounts.

In Soviet Russia you don’t pay IRS, IRS pays you.

I came back from the walk and created these charts that show the difference between our current, not so tax efficient strategy, and PYF strategy that we are going to adopt.

Pay Yourself First

Invest more. Pay less taxes. Get better result.

Being a regular people, working corporate jobs, we have the same investment options as a lot of regular people do:

  • Traditional 401(k) – each of us can contribute $18,000. My employer matches $5670 every year and Mrs. FR’s does $4,500. Hey it’s  $10,170 of free money every year.
  • HSA – up to $6,750 every year for medical expenses. My employers matches $1,750 a year.
  • FSA – $2,600 maximum a year for childcare expenses like daycare or after school programs.

Wow, that’s a huge difference. If we are going to use our current strategy, in 10 years we will end up with $512,166 in retirement accounts. Which is not bad at all.

retirement investment

Half a million on 10 years? Very good result isn’t it?

But if we start paying ourself first, if we are maxing out all the pre-tax accounts, in the same 10 years we would get $878,270.

Almost a million

And I am not including matches in my calculations. Adding my and Mrs. FR’s company matches it could become more that $1,1M just in 10 years. But there’s a catch.

It’s a trap

As it usually happens, this principle has the opposite side of the coin as well. After you maxing out all your available pre-tax accounts, you will have less take home money. And instead of taking home $103,000 a year you will be taking $86,000. But this is great news, believe me.

My lovely wife, when she reads this line probably will say, “Are you kidding me? What do you mean this is great news? We are going to have a serious talk”. 

Now you know who’s spender and who’s saver and geek in our house.

But I am being serious, having less money to spend is actually great.

If you get used to operate your household on $80,000 a year, based on 4% rule you have to have $2M in your investment portfolio. But if you need $60,000 for a year, you can retire with $1,5 in your investment accounts. What about $40,000 a year? You got it. Do you think this is not real? A lot of people can prove you are wrong: MMM, Root of Good Mr.1500 and more.

Baby steps

By decreasing your take home income and increasing your investment what you are doing is you are bringing closer your retirement date. Just close your eyes and imagine how cool would it be to retire in 10 years; in our case I will be 45 years old and my lovely wife a little bit different.  Life is good.

But it requires some drastic changes in our lifestyle as well. And the best way to do this is to use baby steps principles . I don’t know about you, but we can’t go from $120K to $60K without suffering and putting more stress on myself and my family. We’ve never trained a “frugality muscle”, it’s weak and needs to be trained first.

Some of you can say, “Pfff, wimp! Everyone can live on $120K and it’s not a big deal to live on $60K“. Fair enough, but what if I tell you to start living on $30K right now. And I am sure there are people around who can say to you, “Hey, chicken! You can’t live on $30K? It’s easy, we’ve been living this the whole life“.

My point is if we want to win, you don’t go to travel all the way round before you’ve done some short and small trips. And by decreasing our cost of living every year and adjusting our lifestyle we have more chances to get to the final destination, rather than going all the down in one year.

Actions

June 2017 – December 2017

Starting June 2017 we are going increase our pre-tax 401(k) contribution from 6% to 15%. In addition to that we will be continuing our HSA contribution up to the maximum. In addition to our retirement investments we are going to invest money in a taxable account. As you may know Mrs. FR and I we are saving for a house and our goal is to have enough downpayment to buy a house with no more than 25% of just one of either of our salary, which is pretty conservative.

January 2018

Starting January 2018 our plan is to maximize all the pre-tax investment and withdrawals opportunities.

  • Maxing out Mrs. FR and Mr. FR Traditional 401(k) – $36,000
  • Maxing out HSA account – $5000 (My employer contributes $1,750 every year)
  • Maxing out FSA account – $2600 (We are going to use this money for paying for kids after school program)

In addition to our pretax money we are going to maximize two Roth IRA accounts

  • Maxing out Mrs. FR and Mr. FR Roth IRAs – $11,000

If I done my calculation right we will be able to invest $57,000 towards retirement – pay yourself first.

Don’t know about my wife but I am so excited about this. And starting slowly, having 6 months in 2017 for preparing ourself give me the right to think we will be fine.

What do you think? Are we a bunch of wimps, or we are doing the right things?

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2 Responses to Pay yourself first! What do you mean?

  1. Troy says:

    Eating well is so important. I don’t think it’s worth it to save a few hundred bucks every month on groceries. I’d rather eat well and be happy. Hence all be more productive and earn more money.

    • I agree with you 100% – eating well is one of the cornerstones and that’s why I put food first. But at the same time eating well doesn’t equal to buying expensive food.

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