Yellowstone Financial, Inc.

Feel the Financial Burn

Today may be the perfect day to get a handle on your finances.  As the stock market takes a pause in honor of Martin Luther King, use part of this time of reflection to understand your financial burn.  This column is another in a series on good financial habits within your control, as opposed to annual stock market returns, which are not.  Last time we got to work on your estate plan, while today we’ll uncover in under an hour how much you spent and saved last year.

When we request that prospective clients estimate their annual spending, I can almost hear the groaning through cyberspace.  They have visions of convoluted spreadsheets and downloading credit card transactions.  While that may be needed if you’re trying to understand the “why” behind your spending, there’s a much simpler method to get some answers.

Ubersavers and big earners may scoff at this exercise, thinking their monthly cash flow is well in excess of their spending.  They may be maxing out their 401(k) contributions and have plenty left over in their checking at the end of the month.  But without knowing your annual spend, you are flying in the dark when it comes to understanding if you’ve reached your financial independence day.  This is when full-time work becomes optional for you. Similarly if we don’t know your savings, we can’t project when that day will come.

To prepare, download your year-end statements from 2017 and 2018 for your checking and savings accounts, as well as your year-end paystubs.  Also document any savings made throughout the year, such as contributions to education accounts and one-time mortgage principal payments.

We’ll use an example Brian and Janell Hopkins, fictitious midcareer professionals with two children, to walk us through the process.  Their total in checking was $20,000 at the end of 2017 increased to $29,000 by the end of last year.  From their paystubs, we can see they earned $230,000 in gross income.  Their paystubs state they contributed $17,500 into their retirement plans, while their employers kicked in $14,600 with generous matching policies.

When we combine Brian and Janell’s earnings, the paystubs document a total of $152,500 was deposited into their checking for 2018.  They put $800 a month into their 529 college savings accounts deducted directly from checking.  They also made an extra $7,000 principal payment toward their mortgage.

Now we have enough to calculate their annual spending and savings.  We’ll start with their combined net pay of $152,500.   Then we subtract the amount their checking increased ($9,000) and 529 account contributions ($9,600).  Finally let’s deduct the one-time principal payment ($7,000), which give us a total of $126,900 of spending for the year.  The Hopkins spend just under $10,600 a month.  By simply taking the amount deposited into checking for the year and subtracting the savings and the change in the checking account, we can see how much they spent last year.

Their savings are retirement plan contributions of $32,100, along with the mortgage prepayment and savings increase, and 529 plan contributions.  As a percentage of gross pay, they are saving about 25 percent, with just over 4 percent of that going to higher education savings.  We use 15 percent as the baseline for a good savings rate (excluding higher education), so the Hopkins are doing a stellar job.  Once you reach the 25 percent level, you fall into a hypersaver category, which means over a career of savings and with disciplined investing you may be able to retire in your 50s or earlier.

So what can we conclude from this exercise?  If your savings rate is under 10 percent, take steps to increase your savings unless it’s already being done for you with a traditional pension.  Work on getting above 15 percent to hasten your march toward financial independence.  Aim higher if you want to retire in your 50s or earlier or are late to the savings game.  Also now that you understand your annual spend, compare it to your investments and savings other than higher education accounts.  If your investments excluding your personal residence exceed 7 times your annual spending, then you are well on your way to financial independence.