Personal Finance

12/11/09 - 2010: Getting Back to Basics

By: Investor Solutions

The majority of us has experienced or knows someone who has suffered through tough economic times that culminated in the fall of 2008. Job losses abound, the stock market is still trying to get back on track and no one knows when it will all get back to “normal”. That’s the bad news. The good news is that we can use this as an opportunity to get our financial house back in order. Let’s make it our financial resolution to make 2010 the year we get back to basics.

The following are the first four financial tasks we must tackle in order to dust ourselves off.

1. Prepare a budget

If preparing a budget seems too daunting and you’ve already given up, then maybe you should work backwards. That is, instead of preparing a budget to see where you could be saving more set up automatic deposits into a savings or retirement account directly from your paycheck every pay period. This way, you do not have to find money to save but instead automatically spend less on the variable expenses we previously mentioned.

2. Pay down debt

Once you have a budget in place and you know where your money is going, you want to set up a plan for paying down debt. Not all debt is bad. Having a mortgage with a reasonable interest rate on a house that is well within your means is not a bad thing. Credit card debt, though, is a different animal all together. Whereas a home is usually an appreciating asset, the purchases you make with a credit card are almost entirely depreciating assets. Think clothing, gadgets, etc.

With the money you “found” from creating a budget and eliminating some of the unnecessary variable expenses, you want to increase the amount you pay on your credit card assuming you have an existing balance and do not pay the amount in full every month. If you have multiple credit cards with outstanding balances, try and pay off the card with the highest interest rate first. This will allow you to “save” money on the interest that compounds every month. Once your first card is paid in full, add the amount you were paying monthly to pay off this card to the amount you pay monthly on the next card with the highest interest rate. Do this exercise until all your credit cards are paid off. Once you are credit card debt free, use the cards only for emergencies and make sure to pay off the balance in full every month.

3. Set up an emergency fund

An emergency fund should contain three to six months worth of expenses in case of, an emergency. Knowing how much you should have in an emergency fund is simple as long as you completed your first goal of setting up a budget. If there are two working spouses at home or one spouse with two jobs or an additional source of income, three months worth is usually acceptable. However, if only one spouse is working and that is the only source of income, you want to strive for six months worth. This money should be liquid and safe. That is, at a bank or credit union, in a savings account or short term CD. The goal here is not for this money to be growing but rather for it to be readily available in case of the unexpected. Do not touch this money for frivolous purchases.

4. Save for retirement

Now that you have gotten out of debt and have put some money aside for a rainy day, it’s time to get serious about your retirement. Gone are the days when an employer pension and Social Security provided for a comfortable retirement. Now it’s up to you to save lavishly and invest prudently to ensure your retirement years will be golden. Your (retirement) savings target should be a minimum of 15% of your gross annual income. However, if you are close to retirement and have saved little over the years or suffered a significant drop in your portfolio from the stock market debacle of late 2008, you will need to save more.

There are a multitude of options available to save for retirement. There are employer sponsored plans such as 401ks and 403bs as well as individual plans such as Roth, Traditional and SEP IRAs (Individual Retirement Accounts). If your employer has a plan in place and matches a percentage of your contribution, you would be foolish not to contribute. The employer match is essentially “free money”. If, on the other hand, you do not have a 401k or 403b option, you could contribute to an Individual Retirement Account (IRA). Although the contribution limits are much smaller for an IRA versus a 401k or 403b, $5,000 and $16,500, respectively, the growth on these investments is still tax deferred.

Regardless of whether you are investing in an employer sponsored plan or an IRA, you want to make sure you diversify your portfolio among domestic and international holdings as well as large and small company stocks. A diversified asset allocation will provide you with a less volatile portfolio that takes advantage of the growth potential across all asset classes.

If you find the 15% of annual gross income to be unattainable, don’t despair. Saving even 5% can make a difference. Once your economic situation improves, increase the amount until you get to 15% or more. Remember, it is better to save more than less. Having more money than you need during retirement is a “problem” we should all aspire to.

Sometimes we need to have the rug pulled out from under us to realize we are going down the wrong path. Gone should be the days of spending more than we make, racking up credit cards, and saving next to nothing for retirement. Let’s use the experiences of the last two years as the catalyst to reassess our financial situation and take the steps to improve upon it. It’s time we get back to basics and live within our means. Frugality is alive and well!