[Editor's Note: The following guest post was submitted by Tim Quillin, CFA and Partner in Aptus Financial. Aptus is a flat-fee hourly financial advising firm that is a WCI advertiser and on our list of recommended advisors. This is not a sponsored post.]
Financial success hinges on one critical concept: spending less money than you make. For those of you lucky enough to be natural savers, this is intuitive and relatively effortless. For many people, though, even high-income physicians, this is often much easier said than done. If you buy the big house, drive the Model S, send the kids to private schools and make the minimum payments on your student loans, you may never save enough money to retire comfortably.
Over the past 12 months, I’ve worked with a single-income family making $160,000 with $175,000 in student loans. They needed a system. But I’ve also worked with a dual-income family making $750,000 a year who were deep in credit card debt and barely saving 5% of their gross pay. They needed a system as well.
Save More and Live Better — Put Your Money on Autopilot
An automated cash flow system can take a lot of the drama out of managing your money. A good cash flow system should help you determine the best balance of spending in ways that make you happy, bring you peace of mind and express your values while also paying off debt, saving for known and unknown future expenses and building a retirement nest egg.
Automated Cash Flow System
After implementing an automated cash flow system, the $160,000 income family implemented an automated plan to pay off debt in 7 years. The $750,000 income family increased its savings rate from 5% to nearly 30%, putting them in position to retire in their 50s.
An automated cash flow system should include 4 basic steps:
#1 Pay Yourself First
Pay yourself through payroll deductions into company retirement plans, automatic drafts toward debt repayments and consistent, automatic investments into IRAs, HSAs, and other investment accounts. For high-income physicians, the goal is to direct 20%-40% of gross pay into student loan reduction or retirement investments before you even see your take-home pay. Live on 60%-80% of your gross pay while you build net worth for the future.
#2 Set Aside Money for Future Expenses
Do this by auto-transferring fixed amounts each month into individual, named savings accounts. For instance, you might set up individual high-yield savings accounts for emergencies, home repairs, car purchases, out-of-pocket healthcare costs—especially if you use an HSA for retirement savings—and vacations. You can use a 529 plan to save for your kids’ college tuition. You should proactively save for any known future expense, even if the timing is uncertain. While some people prefer a single emergency fund for their savings, it’s often psychologically satisfying to have discrete pools of cash so there’s clarity on how the money is to be spent.
#3 Pay Your Monthly Bills
This is done typically through auto-drafts. Carefully accounting for all your bills provides an opportunity to eliminate or reduce expenses when feasible. Continually validate your term life and disability insurance needs and periodically get competitive quotes for home, auto and umbrella. Pay especially close attention to recurring monthly subscriptions, which often slip off our radar. Don’t pay for a newspaper you don’t read or a streaming service you don’t watch.
#4 Spend the Rest
After you’ve 1) paid yourself first, 2) set aside money for future expenses and 3) paid your bills, you simply spend the remainder of your income. There are essentially three ways to spend the rest. You can use a credit card, but you can easily overspend. You can use actual cash, but this can be unwieldy. If you want some degree of self-regulation, though, you can set up a second checking account and spend with a debit card.
Self-Regulation With a Debit Card
Tim Quillin, CFA
Here’s how it would work. Take your monthly remainder, multiply by 12 and divide by 52 to arrive at a weekly amount you will deposit into a 2nd checking account. Set up a weekly auto-transfer into the 2nd checking account each Monday, as it’s easier to plan your expenditures over 7 days than 31 days. Then use debit cards to spend your weekly allotment. You won’t overspend because you can’t overspend.
The Problem With Credit Cards
Many folks use credit cards prudently and accumulate rewards while staying within their budget. They pay off their credit cards in full each month and go on vacations with their reward points. The academic evidence is strong, though, that people are inclined to spend more—perhaps a lot more—when using credit cards rather than cash. So even people who use credit cards responsibly might end up spending more than they would with cash or debit cards. The 1%-2% you get back in rewards doesn’t seem worth it if you spend 10% more than you would without the credit card.
It really doesn’t matter precisely how you automate. If you are a W-2 employee, the automated flow might look something like this:
It’s not always that easy, especially when your income is highly variable. If your income is less consistent, then you might adjust the flow slightly:
There are dozens of ways to customize an automated cash flow system to fit your specific circumstances and behavioral psychology. The important concept is to set things up on autopilot, so you don’t have to decide every month how much to save.
If you do nothing except pay yourself first, you could still end up having enough money to retire but may bounce in and out of debt due to one financial “emergency” after another. If you also set money aside for future expenses, you should be financially healthy. If you optimize your spending across all four steps, a cash flow system can provide peace of mind, happiness and freedom.
You will slay debt, build wealth and laugh in the face of typical budget busters. The roof leaks. No worries, you have a home repair fund. The car breaks down. No problem, you’ve been saving for a new one anyway. You need a little time to recharge. Time to use your vacation fund for a trip to Italy this summer. Your job’s becoming an unbearable grind. That’s ok, your emergency fund is an FU fund to help you start your own practice.
Make sure the cash flow system reflects your priorities and values. Failing to pay attention to your priorities and values may quickly derail your plan. Ultimately, you will need to strike a balance between your lifestyle and your need for financial security. Don’t underestimate the thinking and deliberating it may take to reach that balance. But, once you have made your decision and implemented the automated cash flow system that works optimally for you and your family, you will never look back.
Have you set up an automated cash flow system? How have you customized it to fit your specific needs? How has it worked for you? Comment below!
Overall good advice. But it does not seem to be tailored to the high income professional.
In #1 you say put 20-40% of your gross salary towards loans and retirement and live off 60-80%. That sounds good but you left taxes out of the equation.
Thank you. This is a concept that works for most of our clients, across all income ranges. This is really the single most important concept of building wealth. If you get your savings rate right and set it on autopilot, you can screw up a lot of other things.
I didn’t forget taxes, of course–it’s hard to forget taxes, ha!–but you’re right that I should have phrased that better. You are living off 60%-80% of income less taxes. I just completed a review for a very high income couple saving 50% of gross pay; ~35% goes to taxes, so they are living off just 15% of their income. More typically we see couples saving ~30% of gross income while ~30% goes to taxes and ~40% goes toward living expenses.
Our clients with closer to median household income can actually save a lower percentage of their gross pay because Social Security will compose a more meaningful chunk of their retirement income. For most White Coat readers, many of whom are getting a late start on retirement savings, 20%-40% is a good target range; 20% should allow you to retire, 30% should allow you to retire well and 40% should allow you to retire early.
Taxes can never be forgotten. However, I don’t think the writer did forget them even for high income people, as he answered above. I try and follow the 30/30/40 rule at worst. Meaning 30% savings, 30% spending, 40% taxes. In the above example with the Dual income couple that makes 750K….that would be $225,000 savings each year, $225,000 spending each year, and $300,000 taxes each year. If you can’t live off of $225,000 in your “spending account” then you have a spending problem. I make more than 750K couple and live VERY comfortably off of about 150K per year in spending (All while driving my 7 year old Model S). And yes, unfortunately I give a huge sum of money every year to our government.
You can’t pay your taxes out of 60-80% of your gross? Over my attending career mine have ranged from 5-34%. That should still leave 26-75% to live off of. Seems like a lot on a doctor salary to me.
Started doing this exact thing about 6 months after residency. And it has helped enormously. Now we don’t stress out about car insurance every 6 months or when brakes need fixing. We’ve also enjoyed several vacations where the money was already saved. Not to mention, we are almost debt free. But it does take discipline. Specially when you make a large amount of money – it’s hard to say no to a lot things when you feel like you can or should be able afford it.
Love the website and keep up with it weekly to keep motivated!
This is a decent approach, but it’s backwards. The difference is subtle so to highlight it I call my system “Pay yourself last”.
The notion is to separate what you live off of from your income completely. This may sound like a minor point, but psychologically it is the crux of the system. Set up an account at a brokerage (e.g. Vanguard) that is moderately hard to get to.. No ATMs, etc.. This is *not* your checking account, I call mine my “slush account” for lack of a better name.
All income gets direct deposited into this account. Paychecks, stock option sales, bonuses, investment residuals, etc.. Everything. Set up transfers from this account to pay your various student loans and what not. Then set up a monthly (or bi-weekly if you prefer) transfer into your real checking account for a fixed amount. This is what you live off, and this is “paying yourself last”.
The magic of this system is that you never have to adjust it. Ever. When you get a raise, that money just disappears. It never makes it into your checking account and you quickly forget it. When you get a bonus, you don’t have an urge to spend it, because it’s not easily accessible (of course it is, but at least for me there’s a mental “barrier” between what is in my investment accounts versus my checking account). Your slush account is in a money market, so you’re always getting competitive rates on this cash savings.
The slush account doubles as your emergency account. I let mine build up to a year’s spending needs, give or take. Once it’s well beyond that I’ll use it to rebalance my portfolio. If I have a bit expense, e.g. need to buy a car, it will drop below but it’ll build back up.
The magic of this is it decouples your “income” from your living expenses. Over time as my investments have grown, and the various streams of money that go into this account have increased, it turns out that those extra streams of money exceed my living expenses. I could quit work today, and not change anything. The money keeps coming into that account, keeps getting transferred into my account. Autopilot.
I started this system 23 years ago when I graduated college. At that point my (now ex-) wife and I made about $150K combined and had plenty of student loans and what not. We used the same system when we were making $750K and, now single, I continue to use it. She would sometimes jokingly call it our “artificial poverty” system, because even though we *knew* our paychecks were $40K/month we only ever saw about $5K/month in our checking account.
That’s a fantastic system and very similar to what I [try to] describe in Example 2. Your automated system is definitely a recipe for FIRE. We have clients running many different variants of the system, customized to their financial situation and psychological makeup. The key point is to automate the flows so you are not having to continuously make proactive decisions.
only issue is the debit card. for high income professionals the security issues are just not worth it.
if you cant figure out how to use a credit card, it should probably just be straight cash you deal with.
Great point, thank you. Credit card companies typically have better, more active fraud detection. AMEX catches fraud before I even notice and let’s me off the hook for fraudulent charges. Banks may not detect fraud as quickly, or at all, but you can challenge fraudulent charges and likely won’t be liable for more than $500.
My experience is that credit card debt is not just a problem with lower income professionals. I think people spend more money with credit cards, and if that’s the case I’m not sure the improved fraud detection is worth it. Using physical cash is a pretty foolproof way to reduce spending, but a major pain in the butt. Debit cards are a compromise. I’m a credit card user, though, so I really don’t believe there are right ways or wrong ways to manage money–just ways that work or don’t work for us.
For sure, I use credit cards not only for convenience (and I guess cash back is nice too) but also to make spending easier/less painful for me. It’s probably a good thing if they help me loosen the pursestrings a bit.