In my post, Money Lessons From One’s Twenties, we saw some financial mistakes made by S.L. Bathgate while in her twenties. We also saw how these errors impacted her later life. And how she is trying to get back on course to better cash management and wealth accumulation.
Ms. Bathgate has a decent plan to strengthen her fortunes.
But if I was advising Ms. Bathgate, I have a few suggestion to improve on her stated plan.
Ms. Bathgate’s Stated Plan
From her story, Ms. Bathgate writes:
I’ve come up with some new goals for my thirties. I am going to contribute at least 10 percent of my salary towards my retirement. I am going to chip away at my student loan debt until it is paid off or forgiven, whichever one comes first. I am going to embrace the very simple concept that I must spend less than I earn. And I am going to be richer than I have ever been in my entire life. But you already knew that, didn’t you?
Admirable, but could be fine tuned for improvement.
Define Your Approach and Put It In Writing
Do not simply say that you are “going to contribute”, “going to chip away”, and “going to embrace”.
Define how you actually intend to do so and create an action plan with short, medium, and long-term realistic milestones.
Put it in writing and adhere to your game plan.
A written investment plan with periodic measurables will keep you focussed on achieving your goals.
Direct Debit Your Investment Contributions
Each month your rent, utilities, cable, etc. are probably automatically deducted from your bank account. You quickly get used to your level of net disposable income and adjust your spending around what is left each month.
Do the same with your investing program. It is easier to invest if you automatically invest a fixed amount each month than if you have to go into your bank account and make a conscious decision to invest.
Many mutual funds and brokerage accounts allow for direct debits from your bank account. Also, consider other simple ways to invest, such as: Direct Stock Purchase Plans, Employee Stock Purchase Plans, Dividend Reinvestment Plans.
Utilize these investment options and you will find it easier to build wealth over time.
Pay Down Non-Deductible Debt
Debt is a negative investment. If you buy a bond, the interest you receive is income. But if you owe money to someone, the interest payments you make erode your capital.
In many situations, the interest you pay is non-deductible for tax purposes. This makes it an even more expensive item.
For example, you have $10,000 and can either pay down a loan costing 8% non-deductible interest or invest in bond paying 8% interest. And your effective tax rate is 30%.
With the loan, you pay $800 annually in interest expense. But since you pay out of after-tax cash flow, you must earn $1143 in salary to pay the interest each year. So the loan is actually costing you 11.43% on a gross basis.
With the bond, you receive $800 annually in interest income. But since you must pay tax on the proceeds, your net return is only $560, or 5.6%.
To build mental discipline for continuous, recurring investment contributions, you may decide that you would rather forego paying down debt in exchange for developing a consistent investing pattern. Yes, likely not the “best” way to do things. But if it builds the basis for a long-term investing strategy, I would not discourage you from doing so.
Minimize Your Investment Related Tax
Always look at investing in terms of after-tax returns. Often you will get a much better net return paying down debt with non-deductible interest expense, than on actual investments. Put your money where it will do the most good for you.
If your interest expense is deductible for tax purposes, then you need to factor in the tax savings. The same may be said if you are investing in a tax-deferred investment account and/or receive tax deductions for contributions made. Always run the numbers to see which options make the most sense on an after-tax basis.
I would also add that in many countries, capital gains are taxed differently from interest income. Dividends may be taxed yet another way. Again, look at your after-tax returns when assessing potential investments. Depending on where you live a 6% dividend yield may be preferable to an 8% interest payment.
Taxes can be the number one problem for those trying to accumulate long-term capital. Always take steps to minimize your tax impact.