Every year you should fully comprehend your annual income, separate your recurring expenses from personal spending, and decide how much positive cash flow you want in the next 12 months.
January is a fantastic time to start.
If you’ve read anything I’ve ever written, you know I’m a huge nerd. I love diving into my finances; I have spreadsheets; I use Mint; I look at performance data on my investments. I love it all.
However, I realize that this behavior is not normal. Most people dread thinking about their own finances. And, the thought of checking them every single day sounds like torture.
But, it is important to have at least some understanding of your financial situation. You should have a solid grasp of what is driving your successes and what is holding you back.
Everyone thinks that if they just had more income, then they would be better off financially. But, if you carry bad habits into higher income, you could end up just as broke as you are now… or worse. We’ve all heard about pro-sports players going broke, right?
To avoid all that, I recommend that everyone do at least these three things once a year. We are heading into a New Year now, and I know a lot of people are into Resolutions, so the timing is great. Although, I’ve never really been a New Year’s Resolution person, January is a fantastic time to do these things because last year’s information is still easily accessible.
1. Fully Comprehend Your Annual Income
If someone asked you your total annual household income, would you know it? Would you have to think about it? Or would you have to go look it up somewhere?
The median household income in the US was about $62k in 2018 according to the US Census Bureau. That means that if your household brings in $62k, then 50% of households make more than you and 50% make less.
If you are making less than this and have been able to keep your debt under control, then I’m super proud of you. The most likely way for you to increase your financial well being is to look long and hard at where your income comes from, and see if there is anything you can do to increase it.
If you are making more than this and can’t seem to get your money to behave, then you have some work to do. As always, this is a no judgement zone. I don’t care what has happened to get you into a situation where the median salary is not enough for you. What matters is what you do next.
If you want to stop living paycheck-to-paycheck then you have to take control of your finances… no matter what your income.
2. Tackle Recurring Expenses and Personal Spending Separately
Now that you know exactly what your annual income is, you can make sure that you are in control of where it goes.
Of course, you don’t get to take home all the money you make because of taxes and insurance. But, once the money is in your hand, it can only go three places: recurring expenses, personal spending, or savings. Remember my article about the undetailed budget?
Income – Recurring Expenses = Personal Expenses + Savings
The best part about this equation is that you don’t have to go dig up all the answers.
For example: let’s say you have no real savings or debt. That means that you have spent all of your income. And, if you know you recurring expenses (housing, utilities, cell phone, internet, etc), then you can just subtract your recurring expenses from your income and that’s how much you spent on personal expenses last year.
Here’s what I do:
- Write down my annual income from last year.
- Calculate and write down all my recurring expenses from last year (this includes everything taken out of my paycheck before I receive it).
- Figure out my net worth at the beginning of last year.
- Figure out my net worth at the beginning of this year.
- Subtract last year’s net worth from this year’s net worth: that’s how much I saved. (If you have investments, ignore any market gains or losses for this exercise).
- Subtract my recurring expenses and my savings from my income, and that is my personal spending.
Once I have all of those numbers, I can look at them and decide which ones make me happy and which ones I’m unhappy about.
Maybe my recurring expenses have gotten out of control and I need to cut back on subscriptions.
Maybe my personal spending is way higher than I thought.
For more detail, check out the article I wrote about finding room in your budget.
3. Decide how much positive cash flow I want in the next year
Now that I know my income, my recurring expenses, my personal spending, and my savings all figured out, I get to decide exactly what I want that to look like next year.
For example, let’s say you’re pretty average. Your household brings in $60k per year and you spend it all. Your recurring expenses are half and your personal spending is the other half.
You feel like you cannot get ahead, and you’re barely treading water. The thought of having a retirement account sounds hard. Maxing one out seems impossible.
Well, it’s not.
Did you know that the Roth IRA contribution limit for 2020 is $6,000 for most people?
So, you make $60k, your recurring expenses are $30k, and your personal spending is $30k. How could we find $6k?
One solution would be to take it proportionally from each source. Half from boosting income, and the other half from reducing spending.
That means you would need to find $3k in new income in 2020. That’s only $250 per month. You can totally do that!
You could split the other $3k equally between recurring expenses and personal spending. That means finding $125 of recurring expenses to cut. And, another $125 of personal spending cut per month.
The best part is: the only bit that you may notice is the $125 of personal spending that you cut. Grabbing $250 of additional income is probably just one or two more shifts per month for most hourly workers. That’s barely a blip on your calendar! And, most people could cut $125 out of their recurring expenses by reducing their cell phone plan, their internet plan, ditching a few cable channels, ditching a landline, or stopping a subscription box or two.
That’s totally doable!
Is All This Effort Worth It?
Some people that I talk to get discouraged because even though they can see a way to put money into a Roth, they don’t think it’s worth it. $6k is absolutely nothing compared to the massive cost of retirement, so what’s the point?
That is literally a million-dollar question!
Let’s say you start at age 30 and add $6k to your retirement every year until age 65. That’s a total of $210,000 that you have contributed. Even if it never gained a penny, having $210,000 in retirement is better than most US retirees.
But wait, there’s more!
If you had invested that $6k per year, and gotten a modest 7% return, then your Roth IRA would have nearly $1 million at age 65 ($956,024 to be exact). Check out my primer on investment diversification or my review of the Fidelity Go RoboAdvisor for more on how to invest.
So, all you have to do is pick up one extra shift per month, reduce your cable and cell phone packages, and dine out one or two times fewer per month, and you will retire a millionaire.
Yeah… I’d say that’s totally worth it.
Winning in personal finance is a marathon, not a sprint.
If you can get yourself to do a few small things regularly, they can add up dramatically over your lifetime.
It is also super important to make sure you keep your perspective. $6,000 might sound like a lot to cut from your budget… but, if you find ways to make small adjustments to a few areas, you can add up to $6k pretty fast.
$6,000 doesn’t sound like much when compared to the massive cost of retirement. But, slowly and steadily building your assets every year can easily make you a millionaire by the time you’re 65 if you start early enough.
I hope this has been helpful! I welcome your comments with your thoughts and questions. And, don’t forget to subscribe to the newsletter to get notified whenever a new article is posted.