Stacey is a dental hygienist making about $66,000 per year after taxes. She is 27 years old, and single. She emailed me to ask about making a plan for her money.
Stacey does not have a budget. I asked her to write down every single thing she spent money on in the past 30 days, and we put them in categories:
- Fixed: $1100 Rent, $250 Utilities (Phone, electricity, internet, water, etc)
- Groceries: $400
- Car: $340 Car Payment
- Discretionary: $650 Dining Out (!!), $600 Other Spending (shopping + bars)
- Long Term Savings: N/A
- $470 towards Student Loans
- $500 towards Credit Card Bills
- $330 towards Medical Bills
Stacey feels like she has good job security and has received decent pay raises the last two years. Her work offers a 401(k) that matches her contributions up to 3%. She has not been contributing to her 401(k). She also has:
- $3500 Checking + Savings
- “Great Health Insurance” through Employer
- She received about $2200 from her tax return last year
In addition to her monthly spending outlined above, she estimates she spends around $800 at Christmas, and probably another $2,000 per year for vacations. She also spends around $550 every six months on car insurance.
- Student Loans: $38500 at 6.8% interest
- Credit Cards: $4800 revolving balance at 18.9% interest
- Medical Bills: $1650 (paying no interest on a $330/month plan)
- Car Loan: $14000 at 2.9%
I don’t feel like I’m falling behind, but I also don’t feel like I’m getting ahead. I want to have a clear plan so I can balance fun in the present with a comfortable retirement in 30 or 40 years. Also, I might want to buy a house and have kids in the next decade.
I asked Stacey some more questions, like if her current standard of living/spending felt realistic for retirement, and she agreed it would be. We settled on:
Big Goal: Retire in 35 years (at Age 62) with a nest egg that can generate an income of $65k/year (2018 dollars).
1. Her Budget
First things first, You Need A Budget! It’s unnecessarily hard to plan without one. So Stacey is going to write down every dollar of income and every dollar of expense from now on. From her spending habits outlined above, I suggested the following initial budget which she’ll change and update as needed:
$1400 – A little more than she needs each month for rent and utilities, so this category will gradually accumulate over time (which is better than steadily running negative).
$500 – This is just for groceries and other “smart” food purchases. I bumped this number up a little because she’s going to save money buying food at the store and going out to eat less.
$800 – Covers her car payment ($340), insurance ($92), and has an extra $370 a month that accumulates for future repairs. All gas purchases come out of this fund, too (She says gas is maybe $80/month). She might bump this up when she wants to start looking ahead to her next car purchase, but $800 is good while there are higher priorities to attend.
$200 – Stacey spent more than $1200 going out to eat and drink and shop last month! I think she can do better, but I know this is a huge challenge. What often happens is people start seeing progress on their debt, savings, and net worth and “voluntarily” cut back their fun money. I hope that’s the case here, too. No Cheat Days!
$100 – Birthdays + Christmas. Save a bit each month all year long and the holiday season becomes a lot less stressful.
$200 – Just like giving, save a little each month and you’ll never put a vacation on a credit card again.
$100 – This is for those unexpected expenses that are not exactly discretionary. A trip to the doctor, a broken phone, or the myriad troubles life puts in her way. It’s nice to have a little fund that builds up against these eventualities.
$2000 – 35% Savings Rate, BOOM! Let’s start throwing some money at this goal. I include all retirement savings and debt payments (medical + credit card + student loans) in this category. We’ll get to the details below.
2. Some Other Homework To Do
Stacey mentioned that she had a sizable tax refund last year. I’m glad she’s paying her taxes, but Just Say No To A Tax Refund. So she needs to fill out a W-4 and withhold about $200 less per month.
Budget Impact: Her savings just jumped from $2000 to $2200 each month!
3. Start Contributions to 401(k)
While she’s talking with HR about her tax withholding, she can give them directions to start contributing to her 401(k). After reviewing her plan documents, I don’t like Stacey’s options much. There are no Vanguard funds offered in her plan and she’s getting hit with 0.95% + $25 per year in fees from the 401(k) management company. Ugh.
But her employer is matching up to 3%! That’s also known as instantaneous 100% return on investment. I think it’s worth paying the high plan fees for that kind of return, and it’s the only type of investment I put ahead of paying off high credit card debt.
Also, she has an option of making the contributions after tax into a Roth 401(k), so that’s what we’ll do. The best fund available to her is DFA U.S. Large Company Portfolio (DFUSX). It has a 0.08% expense ratio and closely tracks the domestic stock market.
Budget Impact: $165 per month out of $2200 Savings, $2035 remaining.
4. Continue Paying Off Medical Debt
Stacey is paying down a medical bill with no interest. We don’t want that falling behind or going to collections, so she’ll earmarked $330 of her savings budget to continue paying off that debt for the next five months. After those five months are finished, she gets that $330 back to put towards other goals.
Budget impact: $330 per month for five months ($1805 remaining).
5. Continue Paying Minimum on Student Loans
Until Stacey’s higher interest debt is paid off, she’ll continue to stay current on her student loans. The $470 payment also comes out of her “Savings” category each month in her budget.
Budget Impact: $470 per month ($1335 remaining).
6. Pay Off High Interest Debt
Stacey has $4800 in high interest credit card debt. Every month that this balance revolves, she’s effectively lighting $76 on fire and throwing it out the window. Before we have any other talks about investments and IRAs, this debt needs to be retired!
Stacey is not using her credit cards again until all balance have been reset to zero. Then she will use them within her budget, so they are paid in full every month. If she can’t pay the balance each month, she can’t use credit cards anymore.
Month 1-3: $1335
Month 4: $977 and the credit card debt is GONE. ($358 remaining in Savings Budget)
We discussed using Stacey’s current checking and savings account balance of $3500 to pay this debt off as quickly as possible, but I think psychology outweighs mathematics in this case. Life is a lot less stressful when you’re paying off this month’s bills with the money you made last month. So the balance she already has in her checking account gives her a little wiggle room and protection against an accidental overdraft, or an unexpected emergency while she’s focused on changing her financial picture. I’d be okay with either decision, but I think there’s some wisdom to keeping a month’s cushion in the bank even if it’ll cost her a bit more in interest payments.
Step 7: Some Planning Choices
At this point, Stacey will be four months into her plan, and so far it’s been pretty straightforward: Attack her awful credit card debt while sneaking the 401(k) match on the side.
She will also have had a few months to enjoy the freedom of living on a budget. Most people find they are motivated to save even more than they planned. If that’s not the case for Stacey, she’ll at least have a more realistic idea if her budget is sustainable and accurate so that she can make adjustments to it as needed.
Stacey is a competent professional, and she feels comfortable making a little progress towards multiple goals at once. So after some discussion back and forth, she’s going to split her savings budget evenly among the following sub goals.
Budget Impact: She has $358 for Month 4, $1805 for Month 5, and $2200 per month after that (because her medical debt will be paid off).
7A. Emergency Fund
I’m sticking to the advice of 3-6 months living expenses in cash/liquid savings. Stacey can live off of about $3,000 per month, and she’s set a goal for $15,000 in her emergency fund. Once she reaches $15,000, she’ll turn off the funding for this goal and divert more money to the following categories.
Budget Impact: 25% of her Savings budget until $15,000 Goal.
7B. Student Loans
There’s ample enough discussion on the debate over whether to prioritize Student Loan payments or IRA contributions:
I tend to subscribe to the thinking that when a lot of smart people reasonably disagree, the decision must be close enough that it doesn’t matter much either way.
Stacey’s student loan interest rate (6.8%) is high enough that she might decide to focus all efforts on paying down this debt first. But she could also refinance her student loans and probably get a rate around 4.5%:
So I recommend she look into SoFi, or one of its competitors. It’s probably worth an hour or two of her time to save a few thousand bucks, and with a lower interest rate she has less incentive to put all her resources into paying down her student loans.
I’ll do the analysis with her original interest rate, but Stacey definitely has a side project: Try to refinance your student loans.
Budget Impact: An equal portion of her savings budget until the student loans are gone in about six years time.
7C. Roth IRA and More 401(k)
It’ll take five months for Stacey to pay off her credit card debt, and though she’s been sneaking in small 401(k) contributions, now she’s ready for a proper investment plan. Stacey does not have much experience investing, but she is pretty confident in her ability to stick to a plan through thick and thin. I’m suggesting she invest in a simple three fund portfolio.
Unlike her 401(k), she has a choice of where to open her Roth IRA account. I believe the best place is Vanguard, so that’s what I recommend for her. See my related post for the steps she’ll follow:
For now, Stacey is going to contribute to three funds – (50%) domestic, (25%) international, and (25%) bond market. This might be conservative for someone with her time horizon for investing, but she has no experience and prefers to error on the side of less volatility. She will only make a change to her asset allocation by writing it down and waiting through a ONE YEAR cooling off period. This helps ensure she’s not reacting to short term market factors or big personal life events.
Once she has reached the maximum Roth IRA contribution for the year (currently $5500), she’ll put the additional contributions into her Roth 401(k). Since her 401(k) has a good domestic index available, it’ll be 100% domestic. Her Roth IRA at Vanguard will cover all her international and bond market needs as well as whatever domestic exposure she needs so that she’s close to her overall target 50/25/25 three fund portfolio between the two accounts.
Budget Impact: This category is the foundation of her retirement plan. It’s taking an equal share of her savings budget each month. After her student loans are paid in full, she’ll divert the money that was going to student loan payments to her Roth accounts.
7D. House Fund
Stacey has a side goal of owning her own home some day in the future; at least she’d like to have that option. So all the while she’s paying off her debts and contributing towards her emergency fund and retirement savings, she’ll contribute an equal portion of her savings budget to a house fund. She’s not sure when she’ll need this money, so she keeps it in a high interest savings account. I count this house fund towards her net worth.
Budget Impact: After credit card debt is paid in full, 25% of savings goes to her house fund. Once the emergency fund is finished, it jumps to 33% until her plans change (or she buys a house).
I distilled the above and ran it through my retirement model. Stacey pays off both her credit card debt and her medical debt within five months, which speeds up her wealth accumulation. In just a little over two years, she has a fully funded emergency fund ready for five months of living expenses if a crisis strikes. That speeds her up again. She’s on track to have her remaining student loan debt paid off in six years:
Note that I didn’t include her car as an asset or a liability. Like food, it’s something that she needs which she’s consuming and I don’t think it makes much impact on her net worth.
Stacey has a side goal of saving up for a house. Setting aside a small amount of her paycheck each month, even in a lowly savings account, really adds up over time:
If she does purchase a house, she’ll benefit tremendously from being able to put down a 20% down payment, and she’ll be able to apply the money she is spending on rent now towards building wealth in her primary residence.
According to the 4% rule, Stacey has a target of $1.625 million to reach financial independence (and a stable and prosperous retirement). Is the plan we developed above expected to achieve her goal? I ran out her information to Age 80, with a retirement at Age 62. I also included the 90th percentile best case scenario and the 10th percentile worst case scenario, to account for the varying and unknowable future returns of her investment accounts:
Stacey is on the path to success. The above simulation shows a very high probability of reaching her goals. Keep in mind that this assumes her contributions and income are stagnant for the next 4 decades – unlikely! There’s also a huge amount of her net worth tied up in her house fund. If her eventual house outpaces a lowly savings account, her net worth will rise commensurately.
Update the Budget
While she is paying off debts and starting her retirement fund, Stacey should drastically curtail her discretionary spending. However, it’s important to celebrate big accomplishments and to balance present quality of life versus future security. I’d suggest after her student loans are paid off, maybe it’s time to increase her vacation budget, or start putting more money into her car fund for an upgraded vehicle. Perhaps Stacey would like to have a few more nights a month to go out for dinner and drinks.
I don’t know what she’ll want to prioritize at this point, and she might not either. The important principle is that she continues to pay herself first with a well funded Savings category in her budget, and only then should she make adjustments that maximize her contentment in the present.
Accelerate the Plan
Like many financial plans, the road ahead for Stacey is simple, not easy. It takes discipline and perseverance to stick to a plan for years and years. She seems to have that special combination of contentment and determination that are very useful in such an endeavor. So what could she do if she wants to accelerate her timeline and have more freedom sooner?
Plenty of people live on less. Living on less means (1) you have more money to throw at your retirement plan and (2) the nest egg you need to meet your retirement spending goals shrinks proportionately. I feed a family of four on $500 a month, I wonder if Stacey could cut back her food budget?
Another big chunk of money each month goes to servicing her vehicle loan, repairs, insurance, and replacement cost. Is she one of the increasing multitudes who eschew a car in favor of bicycle commuting? Biking to work can save you a lot of money and increase your physical health, here’s how to get started.
Stacey might start a side hustle that brings in extra income towards her goals, or just brings extra satisfaction to her life. There’s a lot of ways to accelerate her progress if she’s so inclined.
Stacey should keep track of her progress from month to month, perhaps when she checks in to set a new budget. If she finds that she’s falling far behind her glide path, or a major and unexpected life event occurs, it’s time to think about contingency plans.
First, you might recall from the previous plan that Median Mike relied on social security to make up 40% of his retirement spending. Stacey has no such plans, but could probably count on some support from social security as part of a safety net contingency. She should use my social security calculator to estimate how much her benefit is worth!
Besides wage stagnation, which we discussed earlier, this plan assumes no change to her family status – not married, no kids. Marriage and kids have huge financial implications; sometimes they improve your finances and sometimes they inhibit them. My only advice to Stacey is to have a good discussion with any future spouse about her financial plans – the sooner the better (though hey, maybe not on the first date).
I have a regular caveat in any long term plan that there’s a lot of assumptions involved. This plan is a map and a guide, but it’s a broad brush that will skip a lot of important details. Stacey can follow and keep track as she goes, then make adjustments and updates as life happens. This plan isn’t perfect, and it’s not going to anticipate every twist in the road ahead. But perfect is the enemy of good. And Stacey’s plan is very good.