Money Management

(Part 2 of 8 in the Money series)

Now let's get into the basics of managing money

“I don't know about you, but where I went to school, Money Management 101 wasn’t offered. Instead, we learned about the War of 1812, which of course is something I use every single day.”
~ T. Harv Eker

It's somewhere between a curiosity and a crime that you've gotten this far through your education and have not been required to learn the fundamentals of how money works in our society. It seems to be a topic that you're expected to simply pick up through life, yet that's clearly not working.

According to some recent polls:

87% of teenagers in the US admit to not understanding their finances.¹
61% of Americans are stressed about their personal finances.²
71% of adults in the US believe they have high financial literacy levels. Yet those same US adults correctly answered only about half of the questions on a financial literacy exam.¹

Banking Basics

Each of you is familiar with a checking and savings account and also a debit card. You haven’t really used checks much yet, but you’ve received them from others for birthdays and other events.

These basic bank accounts are most people’s entry into our financial system. They make it easy to receive money from others and to pay for things.

But you have also all grown up in a time when there have been new ways to use money, like Apple Pay, Venmo, PayPal, or Zelle. These are also convenient ways to both pay for things and to send and receive money from others. But while these apps are new and convenient, they aren’t that much different from traditional tools like debit cards or checks. In fact, most of these financial apps need to be connected to a traditional bank account or a credit card so you can get money into them. The apps simply make it more convenient to access the money in those accounts.

A bank account also allows you to set up direct deposit of your paycheck so your money is easily available when you get paid. Most banks will also offer some sort of bill-paying service so you can pay for rent, your cell phone bill, and other regular payments. In fact, in your lives, you may find you rarely need to write a physical check.

Income and Expenses

The most fundamental rule to financial security may be to simply spend less than you earn. That may sound obvious, but there are lots of challenges and complications that can make this difficult at times.

you may have a job with income that is inconsistent from month to month
unplanned expenses will occur, seemingly at the worst time
expenses can increase over time. In fact, that brings us to our first key concept...

Key Concept: Inflation

Inflation is the tendency for prices to rise over time. It has the effect of making your money feel less valuable, as it doesn't buy as much as it used to.

“A nickel ain’t worth a dime anymore.”
~ Yogi Berra

Inflation is expressed as a rate, just like interest is. So an inflation rate of 3% means something that costs $100 today will cost roughly $103 a year from now. Something costing $5,000 today would cost $5,150 in a year.

You might have noticed this tendency with the things you buy. For example, maybe you’ve noticed that a cappuccino at Starbucks is now about $4.25, and just three years ago it was about $3.75. That's an increase of 13% over three years or about 4.3% annually.

Every single thing you spend money on can have its own “inflation rate” but we typically aggregate the costs of all products and services based on what average people buy to get an overall inflation rate.

While we talk about an overall inflation rate (sometimes you’ll hear it as the CPI or consumer price index), each person will experience inflation differently based on where they live and what they spend their money on.

The most expensive things in your life will have the biggest impact on the inflation rate you experience personally. If the national inflation rate is 2% but your landlord is raising rent by 10% then your actual inflation rate will be a lot closer to 10% (since rent will likely be one of your biggest expenses).

Here's a chart showing the prices of a variety of products since 2005—back when you were all very young or just born. You can see that while the prices of different products have moved around quite a bit—and at times some of the prices have even gone down for a while—over the entire time period, they have all increased.

Note that they all start at a reference value of 1.0 and they end up somewhere between about 1.10 (in the case of airfare, which took a big dive during COVID) and 1.75 or 1.8 (for tuition, healthcare, and rent). On average it looks like they've fallen somewhere between that range or around 1.5.

Inflation is typically measured on a broad scale, incorporating prices of lots of different products into one measure. It's not a perfect measure for any one person, but it's a useful tool to see trends over time.

Here's a chart of the CPI or Consumer Price Index over that same period. It's the number that is most often used to talk about inflation in the US. It incorporates the cost of many different products and as we can see, it reflects what we saw in the previous chart with prices moving up from 1.0 to about 1.5 on average over that period.

. . .

Now that we've introduced inflation and its effect on increasing expenses over time, let's go back and look more closely at the income side.

What’s in a Paycheck?

Let's take a look at a paycheck to better understand where all your money goes.

Here's a sample paycheck, parts of which may look familiar based on your summer and part-time jobs, but other parts may be new to you.

This is a semi-monthly paycheck for someone making $75,000 a year. There are a few things to call attention to here:

the "gross pay" of $3,125, is the amount paid to you before any deductions are applied. It's simply $75,000 divided by 24 (since there are 2 pay periods per month or 24 per year).
then you see a long list of deductions starting with various forms of taxes:
- Federal income tax: this is what the US government gets
- Social Security: this is your contribution to current retirees' payments (like your grandparents)
- Medicare: this is your contribution to current retirees' healthcare plans
- and State income tax: what the NY state government gets

These taxes add up to about 24% or a quarter of your paycheck.

Then you see a couple of other "deductions". These are different than taxes. While they are deducted from your check, they are actually money going into special savings accounts for you to use.

FSA Medical is a "flexible spending account" that allows you to set aside money before taxes to pay for medical-related expenses. It's an optional program that some employers allow you to enroll in.
401k is a type of retirement account that allows you to also set aside money before taxes that can be invested for your retirement. Most employers offer some sort of 401k plan and some even provide matching payments. For example, for every dollar you save, your employer might add an additional 50 cents, up to say 6% of your salary. That amounts to a 50% return on your investment for just participating in the plan! Take that deal if you can get it!

This introduces another key concept that's important to understand...

Key Concept: Tax-deferred Savings

Certain types of investment accounts allow for tax-deferred contributions. Normally, taxes are deducted from your full paycheck (your gross pay) and then you receive the remaining take-home amount (your net pay) after taxes.

But tax-deferred accounts allow contributions before taxes are taken out. So you have more to invest and then the taxes are deducted from your gross pay after the tax-deferred contributions, reducing your current taxes a bit.

In the paycheck example, you end up contributing an extra $44.34 to your 401k account each pay period or a little over $1000 per year. And the FSA and 401k deductions before taxes would save you $63.56 in taxes each paycheck.

Note the term is tax-deferred and not tax-free. You still eventually have to pay taxes on this income, but not until you withdraw it in retirement. The bet you are making is at that time, your tax rate will be lower because you aren't working.

The most common forms of these tax-deferred accounts are the Traditional IRA account and the Employer-based 401k account. There is another form of tax-advantaged savings account called a Roth IRA, which allows you to make after-tax contributions but take tax-free withdrawals, later in retirement. Note that the bet here is that you'll be in a higher tax bracket later in life.

Comparison of tax-advantaged accounts

	Traditional IRA/401k	Roth IRA
Contributions	pretax dollars	after-tax dollars
Account Growth	tax deferred	tax free
Withdrawals	taxed	not taxed

But the Roth IRA is also beneficial because the capital gains aren't taxed either, and as we will explore later, over the long term, those gains may be significant and can make up the lion's share of the total investment value. The tax-free withdrawals of these gains can amount to a lot of savings.

We were talking about a paycheck, which is of course, received from your employer. People of your generation are expected to have 12 different jobs over their careers³ and move almost as many times over that period.⁴ That brings up another important concept...

Key Concept: Cost of Living

When we discussed inflation, we saw that the prices of everyday items can vary over time. Similarly, the prices of items can vary over location.

The cost of items varies greatly by location

I've listed the cost of some different items in various cities in the US that all of you have been to and are familiar with. I've also thrown in a few European cities for comparison.

The bottom row shows the ratio of the highest and lowest prices of each item across those cities. You can see that rent in New York (the city with the highest rent) is almost four times what it would be in Des Moines (the city with the cheapest rent).

The "index" is a measurement factoring in many different products and is based on a value of 100 for New York, the most expensive city. You can see that overall, Denver is about 20% cheaper than New York (that is, an index of 80 vs. 100).

However, employers have to consider the cost-of-living otherwise they might not be able to convince people to work there, so the last column shows the median monthly take-home salary in each city. You can see that the more expensive cities also generally offer higher salaries to compensate.

There are a lot of factors to consider when deciding whether to relocate for a job. But cost-of-living is an important one to determine how far your paycheck will go and whether or not you'll actually be better off financially.

Creating a Budget

So how do you make sure your expenses stay below your income? This is the core role of a budget: a tool to help you pay bills on time, save money and create financial stability in your life. Let's now look at a budget and how you might create one.

“A budget is telling your money where to go instead of wondering where it went.”
~ John C. Maxwell

A budget is a spending plan based on income and expenses. It's a way to prioritize what you do with your money to make sure the important items are paid for while still leaving you room to pay for things you enjoy.

Budgeting doesn't need to be an overly complicated process. A very high-level budget is to divide your spending into three different categories:

The first category is needs: these are the expenses you must pay to get by such as your rent, utility bills, and groceries.
The next category is wants: these are the things that you'd like to have, but also wouldn't be a big hardship for you if you chose not to buy them right now. These are expenses like dining out, going to a movie, subscribing to Netflix, or buying a new pair of sunglasses.
And the third cateogry is savings: the money you are putting aside for emergencies, long-term purchases, like a home, investments, and retirement. Think of this as investing in your future self.

50/30/20 Budget

An often-used budgeting plan around these categories—and one that I've followed myself—is called the "50/30/20 Budget". The idea is to spend no more than 50% of your paycheck on "needs", no more than 30% on your "wants" and at least 20% on savings. Needs and wants are maximums, savings is a minimum.

The easiest way to follow this is to just change the order to "savings", "needs", then "wants". You'll hear the advice "pay yourself first" when it comes to saving money.

Budgeting in 3 Steps

save 20% of your paycheck
pay for your needs
use what's left over for your wants

Take 20% of your take-home paycheck and put it in your savings account, then pay for all your "needs". What's left over is available for your "wants". You don't have to spend all of that of course, you could save even more, but you can spend it, free of guilt or stress, knowing that you've met the most important commitments.

Here are some additional suggestions and important points:

savings is not the same as just leaving money in your checking account and using it when you want to. Get in the habit of moving it to a different account where you'll be less tempted to dip into it. You can even set up automatic transfers to put money in your savings account each time you get paid.
save 50% of every salary increase. At most jobs, you'll get a raise every year or two. If you are already getting by on your current salary, then when you get a raise, that should all be extra, so you can save half of it and leave half for your other expenses.
save 75% or more of every bonus (or unplanned) income. Some jobs will pay an additional bonus every year based on how the company is doing. Similar to a salary increase, strive to save the majority of a bonus which is money you shouldn't regularly plan on anway. That's why it's a good idea to put more of it in savings. But it's fine to set some of it aside to treat yourself.

In my experience working in finance, where a large portion of people's income came through an annual bonus, it was common to see people who would inflate their lifestyles to a point where they would depend on that annual bonus. Then they were in a tough situation. If they had a bad year, or worse, got laid off, they didn't have anything to fall back on. I'd also see people who hated their job but couldn't afford to leave because they became so dependent on that bonus. People use the term "golden handcuffs" to describe this situation.

Here's a sample budget for a person bringing home $4,250 per month after taxes have been deducted. You can see that they are able to stay within the thresholds of the "needs" and "wants" categories, allowing them to save a little more than the 20% minimum savings goal. This sample shows an appropriate level of detail for your budget categories when you are starting out. It doesn't need to be too detailed or onerous to be useful.

Example: Expense tracking and budgeting

One thing related to budgeting is tracking your spending. You can't set up a realistic budget if you don't know where your money is already going. Knowing where your money goes helps you avoid getting into trouble by surprise.

Tracking your spending has a number of benefits:

it helps you stay within your budget
it gives you insight into your spending habits and patterns, including areas where you might be wasting money, which could be opportunities to save.
it will help you manage your debt
it provides a basis for long-term financial planning. Knowing how much you need to live on is a key component of any financial plan.

There are a number of apps that can help with both tracking your spending and managing a budget, which takes a lot of the tedium out of the process and makes it easier to stay on track. I used to use Quicken and also used an app called YNAB (which stands for You Need a Budget). There are other apps like Mint, Personal Capital and Rocket Money that are popular, too.

Whether you use an app or are fine doing this on your own, the important thing is to pay attention to your spending so you can make informed decisions about what to do with your money.

Money Management

Banking Basics