Let’s continue our discussion of the information found in David Bach’s second book, Smart Couples Finish Rich. In a previous post we went through the first three steps of Bach’s nine steps to creating a rich future for you and your partner. The first three covered evaluating your current financial situation, what your top 5 core values are and how these affected your financial goals, and established some basic financial truths.

Step 4: The Couple’s Latte Factor

This next step addresses a fundamental problem affecting every American household, the problem is not the income, it’s what you spend. Here we can “learn how anyone can become wealth on practically any income.” As a side note, I was just reading a personal finance journal which stated that 7.4 billion credit card solicitations passed through consumers hands last year. Credit card collections are growing and so are the late fees. Last year, Americans spent 60 million in late fees! We have problems with instant gratification and buying things we can’t yet afford. Bach’s Latte Factor addresses the simple fact that everyone can $5 or $10 a day to save. By eliminating incidentals, snacks, impulse purchases you will find you currently do the have the income to become wealthy. To help you find that 5 or 10 or 20 dollars a day he suggests a seven-day financial challenge exercise. Write down every purchase you make over the next seven days, no matter how small or insignificant write it down and track your spending for a week. He sites an example of a couple who found $85.75 a day that they spent on ‘small stuff’, coffees, muffins, lunch out, takeout dinner, movie rental late fees… With $10 a day working for you, you will experience the miracle of compound interest. Saving systematically over a long period of time greatly increases the rate as which you’ll be able to build wealth. Below is a chart of how paying yourself and using that money to invest in your retirement can really pay off.

Step 5: Build Your Retirement Basket

Building a retirement basket will safeguard your future. In this day and age you can not depend on Social Security to provide it for you. The best way to amassing substancial wealth is by paying yourself first. But what does that mean? How much should you pay yourself? Here are the three principles of pay yourself first:

  1. What “Pay Yourself First” Really Means. Putting aside a set percentage of every dollar you earn and investing it for your future, preferably in a pretax retirement account.
  2. Where the Money You “Pay Yourself First” Should Go. Put part of your earnings into a pretax retirement account, i.e. 401(k), 403 (b) or traditional IRA vehicles. For more information of these types of accounts see one of my previous posts here.
  3. How Much Should You Pay Yourself? You should be saving 10% of your pretax income or gross pay. And this savings is just for retirement. Any savings to buy a new car, renovate your kitchen or take a trip to Cabo is on top of this 10%. If you can’t afford to save 10% then you are living beyond your means.

If you want to be really rich, you should have 15%. Really rich once meant having $1 million in liquid assets above the value of your home. Now a days it requires $1.6 million. To be among the top 1% of Americans you’ll need to save 20% of your gross income. To quote Bach on his idea of pretax investing consider the following:

If you are not currently saving 10% of your icome, you can start doing so tomorrow-without decreasing your spendable income by 10%! Normally you earn $50,000 a year. Assuming you’ve got a combined tax rate of 35%, what you actually bring home is about $32,500 in spendable income. Now, despite what you might think, putting $5,000 into a pretax retirement account will not reduce your spendable income from $32,500 to $27,500. Remember, you’re paying yourself first-before you pay the government. In other words, the $5,000 you’re saving comes off the top. What gets reduced is your gross income, which will drop from $50,000 to $45,000.

So let’s do the math: $45,000 taxed at 35% leaves the two of you with a spendable income of $29,500. Before, you had a net spendable income of $32,500. Now you’re getting $29,250. The difference is $3,250 a year. Divide this by two (there are, after all, two of you) and it comes out to a pay cut of $1,625 a year each. Divide that by 12 months, and that comes to a pay cut of $135 a month. Divide that by 30 days and it comes to $4.51 a day-an amount the Latte Factor can easily cover.

If you are still finding it hard to muster up 10%, start with say 3%, and commit to increasing it by 3% every 6 months. But just contributing a pretax retirement plan is not enough. You have to then invest the money. Usually companies offer a menu of mutuals funds and stocks you can invest in. Do your own research about the quality of each investment and the historical returns at morningstar.com, finance.yahoo.com, finance.google.com, mfea.com, and mutuals.com

Rules of Retirement Investing

  1. Know what your money is doing (Avoid setting it and forgetting it)
  2. Make sure your retirement money is invested for growth. (Money should be growing at 4-6% points above inflation, which translates to a rate of 8-10%)
  3. Allocate your assets so that you maximize return while minimizing risk. (Diversify. Subtract your age from 110. That number tells you the percentage of your portfolio that should go into equities and the remainder should be invested in bonds or fixed-income investments.)
  4. Invest in your company’s stock, but do your homework! (Check the latest annual report and 10-k)
  5. Make sure you read all of Step Eight (The Biggest Mistakes Investors Can Make)

Step 6: Build Your Security Basket

Your security basket protects you and your family against the unexpected, medical emergencies, deaths, lay offs. We can all hope for the best bet we need to prepare for the worst. The following are six things to do now to protect yourself:

  1. Set aside a cushion of cash. Bare minimum should be the equivalent of three month’s living expenses (not earnings). Twelve to twenty-four months is also recommended but you shouldn’t be saving more than 24 months. You money can work better for you in other places. This money should not be linked to your checking account. Ideally you’d be able to find a money-market account that pay 3-4% in interest.
  2. Both of you absolutely MUST write a will or set up a living trust. A will outlines your wishes after you die, custody of children, your estate, etc. A living trust allows you to transfer ownership while you’re still alive. Your house, car, investments can all pass to the trustee without having to go to Probate court and paying exorbitant attorney fees. But creating a trust is not enough, you must put all titles and deeds in the name of the trust. The only thing you do NOT want to put in the name of your trust is any IRA’s. You’ll also want to review your will and trust every 5 years and make sure it is up to date.
  3. Buy the best health coverage the two of you can afford. Bach actually recommends you pick the most expensive health-care option you can find. This is one area where you don’t want to skimp on coverage. Bach likes POS plans, then PPO plans and finally the HMO if that’s all you can afford.
  4. Protect those who depend on you with life insurance. Life insurance is designed to replace income so your family can continue to live comfortably. To determine how much coverage you need think about who relies on your income, what does it cost your dependent to live on for a year, any major debts that would need to be paid off? Your death benefit should be between 6 and 20 times your annual spending needs. If you spend $50,000 a year you’ll want between $300,000 and $1 million. Do you want to ensure your loved ones never have to work again or give them a 10 year cushion to recover? Remember, the stay at home parent should also always have coverage to replace the value their provide to the household, day care, housekeeper, cook. There are two main kinds of life insurance 1) term; annual renewable or level 2) permanent; whole, universal and variable universal. The majority of people should buy a level term life insurance policy. The only time you’d want to consider permanent insurance is if you have at least 15 years to invest in it, you’re maxing out all other retirement options and you earn more than $100,000 a year.
  5. Protect yourselves and your incomes with disability insurance. Disability is also designed to replace income. An adequate policy should pay you the same as your current take-home pay. Most plans offer a benefit equal to 60% of your gross income, which is about what most people take home after taxes. Make sure your plan is portable and guaranteed renewable. Also make sure the plan is “owner occupation” so it will pay out if you are unable to complete your current type of work, not just any kind of work. Coverage should begin about 3 to 6 months after you’ve become disabled and should cover you until you are 65 years old. You’ll also want a policy that cover mental and emotional disorders which would make it hard to sustain work.
  6. If either of you is in your sixties, it’s time to consider long-term care coverage. A long term care facility can cost anywhere from $30-70,000 a year. Medicare only covers acute-care need where you need rehab therapy at least 5 days a week, and only covers the first 20 days and beyond that is only covers a portion. LTC coverage pays for nursing homes, residential-care facility, convalescent facility, hospice or care in your own home. Bach recommends paying the extra 10-15% to get lifetime coverage. You can also reduce your premium by requesting a higher deductible and longer time for the policy to take effect. Make sure your policy payout will also be adjusted for inflation, and that you have a grace period on late payments and that no disease or injury is not covered.

Well that wraps but the middle 3 steps…let’s move forward next week with addressing saving for your dreams and 10 mistakes to avoid.