The basic concepts behind building wealth are quite simple to understand, but highly challenging to execute. The following four tips will help you put a time-tested strategy into practice.
Save money
Invest money
Minimize your taxes
Protect your money
1. Save money.
Creating a budget and sticking to it is the first step toward saving money, especially when it comes to meeting major financial goals. You should outline your earnings and expenses even if you’re comfortable with your current income and ability to meet your expenditures. Keep in mind that budgeting will become much more important when money is tight, especially when you’re still trying to get a handle on where it goes.
Numerous methods exist for tracking income and expenses. These generally involve categorizing them in some way. For example, Kiplinger provides an online household budget tool with individual line items. Income categories in these sample budgets generally include salary and returns on investments, while the primary expense categories are essentials and discretionary spending. Major essential expenses are housing, utilities, groceries and insurance. The most significant discretionary expenses are entertainment expenses such as dining out and cable TV.
In budgeting expenditures, it’s important to think about the expenses that will cost you the most money in the long run. For example, buying a used car may save you money upfront, but cost more in repairs. It often makes the most financial sense to pay cash for a sensibly priced new car and drive it until it’s no longer economical to maintain. Similarly, spending a little more on quality clothing may pay for itself over time if it lasts longer than more cheaply made clothing.
2. Invest money.
Many people have little interest in investing their money, especially younger workers. They may feel that investing is too complicated or that they don’t have enough money to invest. They may be afraid of losing money during a downturn. These viewpoints overlook the powerful wealth-building combination of time and compound interest that investing can produce.
To minimize the short-term impact of poor performance in one investment sector, consider diversifying your investments into multiple sectors of the economy. Different sectors go in and out of favor with investors, so having a diversified investment portfolio will help you capitalize on trends that can change dramatically from year to year, as shown by the Callan Institute’s periodic table of investment returns. For example, stocks in emerging markets provided the best returns in 2017, but holding a large cash horde would have been a better choice in 2018. Stocks in large companies were the top performers in 2019.
The key to diversifying your investments is to ensure they aren’t related to each other. Related investments tend to have generally similar performances, which is uplifting when they all are doing well but distressing when the trend is down. Proper diversification means that at least one of your investments should do well when another one doesn’t. Properly diversified investments will have a more predictable performance over the long term.
Minimizing the cost of your investments is another way to build wealth over time. While you can’t control the performance of your investments, you can control what you pay for them. Investment companies charge a percentage of the price each time you buy or sell a stock, bond or mutual fund, so you have control over your transaction costs. Another way to control costs is to place limits on how often you buy and sell investments. Yet another strategy is to buy in increments rather than all at once, averaging your transaction costs.
3. Minimize your taxes.
You can reduce your taxable income by contributing to a retirement fund like an IRA or 401(k). You can also lower your tax bill through tax-deductible contributions to a health savings account (HSA). For 2020, the contribution limit for an HSA is $3,550 for individual coverage and $7,100 for family coverage, including employer contributions, which are not tax-deductible. You can contribute an additional $1,000 if you’re 55 or older.
Adjusting the amount of your salary that you withhold for taxes is another way to set aside money for wealth accumulation. While it may seem that getting a big tax refund check each year is a good way to save, it really isn’t the best use of your money. It means that you have been having too much withheld throughout the tax year. Instead, you should lower your withholding amount to more accurately reflect the taxes you’ll actually owe to the IRS. You can accomplish this by submitting a Form W-4 to your employer. Use the extra money from your paycheck for savings or investing. To learn more about minimizing your taxes, you can consult a tax advisor.
4. Protect your money.
Insurance is a method of protecting your finances from the sudden, unexpected loss of a major asset like your income, home or car. Reviewing your insurance coverage at regular intervals should be standard practice, especially after a major life change. An insurance agent or financial planner can help ensure that you have the appropriate coverage.
In addition to auto and home insurance, you should consider life insurance that will help cover your family’s expenses in the event the breadwinner dies prematurely. Life insurance comes in two basic types. Term insurance is for protection only, whereas whole life insurance has an additional investment component. Term insurance is for a specific term, or length of time, while whole life insurance is for the lifetime of the insured. The rule of thumb is that the coverage amount should be 7 to 10 times your annual pretax income. Depending on your financial needs, either may be appropriate.
Home insurance should cover the replacement cost of the house in the event of a fire or natural disaster that damages or destroys the structure. You will need to keep your coverage updated to reflect major renovations to your home as well as increases in its assessed value. Insurance riders can provide additional protection from risks not specifically covered by the primary policy, such as a backed-up sewer.
Each state specifies a minimum amount of insurance coverage required for a vehicle. However, lenders may require more coverage to insure that you can repay your car loan in the event the vehicle is a total loss.
