My 401k is at 401K!

As of today (or EOB yesterday), my 401k account balance is officially sitting at $401.5K. Of that amount, my contribution = $205K.

My current 401k plan balance:

S&P 500 Index Fund: $127.5K

U.S. Small/Mid-Cap Equity Index Fund: $125.2K

International Equity Index Fund: $148.8K

Balance as of 02/18/2012 :$401.5K

My ROTH IRA balance, on the other hand, is only at ~$52K (I put in $45K of it). I wish the government would let people contribute more to IRAs. I'm thankful I can do both, but my 401k balance is blowing my ROTH savings out of the water.

I am a huge proponent of 401k plans. Your 401k account is probably the most legally protected savings vehicle you will ever own. If you walk away from your house, your mortgage lender can't get at it. If you get sick and rack up huge medical bills that you are unable to pay, they can't tap into your 401k. If you get sued or have to declare bankruptcy, your 401k balance is protected. Insurance may protect you from many of these things, but it doesn't offer nearly the level of blanket protection.

In addition, I believe most social benefit programs don't count 401k balances against applicants for the purposes of granting benefits. If you have a significant amount of money in after tax accounts or other types investments though, you will likely be denied due to the asset tests. For example: Increasing Retirement Saving: Clarifying Food Stamp Asset Test Rules.

While most of us may never need to worry about these things, we should at least be aware of all the facts in order to make the best assessment on our saving options. I see a lot of people rag on 401k plans as it seems to be a popular thing to do, but they don't seem to consider all the facts before making important decisions.

Further reading: IRAs could be fair game in lawsuits

Budgeting...

Liz Pulliam Weston recently published an article in her MSN Money column titled "How much should you spend on...", which talks about the 50/30/20 budget. Basically, the idea is that you should budget 50% of your after-tax income for "needs." "Wants" should take 30%, and the remaining 20% should be allocated toward savings & debt repayment. The article clarifies what kind of expenses should fall into each category.

I think a lot of people (particularly those with lower incomes) would probably find it difficult to make it on that kind of budget. And prior to refinancing my house from a 10 year loan to a 30 year fixed mortgage, I wouldn't have been able fit my expenses into those guidelines either. However, here are what my monthly expenses look like now:

I estimated some of the above values based on historical spending, but overall it's pretty spot on (I deliberately lumped food into the "wants" category because I know I spend more than I have to in this area). So this tells me that I currently have an excess net of 29% after needs/wants/savings, which I am using to bolster my emergency fund. It also tells me that in order to meet the 50/30/20 budget and maintain my current lifestyle, I need to bring in at least $60,000 a year after-tax. This seems a bit high to me, however the good news is that I can survive on about $32,000 a year after-tax if I stop saving and cut my diet to rice & beans, before I have to start selling assets or dipping into my emergency fund.

I am definitely appreciative of the fact that a lot of families live on less than $32,000 a year, and I know I am in an extremely fortunate position. That said, the majority of my expenses are related to housing, and if I were to downsize I could live on significantly less.

Please note that I do not actively budget per se. I priortize saving by having my retirement contributions deducted from my pacheck, and most of my recurring bills are paid automatically via billpay. What's left stays in my bank account, and I make purchase decisions based on actual need and return on happiness, rather than some preset number that I've allocated beforehand. This has worked well for me in the past, and as mentioned in one of my favorite finance articles, it means that I am no longer relying on training wheels for my savings habits:

"What does that mean in terms of money management? It means I learned how to spend what I needed and save the rest. While “tricks” of money management assume that you are incapable of controlling yourself, that if you have money, you will spend it, taking off the training wheels means facing up to your own ultimate responsibility for your finances. It means facing up to the fact that you are a conscious, reasoning human being who can choose to spend or not to spend. It also means learning that once you have the true necessities covered, enjoying your life has remarkably little to do with how much money you spend." - Holly Ordway, Spending Wisely

3 steps to achieve financial success

I believe that most Americans can achieve financial success. I am living proof that it's possible. Granted, I have a well paying job, but I don't make an obscene income. Besides, I know plenty of people in my income range that have little to show for their years of working. And I think that even if my income was more modest, I would still be well on my way to financial independence; I just wouldn't have accumulated as much.

Here are the three steps that I feel are necessary to achieve financial success:

1. Live below your means. I realized that to make money, I needed capital, and to generate it I had two options: reduce my expenses or increase my income. I increased my income by gaining valuable work skills and hopping jobs, but that may not always be possible depending on the stage of your career. I also kept my overhead low, and that is something that everyone can do.

For one thing, I never tried to keep up with the Joneses. I knew from reading "The Millionaire Next Door" that self-made millionaires lead pretty modest lives, and people who flaunt extravagant lifestyles are financing those lifestyles at enormous opportunity cost. I kept my focus on becoming debt free and saving for early retirement.

I differentiated my needs from my wants, and carefully evaluated each expense that fell into the "wants" category. If it didn't match my priorities, then I opted to forgo it or found cheaper alternatives. That meant no luxuries like designer clothing, Starbucks, BMWs, concerts, etc., but I really didn't care about those things anyway. That doesn't mean I always deprived myself, I just made sure that any money spent on non-necessities was used to buy things that brought real, lasting happiness. I bargain shopped to find the best deals, and I made sure that I could pay off the credit card bills when they arrived. I also understood the eroding effect of taxes on my money: the combined impact of income tax and sales tax meant that only about half of every dollar I earned was available for me to use, so I spent them very sparingly.

2. Save. I knew my ability to work was finite, and I wanted to have the option of not having to work as soon as possible, so I treated my earnings like lottery winnings. I socked away the max into my 401(k) plan immediately upon starting my first job, and continued to do so as I changed jobs (and never cashed out). I figured I wouldn't miss 15% of my salary, and even if I did I could always scale it back. I survived just fine though, and because I kept my expenses low, I was able to save a significant portion of my take home pay and use it to pay off my first house early. I also started a ROTH IRA as soon as I was eligible, and maxed it out every year.

3. Invest.I learned about the amazing power of compounding, and the risk of inflation. Because I started early and had a long time horizon, I was able to invest aggressively. So far it has worked out pretty well for me.

There you have it, the three key steps to building wealth. These aren't new ideas, and it takes time and patience to see the results, but as someone who has done it I can confirm that they will work for you--unlike most get rich quick schemes. I think the most difficult part is the first step, where you have to make the paradigm shift from instant gratification to delayed gratification. Think of robbing your future self when you spend your money in the present, and perhaps that will help you resist the temptation to buy stuff you don't really need.

So if you want to do something to get started on the road to wealth, here is a simple action you can take now: log into your employer's 401(k) plan, and bump up your contribution amount. Remember, if you find that you can't live without the reduction in take home pay, you can always change it back, but I'm betting that you'll learn to live without it, and you'll be thanking yourself later.

Renting vs. Buying: which is the better choice for you?

Mommy Millionaire Next Door has been shaking up the PF blog community with the unconventional wisdom that renting is better than buying a house, and revealed herself as someone who has managed to become a millionaire due (in part) to this fact. Given the current state of the post-bubble real estate market, this may seem like a no-brainer, but she runs the numbers to show that it could hold true at any time. You can read her well articulated posts on this topic here.

After reading the articles, the takeaway is that 1) renting is cheaper than buying when supply is greater demand, and 2) from an investment perspective, renting (and investing the difference) beats home ownership over the long haul. This shouldn't be mind blowing news, and prior to the recent housing boom people didn't view their homes as ATMs or stock-beating investment vehicles. People traditionally bought residences to live in, not to get rich with.

The idea of houses as get-rich-quick vehicles is a recent phenomenon. Real estate investors generated artificial demand driving up home prices, and ordinary people got caught up in the frenzy. However, as incomes failed to keep up with the rising home prices, the trend has come to a screeching halt and even started to reverse itself, leaving latecomers holding the bag. The problem has been compounded by buyers who stretched themselves or used creative financing to pay more than they could conventionally afford.

Except for the lucky few (myself included, see update below) who managed to cash out during the height of the housing rush, most people won't experience gains that approach anywhere near historical long term stock market returns. The primary purpose of housing is to provide shelter, not to make you rich. So if your top priority is maximizing return on investment, then renting and investing is probably your best bet. To help make this determination, you can run the Rent vs. Buy calculator as explained by Millionaire Mommy Next Door.

That said, there are valid reasons (financial and otherwise) that can make home ownership a rewarding experience once the housing market stabilizes. Here are some that I came up with:

• Home as a forced savings vehicle. Let's face it, most Americans are terrible savers. They tend to spend every penny they make, and live paycheck to paycheck. Often times, a home is the only asset many people will ever have to show for all the years they spend working. For the financially savvy, renting can make sense if they have the discipline to invest the savings. For others, they will most likely spend the difference and wind up with nothing to show for it.

• You're not at the whim of a landlord. Some people get really attached to their homes and the memories created there, and being forced to move can cause significant emotional tolls that outweigh the financial gains. Other people find that being able to customize and improve their living space provides a level of personal satisfaction that cannot be measured in dollars.

• Homestead protection. All states afford some kind of homestead exemption to home owners, with Texas, Florida, Iowa, Kansas, and Oklahoma offering some of the broadest protection levels. Besides retirement plans, a person's house is the only asset that cannot be seized for the payment of court judgments (ever wonder why OJ Simpson lives in Florida?). With today's litigious society, this can be an important point to consider. While umbrella insurance can also provide cheap asset protection, it can be difficult to get a policy if you've had an accident, lawsuit, or other significant insurance claims in the past 5 years. Homestead protection is also a completely legal means of asset protection, as opposed to other questionable asset protection methods offered by some companies.

• Pride of ownership. It's true, people tend to take better care of their own stuff than that of others. This is why many people won't buy used cars (I personally won't buy used rental cars), and some people dislike having renters as neighbors. You can usually distinguish the rental houses from the owner occupied homes in most neighborhoods, particularly those without HOAs. Of course some peoples are just slobs, but the likelihood is that people will take better care of their homes if they own them.

• A house is a tangible asset. There is something rewarding about being able to physically see and touch an asset that you own. Perhaps I'm more of a visual person, but when my first house was paid off and I was buying stocks with my disposable income, it just didn't provide the same fuzzy feeling. When you own shares of a company, you cannot walk into the company headquarters and claim a piece as your own. While it may not seem like that big of a deal, my motivation to keep working and saving was reduced because I was physically disconnected from what I was working for.

• A house is usually a safe investment. It might not beat stock market gains, but a house can be a smart purchase because it's likely to keep its value over time. You can't say that about most other consumer goods such as cars, boats, etc.

I think Mommy Millionaire Next Door has done a great service by dispelling the notion that home ownership is the path to wealth. Unfortunately, it's a lesson that has come too late for some. However, hopefully it will prevent others from making the same error.

Update: I calculated the rate of return on my first home using this CNN Money calculator. I purchased the house (and added some improvements) for $102.50 per sqft. in 1997, and sold it for $206 per sqft. in 2005. My result:

Return on investment:
Annualized return: 9.18%
Return for the entire period: 101.18%

*Note: does not include Realtor fees (which I avoided by using FSBO), taxes, insurance(although the difference between homeowner and renter insurance is nominal in my case) and upkeep costs.

A different measure of success

I recently conducted a poll on networthiq.com, and asked people to calculate the percentage of adult earnings that their current net worth represents. Although I haven't received an overwhelming number of responses, I think it is a rather eye-opening exercise. If you're like me, it really makes you think about what you've done with all the money you've earned over the years, and what you have to show for it. By being consciously aware of these things, you may be able to alter your spending and savings habits to keep more of what you make.

So as you progress throughout your working career, keep track of your earnings. For example, I maintain a spreadsheet that lists, by year, my gross income, 401(k) contributions, and net take home pay. All of this information is readily available and/or easily calculated from your W-2 statement or year-end pay stub. This allows me to see, at a glance, my annual earnings, contributions to employer sponsored retirement plans, taxes withheld, and what I got to take home. I can then compare how well I've done at saving (and growing) what I've brought home over the years. It also makes it easy to find out how well my 401(k) plan is doing, since I know the cost basis, which can be helpful in determining whether I need to make any adjustments.

Look at your results regularly, and maybe it will help you stay focused on your savings goals. Good luck!