How to Achieve Financial Freedom in 9 Simple Steps
By :
personMoneyBestPal Team
November 15, 2023
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Image: Freepik / tawatchai07
Main Findings
Financial freedom is the ability to live the lifestyle one desires without having to work for money or depend on others for financial support. It is essential for overall well-being and happiness.
Nine simple steps to achieve financial freedom: track your income and expenses, pay off your high-interest debt, build an emergency fund, increase your income, invest your money wisely, save for retirement, protect your assets, give back to society, and enjoy your life.
Financial freedom is the ability to live the lifestyle one desires without having to work for money or depend on others for financial support.
Financial freedom is essential for overall well-being because it gives one more option, control over their life, and enjoyment. It also lessens worry, tension, and anxiety—all of which are frequently brought on by debt or unstable finances.
Australia topped the list of 175 countries regarding financial freedom in 2023, scoring 90 out of 100, according to the Global Economy website.
This indicates that Australia has low barriers to trade, investment, and entrepreneurship and a high degree of economic openness, efficiency, and competitiveness. North Korea received zero points for ranking at the bottom, signifying a very closed and oppressive economy.
Merely 24% of young adults in the United States were financially independent by the time they were 22 years old in 2018, down from 32% in 1980, per a Pew Research Center analysis of Census Bureau data. At least 150% of the federal poverty line, approximately $18,210 for a single individual in 2018, was required to be financially independent.
Delays in marriage, rising education prices, shifting labor market conditions, and other factors were all blamed for reducing financial freedom.
Based on 12 factors, including property rights, fiscal health, and government integrity, the Heritage Foundation's Index of Economic Freedom evaluates the level of economic freedom in 184 countries. In 2023, the world average score for economic freedom was 61.6 points out of 100, a marginal increase from the previous year.
North America and Europe had the highest levels of economic freedom, whilst the Middle East, North Africa, and Sub-Saharan Africa had the lowest levels.
Despite the difficulties brought on by the COVID-19 pandemic, the financial system in Indonesia demonstrated resilience and progress in October 2023, according to Bank Indonesia's Financial System Statistics. The banking industry's capital adequacy ratio (CAR)Â was 23.7%, much higher than the 8% minimum needed. With a non-performing loan (NPL) percentage of 2.9%, it was below the 5% cutoff.
With a liquidity ratio of 23.1%, there was enough money to cover short-term obligations. The financial market sector demonstrated stability and growth as well, as seen by the record high of 10,000 points reached by the Jakarta Composite Index (JCI) and the appreciation of the rupiah relative to the US dollar.
Step 1: Track Your Income and Expenses
Tracking your income and expenses is one of the first steps towards reaching your financial objectives. By doing this, you'll gain a better understanding of your financial situation and learn how to make more effective use of it. Due to its ability to automatically connect with your bank accounts, classify your transactions, and track your progress, a budgeting app can simplify and expedite this process.
What is a Budgeting App?
A budgeting app is a software application that you can use on your phone, tablet, or computer to manage your personal finances. A budgeting app can help you:
Establish connections with your credit card and bank accounts to automatically import your transactions.
Sort your transactions into categories like food, rent, entertainment, and so forth.
Create a monthly budget for each area and keep track of your spending and remaining funds.
Examine your spending habits to find places where you might make savings.
Establish monetary objectives, such as debt repayment, vacation savings, or retirement investment.
Keep an eye on your net worth, calculated by subtracting your liabilities from your assets.
Receive individualized guidance on how to make your financial condition better.
You may manage your finances better and make wiser decisions by using budgeting software. Nevertheless, not every software for budgeting is made equally. Certain ones might cost more or offer more features than others. Better privacy and security policies might also be found in some than in others. Consequently, before selecting a budgeting software that works for you, it's crucial to perform some research.
How to Use a Budgeting App to Track Your Income and Expenses
Using a budgeting app to track your income and expenses is not difficult, but it does require some initial setup and regular maintenance. Here are the basic steps to follow:Â
1. Choose a budgeting app that meets your criteria
You could wish to take into account elements like price, features, customer service, security, privacy, and user interface. To gain insight into the functionality advantages and disadvantages of the software, you may also read reviews left by other users or experts.
2. Download the app on your device and create an account
Your name, email address, phone number, and other personal information could be required. A code or document may also be required to confirm your identity.
3. Link your bank accounts and credit cards to the app
You will need to provide your login credentials for each account that you want to connect. The app will then access your account information and import your transactions automatically. You may need to grant permission for the app to do this.
4. Categorize your transactions into different groups
The app may do this automatically for you based on some predefined rules or algorithms, or you may need to do it manually for each transaction. You can also create custom categories or subcategories if you want more control over how you organize your spending.
5. Set up a monthly budget for each category
You can either use the app's suggestions based on your income and expense history or enter your own amounts based on your goals and preferences. You can also adjust your budget throughout the month if needed.
6. Track how much you spend and how much you have left in each category
The app will show you graphs, charts, or numbers that indicate how much of your budget you have used and how much remains. You can also compare your spending with previous months or with other users.
7. Analyze your spending patterns and identify areas where you can save money
The app will provide you with insights and reports that show you where most of your money goes, what are your biggest expenses, how often you overspend or underspend in certain categories, etc. You can also set up alerts or notifications that warn you when you are close to reaching or exceeding your budget limit.
8. Set up financial goals and track your progress towards them
The app will help you create realistic and achievable goals based on your income, expenses, savings rate, etc. You can also choose how much money you want to allocate to each goal every month or every paycheck. The app will then show you how long it will take you to reach each goal, and how much interest you will earn or save along the way.
9. Monitor your net worth and see how it changes over time
The app will calculate your net worth by adding up all of your assets (such as cash, savings accounts, investments, etc.) and subtracting all of your liabilities (such as loans, credit card balances, etc.). You can also see how your net worth grows or shrinks over time, and what factors affect it the most.
10. Get personalized tips and advice on how to improve your financial situation
The app will make recommendations and suggestions for you based on your income, goals, and spending patterns, among other factors.
Additionally, you get access to learning materials like articles, podcasts, videos, and more that cover a range of personal financial subjects, including debt management, investing, saving, and budgeting.
By following these steps, you may successfully and efficiently track your income and expenses with a budgeting app. But you should also keep in mind to update your data frequently, evaluate your goals and budget regularly, and make necessary revisions.
You are ultimately responsible for taking the initiative and adjusting to your financial situation; budgeting apps are merely tools to assist you in doing so.
Examples of Popular Budgeting Apps
There are many budgeting apps available on the market, each with its own features, benefits, and drawbacks. Here are some examples of popular budgeting apps that you can try:
With this app, you allocate each and every dollar of your income to a certain objective or category, adhering to the zero-based budgeting system. With the app, you can create a budget, make adjustments as needed, and plan ahead for your savings and expenses.
Along with a helpful user community, it provides a wealth of instructional resources. Following a 34-day free trial, the app costs $14.99 per month or $99 annually.
You can monitor your finances and spending on all of your accounts with the help of this app. Additionally, it provides features like credit monitoring, bill negotiating, cashback rewards, and automated savings. Basic aspects of the program are free to use, but if you want access to more sophisticated capabilities, you can pay Empower Plus for $8 per month or $60 annually.
This budgeting tool is among the most well-liked and extensively utilized ones. It establishes a connection with your accounts and automatically sorts your transactions. You may monitor your credit score, set objectives, make a budget, and more with its assistance. While using the app is free, you can see offers or advertisements from its partners.
With this app, you can use the envelope budgeting approach, which divides your income into various categories or envelopes according to your priorities. After that, you can only spend the money in each envelope until your next payday.
You may monitor your savings and spending on several devices and users with the aid of this app. You can create up to 10 envelopes and sync the app with one other device in its free version. You may build an infinite number of envelopes and connect with up to five devices with the Plus edition, which costs $8 per month or $70 per year.
This app transfers tiny sums from your checking account to a savings account every few days, and it does this automatically by evaluating your income and expenses. In addition, you can earn interest on your investments and set targets for debt repayment or savings. After a 30-day free trial, the app costs $5 per month.
After paying your expenses and achieving your goals, you may use this app to keep track of your spending and see how much money is left over. It also assists you in locating methods to reduce your expenses, end subscriptions, bargain for better terms, etc.
You can link one bank account and establish one goal using the app's free version. You may link an unlimited number of accounts and create an unlimited number of objectives with the Plus edition, which costs $4.99 per month or $34.99 per year.
With just $1, you may begin investing with the aid of this app. Hundreds of stocks and ETFs are available for selection, depending on factors such as goals, interests, and risk tolerance. When you purchase at specific brands or merchants, you can also receive stock rewards. Depending on the plan you select, the app charges a monthly fee: Beginner ($1), Growth ($3), or Stash+ ($9).
This app facilitates joint financial management for couples. All of your transactions and balances may be viewed in one location by connecting your accounts. Together, you can make a combined budget, split costs, keep track of bills, set reminders, and more. Basic parts of the program are free to use, but if you want access to more sophisticated capabilities, you can pay Honeydue Unlimited for $59.99 per year or $9.99 per month.
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Step 2: Pay off your high-interest debt
Paying off your high-interest debt is a crucial first step in achieving financial freedom. Any debt carrying an interest rate higher than the average for a mortgage or student loan—which is often between 2% and 6%—is considered high-interest. Payday loans, credit card debt, personal loans, and other unsecured debt are examples of high-interest debt.
Your cash flow can be swiftly depleted by high-interest debt, which also keeps you from investing and saving for the future. Your ability to pay off high-interest debt will decrease over time as interest rates rise and your available funds are reduced for other expenses. Paying off your high-interest debt as soon as feasible is essential because of this.
But how do you pay off your high-interest debt effectively? Here are some strategies that can help you:
Sort all of your debts by interest rate, starting with the ones that cost the most, and pay them off first. We refer to this as the debt avalanche method. You can lower your overall debt faster and save money on interest by paying off the loan with the highest interest rate first.
As an alternative, you may make a list of all your debts and prioritize paying off the smaller ones first, going from smallest to greatest balance. We refer to this as the debt snowball strategy. Paying off the debt with the lowest balance first can give you momentum and inspire you to continue.
Using either approach you decide on, be sure to pay the minimum amount owed on all other payments to stay out of late fees and penalties. Next, apply any remaining funds to the debt you want to pay down.
Seek methods to raise your income and lower your spending to free up additional cash flow for paying down your debt. You can make financial savings, ask for a raise at work, sell unneeded stuff, cut back on wasteful spending, and/or negotiate reduced rates with your service providers.
To cut your high-interest debt interest rate, think about taking advantage of a credit card balance transfer or a loan consolidation. Your current credit card balances can be transferred to a new card with a 0% APR introductory term, often lasting between 12 and 21 months, with the help of a balance transfer credit card. Several debts can be consolidated into one loan with a set monthly payment and a reduced interest rate by using a consolidation loan. Before applying, though, make sure to thoroughly research your options as some may have costs and qualifying limitations.
As you go, keep tabs on your development and acknowledge your successes. Paying off debt with a high interest rate may be rewarding as well as difficult. The amount of debt you have paid off and the remaining amount can be tracked using a spreadsheet, an app, or a chart. Once you accomplish particular goals, like paying off a particular debt or achieving a particular percentage of your total debt, you can also treat yourself to tiny treats or rewards.
Eliminating high-rate debt is among the wisest financial choices you can make. In addition to saving you interest, it will raise your confidence in managing your finances, lessen financial stress, and enhance your credit score. You can accelerate your repayment of high-interest debt and come closer to your financial objectives by following these measures.
Step 3: Build an emergency fund
Creating an emergency fund is one of the most crucial personal financial tasks. A cash reserve set aside for unforeseen events including unexpected job loss, medical costs, home or auto repairs, and more is known as an emergency fund. When something goes wrong, having an emergency fund will keep you out of debt and prevent you from taking money out of your investments.
However, how much cash do you require in your emergency reserve? In what way do you budget for it? The following recommendations and advice will assist you in responding to these inquiries.
How Much Money Do You Need in Your Emergency Fund?
Generally speaking, you should have three to six months' worth of home costs set aside in your emergency fund. This sum will change based on your location, family size, lifestyle, and income.
You can use an online budgeting tool or just total up all of your bills and spending for a normal month to determine your monthly expenses. Remember to factor in costs for transportation, entertainment, debt payments, groceries, utilities, and insurance.
Let's take an example where your monthly expenses are $3,000. To accumulate a three-month emergency reserve, $9,000 must be saved. To accumulate a six-month emergency reserve, $18,000 would be required.
Why do you need so much money in your emergency fund? Because emergencies can be costly and unpredictable. You never know when you might lose your job, get sick or injured, or face a major repair in your home or car.
Having enough money in your emergency fund can help you cover these expenses without resorting to high-interest credit cards or loans or withdrawing money from your retirement or investment accounts.
How to Save for Your Emergency Fund?
Saving for your emergency fund may seem daunting, especially if you have a large savings goal. But don't let that discourage you. You can start small and gradually build up your savings over time. Here are some steps to help you save for your emergency fund:
1. Set a realistic and specific goal
Decide how much money you want to save for your emergency fund and by when. For example, you might want to save $10,000 in one year. Having a clear goal can help you stay motivated and track your progress.
2. Open a dedicated account for your emergency fund
Choose an account that is separate from your regular savings or checking account, so you won't be tempted to spend the money on non-emergencies. The account should also be easily accessible in case of an emergency, such as a high-yield savings account or a money market account.
3. Automate your savings
Set up a direct deposit or automatic transfer from your paycheck or main account to your emergency fund account every month. This way, you can save money without thinking about it or forgetting about it.
4. Find ways to economize and contribute extra money to your emergency fund
Seek ways to reduce wasteful expenditure and increase your emergency fund contributions. You may cook more at home, sell some unwanted stuff online, cancel some memberships, or look around for cheaper rates on utilities or insurance. Increasing your emergency fund with any windfalls (tax returns, bonuses, gifts, or inheritances) is another way to increase your savings.
5. Review and adjust your goal and strategy as needed
You may have some adjustments to your income or expenses while you save for your emergency fund, which will have an impact on your plan or objective. You may move to a more costly region or receive a raise or promotion.
Then you may choose to raise your emergency fund target amount or your monthly savings amount. Alternatively, you may need to use some of the funds from your emergency fund due to an unforeseen circumstance. You might want to reload the fund as soon as feasible in that scenario.
While creating an emergency fund is difficult, the effort is worthwhile. You and your family can have peace of mind and be shielded from unforeseen financial problems by putting these steps and principles in place.
Step 4: Increase your income
Your financial status may change significantly if you earn more money. It can not only assist you in reducing your stress levels and paying off your debts, but it can also help you save more money and invest more. Nevertheless, boosting your income isn't always simple or easy. Planning, ingenuity, and perseverance are needed.
You can raise your income from your current employment or from other sources in two primary ways. Let's examine each one in greater depth.
From your Current Job
One of the simplest ways to increase your income is to make more money from your current job. This can be done by:Â
1. Asking for a raise
Should you have been putting in a lot of effort, producing outcomes, and contributing worth to your company, you can be qualified for a pay raise. But you must be ready to bargain and support your request with data from market research, accomplishments, and a well-defined objective.Â
In addition, you should be self-assured and forceful rather than conceited or entitled. When you have taken on additional responsibility, after finishing a successful project, or during your performance review, it's a good idea to ask for a raise.
2. Taking on more responsibilities
Assuming greater duties that fit your interests, abilities, and professional objectives is another method to boost your income at your existing position. Your employer may see this as evidence of your initiative, leadership, and potential, which could result in a bonus or promotion.
You must use caution, though, to avoid burning out or overcommitting. You must keep your management and coworkers informed about your expectations and accomplishments frequently.
3. Acquiring new skills
Picking up new abilities that are in demand in your sector or company is a third strategy to boost your income at your existing position. It may also create new avenues for career progression or salary negotiation.
All of these things might increase your value and competitiveness in the employment market. Online courses, seminars, workshops, books, blogs, and professional networks and communities are all excellent ways to learn new skills.
From other Sources
Another way to increase your income is to make money from other sources besides your current job. This can be done by:
1. Starting a side hustle
Any activity that enables you to make additional money outside of your main employment is considered a side hustle. Anything from tutoring, blogging, podcasting, coaching, consulting, freelancing, and so on can be included. You may follow your passions, diversify your revenue streams, and even grow your side hustle into a full-time business with the advantages of having one.
But you must be reasonable about the amount of time, cash, and work needed to launch and expand a side business. It must be balanced with your personal life and primary employment as well.
2. Selling your unwanted items
Another way to make money from other sources is to sell your unwanted items that are cluttering your home or office. You can sell anything from clothes, books, electronics, furniture, etc., online or offline.
The benefits of selling your unwanted items are that you can declutter your space, simplify your life, and generate some quick cash. However, you need to be careful about the fees, taxes, and scams involved in selling online. You also need to price your items competitively and realistically.
3. Monetizing your hobbies or talents
Making money from your interests or talents is a third option to earn money from extracurricular activities. Everything can be made money, whether it's online or off: games, music, art, crafts, photography, etc.
You may have fun, express yourself artistically, and possibly reach a wide audience or market by making money off of your hobbies or talents. However, you should be mindful of the financial, ethical, and legal ramifications of making money off of your interests or skills. You must continue to produce work that is both unique and of high quality.
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Step 5: Invest Your Money Wisely
One of the most important steps in achieving financial freedom is investing your money wisely. Investing is not just about saving money for the future, but also making it grow and work for you.
Investing can help you reach your long-term goals, such as buying a house, sending your kids to college, or retiring comfortably. But how do you invest your money wisely? Here are some basic tips to help you get started.
Learn the basics of investing
Before you invest your money, you need to understand some basic concepts and terms, such as:
Risk: The possibility of losing some or all of your money in an investment. Generally, the higher the risk, the higher the potential return, and vice versa.
Return: The amount of money you earn or lose from an investment over some time, usually expressed as a percentage of the initial amount invested.
Asset class: A group of investments that have similar characteristics, risks, and returns. The main asset classes are stocks (also called equities), bonds (also called fixed income), and cash (or cash equivalents).
Stocks: Shares of ownership in a company. Stocks can increase or decrease in value depending on the performance and prospects of the company, as well as the supply and demand in the market. Stocks tend to have higher risk and higher returns than bonds or cash over the long term.
Bonds: Loans that you make to a government or a corporation in exchange for a fixed interest rate and a promise to repay the principal amount at a certain date in the future. Bonds can increase or decrease in value depending on the interest rate environment, the credit quality of the issuer, and the maturity date. Bonds tend to have lower risk and lower returns than stocks over the long term.
Cash: Money that you keep in a bank account, a money market fund, or other highly liquid and low-risk investment. Cash can provide stability and safety for your portfolio, but it also has very low returns compared to stocks or bonds over the long term.
Create a diversified portfolio that matches your risk tolerance and time horizon
A portfolio is a collection of investments that you own. To create a portfolio that suits your needs and preferences, you need to consider two factors: your risk tolerance and your time horizon.
Risk tolerance:Â Your ability and willingness to accept fluctuations in the value of your investments. Your risk tolerance depends on your personality, your goals, your income, your expenses, and your financial situation. Generally, you should invest more aggressively if you have a higher risk tolerance, and more conservatively if you have a lower risk tolerance.
Time horizon:Â The amount of time you intend to invest your money before requiring it to achieve a particular objective. Your age, goals, and stage of life all influence how long you want to live. Generally speaking, if you have a longer time horizon, you should invest more aggressively; if not, you should invest more cautiously.
You must distribute your funds among various asset classes, such as stocks, bonds, and cash, to build a diverse portfolio. By dividing your portfolio's total risk among several investments that move at different rates, diversification can assist you in lowering that risk. Bonds, for instance, might rise or remain steady when stocks decline, and vice versa.
There's no magic bullet when it comes to dividing up your money among various asset groups. It is contingent upon your individual risk appetite, time horizon, and predictions regarding inflation and future returns. However, here are some general guidelines that you can use as a starting point:
You can invest more in stocks (up to 80% or more) and less in bonds and cash (20% or less) if you have a lengthy time horizon (more than 10 years) and a high tolerance for risk.
You can allocate your money more evenly between equities and bonds (for example, 50% each) and hold onto some cash (say, 10% or less) if you have a moderate risk tolerance and a medium time horizon (five to ten years).
You can invest more (up to 80%) in bonds and cash and less (up to 20%) in equities if you have a low tolerance for risk and a short time horizon (less than five years).
Invest in low-cost index funds, exchange-traded funds, or robo-advisors
Selecting certain assets that correspond with each asset class is necessary once you've determined how much to invest in each one. Purchases of individual stocks or bonds can be made directly from the market, or funds containing a variety of equities or bonds can be purchased.
Investing in funds enables you to hold a portion of a huge portfolio of securities without having to purchase them one at a time. Mutual funds and exchange-traded funds (ETFs) are the two primary categories of funds.
Mutual funds:Â Funds that are overseen by a qualified fund manager who makes decisions about which securities to purchase and sell for the fund. Either actively or passively managed mutual funds are available. Actively managed funds select securities that they believe will outperform the market in an attempt to beat it. In an attempt to track the market, passively managed funds contain securities that replicate a particular index, like the S&P 500. Typically, mutual funds have greater fees than exchange-traded funds (ETFs) and are purchased and sold through a fund firm or broker.
Exchange-traded funds (ETFs):Â Funds that are exchanged like individual stocks on a stock market. While actively and passively managed ETFs are also options, the majority of them are not. Generally having lower fees than mutual funds, exchange-traded funds (ETFs) are purchased and sold through a broker.
The cost of investing is one of the key elements influencing your investment outcomes. The return increases with decreasing cost. As a result, you ought to search for funds with low expense ratios—that is, funds with annual fees expressed as a proportion of your investment. For instance, you will pay $50 in fees annually if you put $10,000 in a fund with a 0.5% expense ratio.
Because they don't require the fund manager to conduct as much research and trading, passively managed funds typically have lower expense ratios than actively managed funds. Furthermore, because they incur fewer fees and make fewer mistakes than actively managed funds, passively managed funds typically outperform the latter in the long run.
Consequently, investing in inexpensive index funds or exchange-traded funds (ETFs) that mirror a wide market index, like the S&P 500, the Dow Jones Industrial Average, or the MSCI World, is one of the best methods to manage your money. With little risk and expense, these funds can give you exposure to thousands of businesses in various industries and geographical areas while capturing the market's average return.
Using a robo-advisor, an online service that creates and manages your portfolio using algorithms is an additional choice. In addition to automatically investing your money in inexpensive index funds or exchange-traded funds (ETFs), robo-advisors can assist you in selecting a proper asset allocation depending on your time horizon and risk tolerance.
Additionally, they may provide tools that improve the efficiency and profitability of your portfolio, like tax optimization and automatic rebalancing. A small portion of your account balance, usually 0.5% or 0.25%, is what robo-advisors charge as an annual fee.
Avoid chasing returns, timing the market, or paying high fees
Finally, some common mistakes that you should avoid when investing your money wisely are:
Chasing returns: Investing in whatever is hot or trendy at the moment, without considering the fundamentals, risks, or costs of the investment. Chasing returns can lead you to buy high and sell low, which can hurt your long-term returns.
Timing the market: Trying to predict when the market will go up or down and buying or selling accordingly. Timing the market is very difficult, if not impossible, to do consistently and accurately, and it can expose you to unnecessary risk and cost.
Paying high fees: Investing in funds or services that charge high fees without providing commensurate value or performance. Paying high fees can erode your returns over time and reduce your compounding potential.
Instead of making these mistakes, you should follow these principles:
Invest for the long term: Invest in quality investments that have strong fundamentals, reasonable risks, and attractive valuations. Hold them for as long as possible and ignore short-term fluctuations in the market.
Dollar-cost average: Invest a fixed amount of money at regular intervals, regardless of the market conditions. This can help you reduce the impact of volatility and buy more shares when prices are low and fewer shares when prices are high.
Rebalance periodically: Adjust your portfolio allocation from time to time to keep it aligned with your original target. This can help you maintain your desired risk level and take advantage of market movements.
By following these tips, you can invest your money wisely and achieve your financial goals.
Step 6: Save for Retirement
Many people's top life goal is to retire, but getting there calls for diligent saving and planning. Setting aside money for a comfortable retirement is one of the most crucial things you can do. You may pay for your costs, keep up your lifestyle, and enjoy your golden years by setting aside money for retirement.
Utilizing tax-advantaged retirement funds, such as a 401(k), IRA, or Roth IRA, is one of the most popular and efficient strategies for saving for retirement. By lowering your taxable income or avoiding paying taxes on your investment gains, these accounts let you save money for retirement.
What are 401(k), IRA, and Roth IRA?
Employees can contribute a percentage of their pre-tax pay to a designated account through an employer-sponsored retirement plan called a 401(k). In addition, the employer may contribute in part or in full, subject to a cap.
Before being withdrawn in retirement and subject to regular income taxes, the funds in the account grow tax-deferred.
Anybody, regardless of job status, is eligible to open and contribute to an Individual Retirement Account (IRA). IRAs come in two varieties: standard and Roth. Pre-tax contributions to a traditional IRA grow tax-deferred until they are withdrawn in retirement, at which point they are subject to ordinary income tax.
You can make after-tax contributions to a Roth IRA, which grows tax-free and enables tax-free withdrawals when you're retired.
The contribution limits for 401(k) and IRA accounts are set by the IRS every year. For 2023, the limit for 401(k) is $20,500 for employees under 50 years old and $27,000 for those 50 and older. The limit for an IRA is $6,000 for individuals under 50 years old and $7,000 for those 50 and older.
How much should you contribute to your retirement accounts?
Your income, spending, goals, age, risk tolerance, and expected rate of return are just a few of the variables that will determine the answer to this question. For retirement, it's generally recommended to set aside at least 15% of your salary. This covers employer matching as well as any personal contributions you make.
Although saving 15% of your salary might seem overwhelming, over time it can have a significant impact. For illustration, let's say you start saving $7,500, or 15% of your annual income, at age 25, and you make $50,000. You will have almost $1.2 million by the time you are 65 if you put your funds into a diversified portfolio with an average yearly return of 7%.
On the other hand, you will have roughly $540,000 by the time you are 65 if you begin saving 15% of your income at age 35. At age 45, you can start saving 15% of your income, which will provide you almost $240,000 by the time you're 65. Your retirement funds might significantly change if you start saving early and maintain a steady savings rate.
Of course, saving 15% of your income may not be enough or feasible for everyone. Some people may need to save more to achieve their desired retirement lifestyle or to account for inflation and rising healthcare costs. Some people may not be able to save as much due to low income or high debt. In any case, the key is to save as much as you can afford and increase your savings rate whenever possible.
Why should you max out your retirement accounts?
Reaching the maximum contribution limits for your retirement accounts is one of the best strategies to increase your retirement savings. This entails making the annual contribution that the IRS permits. You can lower your tax liability and take advantage of compound interest by doing this.
Assume, for illustration purposes, that you make $100,000 per year and make the maximum contributions to your 401(k) ($20,500) and IRA ($6,000) each year between the ages of 25 and 65. At age 65, you will have almost $6 million if you invest your funds in a diversified portfolio with an average yearly return of 7%.
You will have around $3 million by the time you are 65 if you simply contribute half of the annual maximum ($13,250) to your 401(k) and IRA from the age of 25 to 65. You will have around $1.5 million by the age of 65 if you only contribute a quarter of the maximum amount ($6,625) to your 401(k) and IRA each year from the age of 25 to the age of 65.
As you can see, funding your retirement accounts to the maximum will help you become financially independent and considerably boost your retirement savings. It might not be feasible or essential for everyone to max out their retirement accounts. Other financial goals for some people can be debt repayment, house savings, or supporting their kids' schooling.
Some people may already have enough savings to retire comfortably without maxing out their retirement accounts. In any case, the key is to contribute as much as you can to your retirement accounts and take advantage of the tax benefits and employer matching.
What are the challenges and trends of retirement saving in the US?
For many Americans, saving for retirement is a difficult task. As of 2019, the average retirement savings in the United States were $255,200, according to the Federal Reserve. This average, though, conceals a significant difference between various groups of individuals.
For example, households with heads of household between the ages of 55 and 64 had median retirement savings of about $144,000, well below the recommended amount for a pleasant retirement.
Furthermore, a large number of Americans have no retirement savings at all. The US Census Bureau reports that 47% of persons between the ages of 18 and 64 had neither a pension plan nor any retirement savings. Merely 26% of individuals who do own retirement savings possess $100,000 or more.
The inaccessibility of employer-sponsored retirement plans is a primary contributing factor to the low level of retirement savings in the United States. The Bureau of Labor Statistics reports that just 49% of private sector employees enroll in a retirement plan, and only 55% of workers have access to one at work. Just 22% of part-time employees' employers provide retirement plans, and only 16% of them make use of them.
The US has low retirement savings in part because of a lack of confidence and financial understanding. In a survey conducted by the Employee Benefit Research Institute, only twenty-three percent of workers said they were extremely confident that they would have enough money to live well in retirement. Furthermore, just 42% of employees have attempted to determine how much money they will require for retirement.
To address these challenges, some policymakers and experts have proposed various solutions, such as expanding access to retirement plans for small businesses and gig workers, increasing financial education and guidance for workers, and raising awareness and incentives for saving for retirement.
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Step 7: Set financial goals and track your progress
Identifying what financial freedom means to you and the amount of money required to achieve it is one of the most crucial steps toward obtaining it. Living comfortably without relying on employment or other sources of income is the definition of financial freedom. It provides you with the freedom and choice to follow your interests, passions, and hobbies without having to worry about money.
But how can you figure out how much money is sufficient to become financially independent? Various techniques and equations might assist you in estimating your target figure, contingent upon your presumptions and inclinations.
Here are some of the most popular ones:
1. The 4% rule
This rule is predicated on the notion that you can never run out of money in retirement if you take off 4% of the value of your portfolio annually. The 4% rule is predicated on the idea that your portfolio can tolerate inflation and market swings over time and is composed of 60% equities and 40% bonds.
Just multiply your annual expenses by 25 to use this rule. To retire, for instance, you would need $1 million ($40,000 x 25 = $1 million) if your annual expenses are $40,000. Your FIRE number (Financial Independence Retire Early) is another name for this.
2. The FIRE calculator
An enhanced and adaptable variant of the 4% rule is provided by this calculator. Many variables, such as your age at current, income, spending, savings rate, investment return, inflation rate, retirement age, and retirement expenses, can be entered.
The amount you need to save and invest to achieve your FIRE goal is then calculated, along with the estimated time it will take. To observe how it influences your results, you may also change the withdrawal rate.
3. The net worth formula
The idea of net worth, or the gap between your assets and obligations, is the foundation of this method. All of the valuable possessions you hold, including money, investments, real estate, cars, and so forth, are your assets. All of your debts, including credit card debt, loans, and mortgages, are considered liabilities. Just deduct your liabilities from your assets to apply this calculation.
Your net worth is $300,000 ($500,000 - $200,000 = $300,000) if your assets are $500,000 and your liabilities are $200,000. Your wealth and financial stability are represented by your net worth at any particular time. You must raise your net worth to the point where it permanently meets your yearly expenses if you want to be financially independent.
Following the selection of a technique and computation of your target number, you must periodically evaluate your progress and make necessary adjustments to your plan. Tracking your net worth over time will help you determine how much it increases or decreases based on your debt, investments, savings, income, and expenses.
You can track your net worth each month or every quarter using an app or spreadsheet, and then compare it to your target. Indicators of performance and efficiency include your savings rate, which is the portion of your income that you set aside for savings, and your investment returns, which show the proportion of growth or loss on your assets.
Achieving financial freedom is not easy or quick. It requires discipline, patience, and perseverance. But by setting clear financial goals and tracking your progress, you can make it happen sooner than you think.
Step 8: Live Below Your Means
Living within your means is one of the most crucial personal finance concepts. In order to avoid lifestyle inflation and keep up with the Joneses, you must spend less than you make. You may save more money, pay off debt more quickly, and reach your financial objectives sooner if you live below your means.
But how do you live below your means?Â
Here are some tips to help you adopt a frugal lifestyle that prioritizes value over price and quality over quantity.
1. Automate your savings
Paying yourself first is one of the best ways to live below your means. This entails putting some money aside for savings before you spend it on other things.
This can be automated by utilizing an app that rounds up your purchases and deposits the difference to your savings account, or by setting up a direct deposit from your paycheck to your savings account. You will save money in this method without even realizing it.
2. Shop around for the best deals
Another way to live below your means is to shop smartly and compare prices before you buy anything. You can use online tools, apps, or coupons to find the best deals on groceries, utilities, insurance, entertainment, and more. You can also use cashback sites or credit cards that offer reward points to get some money back on your purchases.
3. Find joy in simple pleasures and experiences rather than material possessions
Living below your means does not have to equate to a life without joy or happiness. It entails finding fulfillment in the pursuits that enrich your life and hold the greatest significance for you. Invest money in experiences that will enhance your life and leave enduring memories, rather than items that you don't need or that will eventually lose worth.
You may, for instance, volunteer for a cause, spend time with your loved ones, acquire a new skill, or follow a hobby or interest.
Living below your means benefits both your health and your pocketbook. You can attain financial freedom, improve happiness, and lessen stress by using these suggestions.
Step 9: Increase your financial literacy
Increasing your financial literacy is one of the most crucial elements to becoming financially independent. Financial principles like budgeting, saving, investing, managing debt, and retirement planning are all part of financial literacy.
You may accomplish your financial goals more quickly, avoid costly errors, and make wise financial decisions. All with the aid of financial literacy.
But how may one improve their knowledge of finance? Read books, blogs, podcasts, or videos that show you how to handle your money wisely and accumulate wealth more quickly are just a few of the numerous resources available to you for financial education.
You can also learn from experts, mentors, or peers who have achieved financial freedom and follow their advice. However, you should also be careful to avoid scams, myths, or misinformation that can derail your financial journey.
Here are some tips on how to increase your financial literacy effectively:
Read books that cover the basics of personal finance, such as The Total Money Makeover by Dave Ramsey, The Richest Man in Babylon by George S. Clason, or Rich Dad Poor Dad by Robert Kiyosaki. These books will teach you the fundamental principles of money management, such as how to pay off debt, save for emergencies, invest for the future, and build wealth.
Follow blogs that offer practical and actionable advice on personal finance, such as The Simple Dollar, Money Under 30, or Mr. Money Mustache. These blogs will show you how to apply the financial concepts you learned from books to your own situation, such as how to create a budget, reduce expenses, increase income, or optimize taxes.
Listen to podcasts that interview successful people who have achieved financial freedom, such as The Tim Ferriss Show, The Dave Ramsey Show, or ChooseFI. These podcasts will inspire you to learn from the experiences and strategies of others who have overcome financial challenges and reached their financial goals.
Watch videos that explain complex or advanced topics in finance, such as Khan Academy, Investopedia, or Graham Stephan. These videos will help you understand and master topics such as compound interest, asset allocation, diversification, risk management, and passive income.
Learn from experts, mentors, or peers who have achieved financial freedom and follow their advice. You can find them online through platforms such as YouTube, Udemy, Coursera, or Skillshare. You can also find them offline through events such as seminars, workshops, or meetups. You can ask them questions, seek feedback, or join their communities.
Avoid scams, myths, or misinformation that can derail your financial journey. You can do this by doing your own research, verifying the sources and credentials of the information providers, comparing different opinions and perspectives, and using common sense and logic. You should also be wary of any promises or guarantees that sound too good to be true.
By increasing your financial literacy through these methods, you will be able to make better decisions with your money and achieve financial freedom faster.
Bonus Step: Enjoy Your Financial Freedom
The ability to utilize your money to follow your aspirations, passions, or hobbies is one of the most fulfilling parts of financial freedom. You are in control of your life and can choose to pursue your goals of seeing the globe, launching a business, helping others, or retiring early.
Savoring your financial freedom is the added benefit of achieving financial freedom. Celebrate your success and give yourself a gift for your diligence and self-control once you have attained your financial objectives. You are entitled to the satisfaction of your hard work and the freedom to live your life as you see fit.
But that doesn't imply you should stop practicing prudent money management when you're enjoying your financial freedom. Spending control, net worth tracking, investment monitoring, and plan adjustments are still necessary. Inflation, taxes, legal action, and other dangers must all be avoided when managing your wealth.
FAQ
Saving is putting money aside for future use, usually in a low-risk and low-return account such as a savings account or a certificate of deposit. Investing is allocating money to an asset that has the potential to generate higher returns over time, such as stocks, bonds, real estate, or a business. Saving is important for building an emergency fund and meeting short-term goals, while investing is essential for growing your wealth and achieving long-term goals.
High-interest debt is any debt that charges an annual percentage rate (APR) higher than the average return of your investments. For example, if your investments earn an average of 8% per year, any debt that charges more than 8% APR is considered high-interest debt. Some common examples of high-interest debt are credit cards, payday loans, personal loans, and car loans.
There are several ways to increase one's income without working more hours or getting a second job, such asÂ
- Asking for a raise or a promotion at their current jobÂ
- Negotiating a better salary or benefits package when switching jobsÂ
- Developing a valuable skill or certification that can boost their marketability and earning potentialÂ
- Creating a passive income stream from an online business, a blog, a podcast, a book, a course, or a productÂ
- Renting out a spare room, a parking space, or a storage unitÂ
- Selling unwanted items, unused gift cards, or unused subscriptionsÂ
- Participating in online surveys, focus groups, or product testingÂ
- Doing freelance work, consulting, or coaching in their area of expertise
