Pay Yourself First? No, Pay Yourself Last.

Today’s insightful guest post comes to you courtesy of a financially independent physician who has had a blog longer than WCI and I combined.

Dating back to 2007, wealthydoc.com has been sharing wisdom in numerous areas including investments, financial planning, careers, and he has written a number of pertinent book reviews for the FIRE minded physician.

Check out his counterintuitive advice below, check out his site, and look for him on Twitter with the handle @Wealthy_Doc.


 

Pay Yourself First? No, Pay Yourself Last.

 

If you have been reading about personal finance at all you likely came across the phrase, “Pay yourself first.” I’m not sure who originated it. Some quote Robert Kiyosaki, but he didn’t originate it twenty years ago. He may have popularized it for today’s younger readers. I first read the phrase in George S. Clason’s The Richest Man in Babylon which was written in 1926. Even he may not have originated it, but he at least popularized it in his day.

The idea of pay yourself first is to automate your savings.

Normally, people pay all their bills after their paycheck comes in. Then they pay for the fun stuff they want. There is no “left over” or “excess” funds that can then go to a retirement account or for long term savings. This results in a low or negative savings rate across America.

You have nothing left over for yourself. You toil and strain to bring home a paycheck and then don’t keep any for yourself. To avoid this, these authors recommend you pay yourself first. Namely, have 10% of every paycheck automatically, electronically sent to a separate account for the purposes of savings or investments. That is an easier and more reliable method than just sending whatever is left over at the end of the month. You may find there is no money at the end of the month.

The 10% that is recommended in The Richest Man in Babylon is more than the average American saves. Following that advice would therefore improve one’s financial status. Nevertheless 10% is likely a bare minimum. It may lead to a subsistence level retirement after 40 years of work. Better than nothing – but not ideal. Wouldn’t you agree?

 

Pay Yourself More?

 

So maybe the method is fine, but the amount is too low? Dave Ramsey recommends you invest 15%. Many millionaires in Tom Stanley’s The Millionaire Next Door were “20% savers.” Some physician bloggers (e.g. Jim Dahle of the White Coat Investor) also recommend saving 20%. Others (Physician on Fire) challenge us to save 50%. The rate is within our control and is the surest way to shorten the time to FI (financial independence) or being financially able to retire.

So, what did I do? I never had a fixed savings percentage! For most of my career, I did indeed pay myself first. I had the maximum amounts automatically prorated and diverted from each paycheck into my various retirement accounts (IRA, 401K, 457, etc.).

At some point, I realized I needed to boost my savings and contribute to a taxable account. As my income grew and my student loans were paid off, I found it easy to divert more money into my taxable accounts. Also, any bonus money, dividends, or other investment payoffs went into investment accounts. This method worked well for us without needing to obsess over a budget, allowances, etc….

Since I reinvested all investment income and had no debt after the first few years, saving became effortless. I never felt deprived. Looking back, I averaged a savings rate of about 38% of gross income and achieved FI (Financial Independence) after fifteen years at the age of 46.

 

What it Means to Pay Yourself Last

 

What I do now though is different and better. I wish I had thought of it sooner. Better late than never. I recommend it to you.

I’m calling it the “Pay Yourself Last” method. As far as I know, I invented the term. I’m sure other people have done it, though.

Let’s say I’m setting up my electronic transfers for direct deposits from my employer. To put some hypothetical numbers on this:

Suppose I’m pulling in $240,000 per year. Currently, that is on the high end for primary care and near the low end for specialists.

That’s $20,000 per month. Given that the median family income is currently just over $50,000 per year (about $4,500 per month), that $20,000 is a lot of moola.

How much should I save? 10%, 15%, 20%, 50? Whose advice should I take? What if my income goes up or down a lot? What if I get a big bonus that I don’t need? Do I still take out the same percentage on that?

These are the kind of logistics I ran into a lot with the pay yourself first method. I was never quite sure I was making all the right choices.

Also, when I did get paid a bonus, it would get direct deposited to the same account just like a regular paycheck. I then needed to act – to write a check to move the money out. I was paying myself first, but it was anything but automatic. There is a lot of temptation to spend that money, although we have been good about not doing that. Still, I have wondered if there was a better system.

Now I approach it differently. I decide my own “paycheck.” That is what gets transferred to my checking account. All the rest goes for savings and investing. My “paycheck” in my checking account is for my routine expenses and short term wants. I also have some money sent to a “savings” account for periodic expenses like property taxes, vacations, disability insurance, etc… that might otherwise throw off our monthly amounts in checking or cause an overdraft.

 

The Benefits of Paying Yourself Last

 

I decide I need to “earn” a gross income of about $10,000 per month. That is more than twice the median income so we won’t be scraping by on a subsistence living. On the other hand, I won’t be tempted to waste tens of thousands of dollars on things that won’t increase my happiness.

 

pontoon with slide

would that slide make me happier?

 

That mindset creates a false scarcity that prevents me from spending everything. After taxes, I would then take home about $7,000 per month. If I’m paid every two weeks that would mean $3,000 goes into checking for routine expenses and splurges. Another $500 per pay goes to “savings” for periodic expenses. That way I have a steady, predictable income that is comfortable. All the rest goes into investment accounts.

The percentage savings may vary depending on my salary, productivity, contract, incentives, tax rates, etc… Those factors seem to be in constant flux. My income is smooth though. Also, if I get a raise, there is no temptation to spend that extra money since I never see it.

This “Pay Yourself Last” method works great for me, and I think it would help others. You don’t have to spend time budgeting and making decisions all the time about how much to invest. It also helps protect from one of the biggest dangers: Lifestyle Creep (hedonic treadmill).

Now that I have been FI for several years, my income has grown. My spending has not increased, so my gross savings rate has slowly creeped up over 40% without me doing anything differently. I love how the increased savings requires no action on my part.

I just wish I had thought of this sooner. I ended up fine financially, but my other approaches were more of a struggle until I made the switch.

 


You’re still not using Personal Capital? Track all your accounts in one place like I do.


 

[PoF – I suppose I’ve been doing some combination of paying myself first and last over the years. I frontload my retirement accounts early in the year, and make a taxable account investment at the beginning of each month, being sure to leave at least a month’s worth of expenses in our checking account.

So I leave a paycheck of sorts in our account each month, and the extra money that is accrued over the course of the month typically lands in our taxable account at the beginning of the next month. I’m not sure if that’s paying myself first, last, or both, but it seems to be working quite well.

The key benefit of paying yourself last is that you essentially limit your spending without budgeting in a strict sense. Pretend the “extra money” doesn’t exist and redirect it to accounts that will benefit you in the future. Makes good sense to me.]

 

What do you think? Do you have a fixed savings rate? What savings rate would you recommend to a new doctor starting out? Do you pay yourself first? Or last?

 

 

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49 comments

  • NH

    I have been doing the “pay yourself last” approach as well. As a recent residency graduate I put aside $4000 for monthly spending- a bit of an increase from residency salary. The rest is shunted to taxes (about 32% as I’m in CA) and then to max out retirement accounts, and then taxable savings (most to cash savings account as looking to save for a house with its extra expenses and overall lifestyle increase in the next 1-2 years). This leads to a net savings rate of about 75%. This will likely drop to 65-70% once I buy a house and then down to 50% or so once kids come into the picture. Still not sure when the right time will be to cut back on savings and work less…

    • NH,
      Living on 4K per month in CA is a pretty frugal budget. Congratulations on not being wasteful.
      Saving 50-75% is incredible too. You are on a great path for sure. You could easily reach FI within 10-15 years at this rate. When to cut back is a personal choice. I cut back when I reached FI. You would likely be safe to do so before then though if you want with such a high savings rate.

  • Rather than shooting for a percentage of gross income, I aim to hit a relatively conservative total savings number each year. I do this for psychological purposes: once I hit that number, I have achieved some level of success, and anything I save above and beyond (which I always do) is gravy.

    • Dr. Curious,
      I like your approach. I too avoid percentages. I set my fixed target amount on the spending rather than the savings. You are ending up at a similar place though. Congratulations on exceeding your own savings targets.

  • I’m also on the “pay yourself last” bandwagon, which I call “choose your income”. I give myself a fixed amount every month and rarely offer myself raises, except when certain circumstances come up (like when I got married and took on more of the household expenses so we could up my wife’s contributions to retirement accounts).

  • This is a great idea! And a bit like the doctor you just profiled who writes his wife a check for $70K at the beginning of the year for their household expenses. A great way to budget without following a strict budget, like you said in your closing comments.

    • Laurie,
      Yes, it is similar. Can you imagine if he did the traditional “save 10%” or “save 20%?” He would end up wasting a lot of money that he could have invested. It is better for him – and me – to set the spending and then invest all the rest no matter what that is. Glad you liked the post and idea.

  • hatton1

    Since I spent most of my career with no salary as a solo practice doc I paid myself what was left over. Once money got “invested” it really did not exist as far as spending was concerned. I think this is what wealthy doc is talking about with a scarcity mentality. As you vacuum up the excess and invest it you feel like you don’t have much money because it is invested so you do not buy something stupid.

    • Yes, hatton1
      The logistics are a little different for those not on salary but the concept is the same. Some of it is what works easiest as far as simple money transactions. Some of it is just making ‘doing the right thing’ (investing) made easy. The default is to investments.
      Also -as you point out- there is some psychology here. I didn’t go into that in the post but we benefit from a false scarcity. I’m more likely to bargain for deals, etc. since money seems a little more scarce than it really is. That in turn leads to less spending. Good point. Thanks for the comment.

  • My goal is to maintain low expenses so I can save and invest as much as possible. Not sure what my savings rate was right after college. Last month I saved 53% of my gross income which includes maxing out 401K, contributing to IRA and taxable accounts.

    • Lance,
      Thanks for the comment. Avoiding lifestyle creep is a lot of this for sure. It sounds like you are doing an incredible job though. 53% of gross is amazing. Even the PoF save half challenge is based on NET which is more like 35% gross. Your savings rate is higher than mine. If you keep that up you will be FI SOON.

  • I still do a juggling act. I take the money that comes in at the beginning of the year and contribute to our backdoor Roth IRAs and my son’s 529. I pay into the 401k monthly. Then there is the money that is left over.

    Since I am not debt free, I have been accumulating it in chunks, say $10 to 20k and then deciding how to allocate it. Do I pay down debt or put it in a taxable investment account. For now I have mainly been paying down debt.

    I look forward to paying myself first, last and in between as the years go by. 48 is my early retirement day (and that is with going down to part time at age 41) but we will see what happens.

    • We tired of the juggling so just pay out the Backdoor roth and 529 right away in the new year. Yeah no dollar cost averaging, but you do get the full 12 months of tax free growth for both accounts.

    • Dads Dollars Debts,
      Sounds like an awesome plan to me. I think there are many ways this can be done. You have the right components in place. Living below your means. Exploiting tax-sheltered opportunities. Saving for kid’s college. Paying down debt. Plan to cut back at work when it makes sense. Beautiful! Keep on juggling!

  • Great read! I guess the first/last depends on the definition of what “pay” means! Payments to 401k first, payment of the golf club membership last (or not at all!). Have a great Thursday everybody!!!

  • Mike

    I think the best way is “give every dollar a job”

    Decide how you will spend each dollar and then stick to your budget. Couple that with a robust “rainy day fund” to handle unexpected expenses and it’s easy to save a ton because you decided to save a ton.

    • I don’t disagree with you Mike.
      In theory, budgeting is best. For me and my wife – we just have never done that. I’m not sure if it is our time constraints or our personalities, but we just don’t. I know that as long as I force the “salary” to be a relatively low level and as long as we don’t overspend and start bouncing checks – we will get there. I admit it is a bit lazy and sloppy. It did work to get us to FI within a reasonable time frame though.

  • Ginzu

    The invention of the term, then explained by a definition, “Pay Yourself Last” has served you well PoF. The years of paying yourself first certainly allowed FI and the discipline of mandatory savings rates could easily carry over to an apparent reversal of pay first to pay last. Being simple, because simple works even in times of stress, treating savings and investments as an “expense” keeps me in line with your teachings. No leftover dollars, because each dollar in my employ has a function.
    Thanks for the read PoF, great topic!

    • Ginzu,
      It sounds like you are on the right track. Indeed simple is best. We have always been good savers. Changing the direct deposit instructions from invest X amount each month and deposit the rest to spend in my checking account to send X amount to checking for spending and the rest to investing has really boosted my savings rate. More importantly it is simpler and requires no adjustments during the year when tax rates change or a bonus is paid or I paid all I need to into social security for the year or the 401K is maxed out etc.
      p.s. The way I read your comment it seems like you thought PoF wrote the post? This was a guest post. If that is the case, I take it as a tremendous compliment to be mistaken for PoF. He is a wonderful writer.

  • Like Pof, we have a combination of techniques. Our 401ks (both maxed out for this year), HSA, mega backdoor Roth are all fixed paycheck deductions, and so I guess for those savings we pay ourselves first. For everything else (taxable, backdoor Roths) the money from both our paychecks, bonuses, RSU and ESPP sales etc. flows into a single account and I manually move the surplus into various investment vehicles every month based on our the asset allocation we try to maintain. We have a fixed balance that we try to start each month with, everything over that gets invested – unless we are planning for a big expense (e.g. a planned house repair). I guess this is similar to what the good doctor suggests in this article, except we don’t have a separate account for the amount we’re paying ourselves – the division exists only in our minds.

    • Mrs. BITA
      Thanks for the comment. Yes, it does sound similar. It sounds like it is working well for you, so stick with your system. For us, we need to keep investment money out of our checking account to begin with. Whatever I put in there eventually gets spent and disappears. We aren’t big spenders, but still it is easy for us to blow through whatever money we have. This system protects us from our spending selves.

  • I sort of do a version of this – but my work is contract and my income fluctuates like crazy depending on what month it is. The only way I can feel at all stable with my finances is to keep my expenses as consistently low as I can.

    I also think a lot of people who want to “pay themselves first” skip over the part that you say: “The idea of pay yourself first is to automate your savings.”

    Instead, savings is on the back burner, and frivolous fun is at the forefront. Which isn’t to say that people don’t need a break and some reward every once in a while, but the mentality is skewed in a “I deserve to spend this money wherever I want before dealing with debt and loans and savings and rent” instead of: “This money is meant for savings and I can play with whatever’s left over”.

    • Ms. Raggedly,
      I agree. A lot of this is establishing good habits and some of this is the psychology involved. If the investment money never goes into my checking account I never see it or could spend it. I also don’t need to act and transfer it out into an investment account – it is already invested without me doing anything.

  • I like your idea of paying yourself a paycheck. Right now we’re making a lot of money but I will be cutting back soon thanks to pending FI. My pay will go down and I like your method of determining how much I need and then investing the rest. Since we don’t need to invest much, the invested amount is variable which is all lagniappe anyway. However, our monthly “pay” reminds steady despite our monthly take home pay varying. Very cool. We’ve thought of this before and did come up with 10K post tax for expenses. We are debt free and own our house so that 10K is probably on the high side. So we’ll live it up for a while then probably down adjust later.

    • aGoodLifeMD,
      Congratulations on your success and impending FI. I am cutting back too. Since we are used to the same “paycheck” coming in every two weeks we didn’t have any reduction of spending or QOL when I recently dropped back on my workload. I could cut back A LOT more before anything changes with this system in place. In the mean time we add heavily to our investments every two weeks without me having to execute any transactions. I recently took a 3 week vacation and the direct deposit transactions all took place while I was floating on lake!

      • My pay is strictly production based and can vary greatly especially if I take time off. I’ve thought about your automation method but am reluctant because of this. Have you ever tried to automate a deposit to your brokerage, 529, IRA or whatever and not had the funds in the account? Does it just not go through or is there a penalty like the old NSF checks i used to accidentally write in college before debit cards became popular?

        • aGoodLifeMD
          My pay varied a lot too. Especially as the year went on and the 401K was maxed out and social security was paid. My take home check would then get bigger and I would have to transfer that money into an investment account. Fortunately I usually (but not always) had the discipline to do that but it was a bit of a pain. Now I just have more being invested later in the year without me doing anything.
          I think this works for me since although my pay varies it is always more than the fixed “paycheck” of 7-8K per month. This would not work as well if yours dips below your set income level. Hmmm you may have to modify it somehow.
          As far as the other accounts. I preloaded the 529 accounts when the kids got a Soc Sec #. I think there is 150K or so in each kid’s 529. Each Jan I add the minimum to get our state’s tax credit but I don’t think I will add much more. Each Jan I also write the Roth IRA’s from other investment income. This is what works well for me and may for others – but not for everyone.

  • Right on! We take the same approach with our businesses. Paying yourself last means to me that you’re covering the important stuff first – debt repayment chiefly among them.
    As for a savings rate, we’re at 70% this year and aiming for 75% next.

  • We also follow a similar approach. Our salaries are consistent and so are our expenses. At the end of the month, we just need a fixed ammont to pay our expenses and balance on our points card. Those bills are paid after our various investment accounts are funded. The rest is for spending on wants.

    • Congratulations, Dave.
      It sounds like you have a system in place that forces you to live below your means. You are in a successful minority. Keep up the great work.

  • Ann

    My husband and I do a similar approach to PoF–invest on the front end and also on the back end. We don’t budget or give ourselves a monthly spending limit, but we do track how much we spent each month after the month is over, and it stays pretty steady, well under 25% of our gross income. Of the rest, what doesn’t go to taxes gets invested. It helps that we really aren’t interested in buying too much outside of food and travel.

    • Wow! Incredible savings rate. Ann that is amazing. It sounds like your system is pretty easy to carry out for you guys but is launching you to FI success. Thanks for sharing.

  • EnjoyIt

    Our strategy has always been to maximize all tax deferred accounts, spend whatever we want which is actually pretty frugal and invest the rest in taxable whenever the checking account gets to big. This strategy has us saving over 50% every year. In under 1 decade we are about 80% of the way to FI based on our average spending over the last 4 years.

    This strategy works for us because we tend to be relatively frugal.

    • EnjoyIt
      I would say your method works for sure! When my checking account balance tends to get too big, we spend it. You guys sound more disciplined though. As the terrible saying goes, “there is more than one way to skin a cat.” Ugh. I love my cat. Anyways, as PoF and MMM have demonstrated a 50% savings rate brings you to FI well before the average retirement age. Congratulations. I’m seeing a trend that being “naturally frugal” seems to be a key. I hope to teach my kids that – if it is something that can be taught?

    • EnjoyIt
      I would say your method works for sure! When my checking account balance tends to get too big, we spend it. You guys sound more disciplined though. As the terrible saying goes, “there is more than one way to skin a cat.” Ugh. I love my cat. Anyways, as PoF and MMM have demonstrated a 50% savings rate brings you to FI well before the average retirement age. Congratulations. I’m seeing a trend that being “naturally frugal” seems to be a key. I hope to teach my kids that – if it is something that can be taught?

  • I really like the thinking behind this. Taking an approach like this forces us to think more about what our needs are than assigning an arbitrary rate.

    We’re in the midst of a mini-retirement now and I’ve been thinking a lot about what our future income might look like. Without income, savings rate isn’t much of a question, so I’m getting a chance to test the waters on what our real income needs are.

    Taking our budget and adding back in for taxes give me a *much* lower number for my needed replacement income once our min-retirement is over. This gives me a lot of options – either taking a lower-paying job if I find it more interesting or enjoyable, or ending up with a really high savings rate if I return anywhere close to my prior income.

    Thanks for sharing this great concept!

  • I love this – flipping everything on its head just makes sense when you think about it.

    We’re banking an entire income right now so we’re kind of doing the same thing. We still have some wiggle room though, and so we could be doing a better job. 🙂

    Still, our savings rate will turn out to be something around 40% of our net pay I think with this strategy. As our incomes grow, we’re making an effort to not inflate our spending, so this should just increase over time.

  • Dave,
    Glad you liked it. It sounds like what you are doing is working for you – as revealed by your high savings rate.
    There is another benefit that I didn’t mention and that is predictability. Previously I would tell my wife “I’m getting paid next Friday.” I then would look at my direct deposit check to see how much and record that in the check book. Then I wrote a check to transfer some variable amount to the mutual fund investment account. Now I know exactly what my paycheck is since it is fixed no matter what. It is predictable and easy as well as effective. Thanks for the comment and sharing your info.

  • Reminds me of post about how budgets are for rookies. You’re clearly no rookie, and clearly have no need of a classic budget to control your spending.

    https://www.whitecoatinvestor.com/budgets-are-for-rookies/

    • Thanks. That is reassuring to hear that from you. Every time I read about budgeting I start feeling bad that I’m missing out on some opportunity. I’m pleased to hear that you and MMM and other smart folks don’t obsess over it as long as you meet your other financial goals.

  • This is a great method if you’re month to month salary is in flux! I never really thought about it that way. Though it seems if you make a fixed salary, pay yourself first and pay yourself last are the same if you decide the amount that automatically gets transferred into checking is your true take home/completely available for spending.

    It did still take me a while to just decide x% into checking is the absolute amount I need every month. I was doing the transfer from checking to savings to investment accounts thing for a long while! I like to also call it pay your future self first 🙂 I find it cool there are so many subtle differences in the way we think about this topic but that one 2mm shift can really change our behavior!

    • You have great insight, Jing. Even a “2 mm shift” has great effects.

      I am on a “fixed salary” but it is amazing how much things still do change. My gross income is fairly stable. The net can vary more though. I may get a small raise or rate change now and then. Health insurance premiums tend to go up each year. Some other benefit costs go down. I may change my life insurance choices year to year. There is a bonus once a year. Sometimes payroll messes up and they make a correction with back pay in a lump sum. Then when I reach the max for my 457, 401K, or Roth 401K my take home increases. Also, reaching the maximum you can pay into social security happens early in the year for me. Normally I would get a big unnecessarily increase in my take home pay after that. Now my paycheck is steady as a rock and I’m investing more than ever and using dollar cost averaging effortlessly. It works great for me.

  • Swantje B.

    Once a month–right after my salary is credited to my checking account–I look at the balance and invest everything that’s more than “x”. I do this in a way that at the start of each month I have the same amount “y” as my budget/allowance/whatever you may call it to freely spend.

    What’s the difference between “x” and “y”?

    All fixed expenses for the upcoming month are “x”. So, “x” consists of the monthly recurring expenses such as rent, netflix, monthly subscriptions and the like on the one hand, and expenses that come in other intervals (e.g. annual/biannual/once per quarter) and are due in the following month on the other hand.

    “y” is a number that I know from experience is enough to keep up my (fairly modest) lifestyle with rather little leeway, and it’s the same every month.

    There are, obviously, some prerequisites for this to work: You need to thoroughly know your fixed expenses so you don’t get caught by surprise, and you need to keep track of your current spending to know your remaining budget at any given moment. (I found a way that’s really simple, low-tech, low effort. I can elaborate more if anyone is interested, but this comment is getting quite long already.)

    Remaining questions:
    What happens when the balance of the checking account after receiving the fresh salary is still less than the sum of “x” and “y”? What happens when unexpected or off-the-regular-expenditures such as vacationing arise?

    For this I have a separate money market account from which I can quickly transfer money to my checking account if the need arises. Think of this as a kind of surge tank for my liquidity. The MMA is usually fixed to a balance of “z” and undisturbed most of the time. “z”, by the way, is set to about 1/3 of annualized total expenses. Of course, accessing the MMA requires a conscious decision and thus is a separate trigger to rethink the necessity of the expense in question, or to rethink if the “y” budget needs to be readjusted–if the dips into the MMA become necessary more frequently.

    And, naturally, if I accessed the MMA, first thing next month (after salary) is to reset the balance to “z”.

    This setup keeps me from overspending, keeps lifestyle inflation at bay, stops those seemingly innocent small expenses from eating away the money unnoticed, while at the same time giving me the peace of mind that knowing your expenses are covered provides. And usually it shovels a substantial chunk of my income right into the investment account, where it stays. For FIRE.

    • A similar system to the author’s “pay yourself last” method. It sounds like you are well on your way to FIRE.

      Since I started tracking expenses nearly two years ago, I have found our expenses slowly decreasing. It wasn’t part of the plan, but I think the main reason is we have realized we already have more stuff than we need. Too much, in fact.

      Cheers!
      -PoF

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