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.
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.
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:
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.
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.
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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.
[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?