The 10/20/70 rule is the golden rule to start building wealth. This strategy taken from the book Richest Man in Babylon by George Clason is one of the foundations of our wealth management firm. The rule is a general guideline of how much to spend and save your take home pay as percentages of your income. We use percentages because it takes into account the chance that your income will fluctuate, hopefully increasing over time. As your income goes up, so does your savings and not just your lifestyle spending.
The very first step to this is to make sure to get any of the free money (if there is any) from your company retirement plan. Companies will often have a matching 401(k) plan or other retirement plan. In order to get the match you need to put a percentage of your gross income into the plan. We recommend that you start by contributing enough to get the full matching amount. If you don't, you are leaving a major benefit of your job on the table and ultimately lose it.
After contributing to get the full match in your company sponsored retirement plan, we recommend that you allocate your take home pay among these three categories:
10% - Savings
PAY YOURSELF FIRST! - One of the most important rules to building wealth. You must, at a minimum, take 10% of your take home income and save it for your future.
For those who have made the commitment to build wealth, start the journey towards financial independence by saving to fund 3 months of their absolutely necessary bills in a savings account. The emergency fund is one of the most important financial tools to protect your future and reduce any use of consumer debt. The emergency fund will become necessary when unforeseeable circumstances arise such as a job loss, injury, or health issues.
The next step, after having a 3 month emergency savings, is to take 1/2 of your 10% take home savings and continue to fund your emergency savings until you have enough to cover 6 months of your monthly bills. The other 1/2 you should dedicate towards funding either an IRA or a Roth IRA. For the most part, we prefer using the Roth IRA due to it's flexibility and tax free draws in retirement; however, we recognize that it depends on your personal financial situation. Once your emergency savings has enough to cover 6 months of your expenses, we then advise that you put all of your savings towards the appropriate retirement account for you until you have maxed it out.
Lastly, for those who have the earning power to fully fund their emergency savings and max our their IRAs or Roth IRAs, the next step is to see if your company has the Mega-backdoor Roth conversion available, If so, we recommend that you work to maximize this great benefit. If it is not available, then we recommend that you start your journey on building additional streams of passive income whether it is through real estate, dividend paying stocks or funds, or other interest paying investments.
The journey to building wealth begins with the commitment to do so, as well as implementing the plan over time. For most of us, it is a grind and won't happen in a short period of time. However, we can attest that, for those who work their plan and look back 5 or 10 years later, you will see there wealth truly growing with compound interest working in their favor.
20% - Consumer Debt
Debt can be a drag on your savings, especially bad debt. It is an absolute wealth killer. There is a reason why banks have big buildings and we have small houses. They are taking your future cash flow by making credit easy, and if you end up paying only the minimum payments, your purchases could cost you 40%, 50%, 100% more or even worse. For instance, if you borrowed $18,000 on a credit card paying 17% interest and made the minimum payments over 10 years, you would end up spending more than $20,000 on interest alone. It will take you think next time if you really want to buy that lunch on credit.
Not all debt is equal. There is bad debt, usually to buy stuff or depreciating (losing value) items, think of a car, boat or that big screen television. There is also good debt to pay for appreciating (gaining value) assets like real estate or for education or credentials that will help you earn more over time. You should pay down high interest bad debt first. Examples of high interest debt include credit card debt, personal loans, and car loans.
Sometimes, it is better to focus on paying your consumer debt down before beginning to save money above a basic emergency savings. If you are paying off a credit card that is charging you 18%, you have assured yourself that savings on your money. There are numerous strategies to pay off your debt, but the key is to free up cash flow. A good strategy is to attack some of the smaller balance cards first, while paying the minimums on the larger ones. This will free up
After you are consumer debt free, the next step is to create a future purchase savings account. This is an account to help you avoid some or all future bad debt. Clearly the more cash you have for these purchases the less you will pay for it overall by eliminating the interest expense. You also may have more bargaining power on large purchases by using cash rather than being reliant on debt.
Avoid being the person who is all flash and no cash by getting out of bad debt and building wealth for your future.
70% - Living Expenses
Your expenses should take up no more than 70% of your monthly income. These expenses may include housing (mortgage or rent), transportation, utilities, and any recurring bills you find yourself paying every month.
Budget. Being aware of what you are spending money on can help control your habits. Track your spending for a month to see what they are. Be thorough! You must categorize each expense and know what each dollar was used for. A spreadsheet or financial software can make this easier. Don't forget those random bills that may not be monthly, like car and home owner's insurance.
What if I'm using more than 70%? If you can’t get your budget to fit this rule, you’re spending too much money. Most people think they need a raise in order to begin saving but the reality is that it is easier to cut expenses. There’s no way to sugarcoat it.
The good news is that with a budget, you can see what the excess expenditures are. Break down your expenses into wants and needs. For everything that is unnecessary, find ways to eliminate or set limitations for it. If you find that you are living outside your means, it may be time to come to the difficult decision of downsizing your house or car.
Follow the Rules!
This rule is simple to understand, but hard to follow. If you are serious, please consider the details of each of your spending categories as it takes focus and organization to manage. It takes determination to stick to a script when spending money but by doing so, you can achieve your personal financial goals and build wealth.