Bloodletting. Starving. Sensory deprivation. Crying alone outside with your nose pressed to the window as you watch all your friends happily dive into a warm vat of chocolate-covered caviar. These are all ways to think about saving. Personally, I like to think of it as forgoing some immediate gratification in order to gather your own ever-expanding army of tireless, dollar size laborers.
The other day I was wandering through the various personal finance blogs/books/podcast/magazines that I regularly read, and I came across the same sentence written by two different authors. On the second reading it struck me as a one of those truths that people who have been educated in the ways of money intrinsically understand, whereas people who haven’t been educated, may not have fully grasped. While taking classes in finance I would come across these realizations all the time. Sitting in class with a bunch of suit-wearing, financial professionals, I’d suddenly want to scream “Wait a minute, why didn’t anybody tell me sales tax is totally regressive!” while my classmates just sat passively confirming what they already knew.
This recent realization came after reading the sentence, “Your money can work harder than you can,” twice in the same day. As it settled into my mind, I fantasized about an industrious, hardworking assistant who never tired, and labored endlessly doing my work for me — like the unstoppable, single-minded, bucket-toting broom in the Mickey Mouse version of the Sorcerer’s Apprentice. I smiled as I clearly envisioned an upright, quick-striding dollar bill pouring load after load of gold bullion into my already overflowing bank account. This may sound ridiculous, but it’s what the suit-wearing, regressive-tax-understanding, financially-savvy people out there already know to be true — money, when set aside, can do the work for you.
My goal with this post is to get you excited about saving, which is at the center of the second point in my 5 Sm*artly strategies to smooth out a fluctuating income. Having a savings reserve will not only even out the ups and downs of an artist’s fluctuating income, it will insulate you from the inevitable catastrophes that await everyone — So please join me for a little ra, ra feel-good, cheerleading for saving!
Many of us are stuck in a cycle of working for every dollar that we have — but just imagine if you set a few of those dollars aside and let them do the work for you. Maybe you stack 10 of them together in an S&P 500 index fund, and at the end of a year they’ve made an 11th dollar for you — how profound would that be? A dollar you didn’t have to sweat over, a dollar you didn’t have to think about, a dollar that just magically appeared because your other dollars made it?!
How do you get these magical, hardworking dollars that make more dollars? A regular humdrum dollar turns into a magic money-making dollar with one simple change: you have to save it.
Stick with me for a short mental exercise. Think about the process you go through to make money. Say you’ve created a piece of art and sold it, and as a result you’re paid some money. Out of that money, you pluck a single dollar that you’re considering spending. What is that dollar worth? You might say it’s worth a dollar, but let’s think about what had to happen for you to get that dollar — you had to pay tax on it. If you make $40K a year, your Federal tax bracket is 25% and in California your marginal State tax rate is 8%. If you add to that the federal self-employment tax of 15.3%, you’ll see that you actually had to make $1.48 just to get that dollar. Now let’s say you live in San Francisco where the sales tax is 8.75%. If you want to spend that dollar on a consumer good, you’ll only get 92¢ out of it… Was it worth it? Is that 92¢ widget giving you $1.48 worth of happiness?
Now to fill the dollar-sized hole created by the dollar you spent, you’ll have to do another $1.48 worth of work. However, if you decide to not spend the dollar, you won’t have to fill the hole, and you’ve instantly earned a 48% return. If you saved that dollar by holding off from buying something subject to sales tax, you’ve actually made a 60% return — I challenge you to find a better investment!
Now the dollar you’ve so carefully refrained from spending is still a regular humdrum dollar — but it’s primed and ready to be transformed into an enchanted, broom-like, tireless worker. All you need to do is to put it somewhere. And where you decide to put it determines how much magic it has.
If you put it in a savings account which offers 0.5% interest, the magic is quite small. After a year your dollar would have made ½ a cent. If you put it into a CD (Certificate of Deposit) at today’s top rate of 1.2% interest, you will earn 1.2¢ at the end of a year. If you put it into a Total Market Bond index fund, you could have close to 4¢, and if you put it in the stock market you could potentially have an entire dime!
You may be thinking — these are just pennies, why would I skip the joy of a 92¢ widget for a couple extra cents one year from now? But if you start imagining dollar after dollar, and year after year, these pennies add up. They add up to down payments on houses; they add up to tuition for your kid to go to college; they add up to a secure retirement when you’re older, and perhaps if you don’t want to deal with all the hustle of the art world (or your own business), they add up to financial security. Financial security lets you rest easy at night knowing that you’ll be able to weather the ups and downs of a creative career and fluctuating income.
You may also be thinking — I’ll just go for the dimes! Why would I put my money in a savings account when I could potentially make 20 times more money in the stock market? Whoa, slow down Warren Buffet! Each one of these investment vehicles has its purposes (yes, a savings account is an investment, too). Using all of them in the right way will give you a stable and strategic system that will allow you to weather market volatility and life’s unforeseen pitfalls. The lower interest rate savings options offer something the higher interest rate options cannot — security. Bank accounts are FDIC insured up to $250K, so even if the shenanigans that we all lived through in 2008 come back to haunt us (financial crisis/banks busting/wall street burning/hell freezing over), your money in the bank is safe. This isn’t necessarily the case in the stock market, bond market or anywhere else.
We, as artists, should feel empowered to give ourselves an understanding of these basic principles, and to use them as effectively as possible to create our own safety nets. What I’ve heard over and over again from people in the arts is that they wish they had more of a financial cushion between themselves and disaster. While moving towards this goal, a regular practice of saving is our greatest ally.
Making saving your first expense
If you got through my last two posts on issues of a fluctuating income, I applaud you! This is a dense topic, and wrapping your head around it can be emotionally exhausting. But the work you put into creating a sustainable system now, will benefit you and your practice for years to come. This brings us to #2 on my list of 5 Sm*artly strategies to smooth out a fluctuating income:
1. Pay yourself a salary.
2. Make saving your first expense.
3. Prioritize your spending
4. Amortize everything
5. Create a robust emergency fund
If you’ve even dipped a toe into the billions of words written about personal finance, you’ll have probably come across the concept of paying yourself first. I don’t know who came up with this turn of phrase, but reframing savings as paying yourself first actually makes it easier to do. It no longer seems like pain or deprivation being inflicted on you, but it becomes a positive, empowering act of self-fortification. I have to admit, saving is one of my absolutely favorite things to do! It’s like buying a gift for your future self, and who doesn’t get excited about giving a gift – and getting a gift? When you pay yourself first, you get to eat both sides of that love sandwich — and in my opinion, there’s nothing more delicious than money in the bank.
After reading my last post about paying yourself a salary, I know you ran right out and set up your new banking system. However, if you happened to missed it you can read it here. And as a handy reference, I am reattaching the mind-bendingly awesome flow chart I created just for you describing exactly how to set-up your accounts.
And now that you have this nice system where you’ve given yourself a predictable amount of money to work with every month, you’ll want to use it to set-up positive strategies to get ahead. Let’s not delay – let’s start saving! But first take a moment to pat yourself on the back. You’ve examined your situation and done the work to stabilize your income – bravo! You can think of setting up an automatic savings plan as the party you throw yourself to celebrate.
I know you memorize everything I write, but just to recap from my previous post: when you came up with your monthly salary number — the amount you gave yourself to live on every month, regardless of your fluctuating income — that number included the amount you intend to save.
I can go on and on about how much you should save, where you can save it, and what you can do with it once you’ve saved it — and through the course of this blog I promise that I will. But for the purposes of this post I am going to discuss saving and investing in broad strokes. I know attention spans are short, time is tight, and I’ve already dragged you this far down the rabbit hole — so I’m trying to get to the end as quickly as possible, and will therefore leave the specific details for a later date.
With this in mind, I am going to start by lumping all your savings goals into one number, and I’m going to use the number I’ve seen tossed out by planners time and time again. This may not be your number, but it’s a solid number, and if it seems like a big number, then good – you deserve to save a lot of money. The number I’m going to use is 15%. If you can save 15% of your income, you’re doing really well, and you’re ahead of most of the rest of the country. Over the last year the personal savings rate bobbed around 5% according to the Economic Research arm of the St. Louis Federal Reserve Bank. [Read all about it HERE]. If you adopt 15% as your own personal savings rate, you’ll start to quickly build an emergency reserve, a retirement savings and give yourself the ability to invest in other necessities (hello, down payment on a house!).
These are not luxuries, and they aren’t things that you should consider living without because saving is difficult. These are the non-negotiable basic building blocks that you’ll need for a life that will take you from your 20s to your 80s, that will carry you from being a single, free spirit to the heart-pounding expense of having a family (preschool costs how much in San Francisco?!). Having an emergency fund, saving for retirement, and putting aside money for all other necessities allows us put down roots into our communities, and into our practices. These things also help us weather the inevitable slings and arrows of outrageous fortune (you know they’re coming!). So I advocate being more ambitious than not with your savings rate. If 15% is too big of a number to start with, then make it your mission to gradually work your way up, adding 1% per month until you’re there.
So what is this simple savings plan? It’s got 4 main parts: 1. An emergency reserve, 2. Ongoing retirement savings, 3. Things you want to save for within the next four years, and 4. Things you’re saving for that are more than four years away, but before retirement. You can think of it in terms of timeline and accessibility. Emergency reserve is immediately accessible, your ‘within 4-years’ account is close by, your beyond 4-years account is at arm’s length, and retirement savings is, for all intents and purposes, inaccessible until you hit retirement age.
If you are starting from zero, you’ll want to build up your savings plan in the most stable way possible. Therefore the first thing you’ll want to start is your emergency cash reserve. This is perhaps the least sexy part of the plan, but it’s the most essential. Your cash insulates your other investments, like a warm, cozy blanket. The more cash you have in a savings account, the thicker the blanket, making it harder for life’s foibles to munch through the green shoots of your newly-established investments. What in the world am I talking about? Here’s an example: If your cat needs emergency laser-assisted arthroscopic surgery, the last thing you want to do is have to pull out money from your 401K to pay for it — raining down tax and penalties like a plague of frogs. A robust, easily accessible cash reserve protects your cat and your 401K, while keeping the amphibian hail storm at bay.
I can’t tell you how many times have I heard someone say ‘Oh yeah, I had a retirement account once, but I cashed it out [and swallowed the penalties] because I needed the money.’ A strong emergency reserve stands in the way of that happening.
Planners usually like to allocate three to six months of living expenses into an emergency reserve. The amount that is right for you is going to be enough money to tide you over between income events. For example, if you are in a highly sought-after field, and you lose your job, perhaps it only takes a month until you’re working again. You’d then want a month of living expenses in your emergency reserve. However, if you are gallery artists, doing two shows annually, and one gets canceled at the last minute, you’ll want a much bigger reserve, since your next show (or income opportunity) is still six months away.
I know this seems like a lot, and I don’t want you to get overwhelmed before you’ve even started. So pick a manageable goal to hit, say $500, and once you’ve achieved that, pick another. If you work at it consistently you’ll find yourself making more progress than you could have imagined. And all this hard work is worth it, because once your cash reserve is established you have the freedom to build your investments, knowing that you can wait-out any set-backs.
And keep in mind we’re talking about ‘living expenses’ not income replacement. So you can remove some of your working expenses from the total — like income and self-employment tax, commuting costs, your 15% savings rate, and whatever else you won’t need to pay for if you’re not working. Be comforted that three to six months of living expenses is less than three to six months of income.
I generally think artists would benefit from a larger emergency reserve, because their income can be so volatile, and having a larger reserve can make you more confident in taking on risk (aka: investing in the stock market) with your other savings. As it turns out, my unscientific polls have shown that free-wheeling artists are the most risk-averse investors out there — often choosing long-term investments that don’t even keep up with inflation. The tragedy in this is that artists in particular need the long-term growth that only the stock market provides to mitigate the uncertainty inherent in their careers.
The next thing to get rolling is your ongoing retirement savings. Retirement is a long-term project that benefits most from decades of consistent investing. In the early years your plan should include an aggressive asset allocation which gradually shifts towards more conservative investments over time. [Okay, okay, too much information! We’ll talk about asset allocation in a future post — just hang in there!] The key to amassing the amount of money you’ll need in retirement is to start saving early, never stop, and once you’ve saved it — don’t touch it. With your emergency reserve in place, your retirement savings should be well insulated from the prying fingers of the outside world.
Your retirement account is where you’ll be accumulating the great wealth of your life. Not only do you have (ideally) 40+ years of working to contribute to it, but the tax advantages that you’re given through IRAs and 401K, will super-charge your savings by allowing it to grow tax-free. Since the government would rather not have to deal with a nation of destitute elderly people, they throw us this one bone — so grab it, and chew it for all it’s worth. Embrace the growth of the stock market by creating a diversified portfolio of low-cost Index Mutual Funds, or Target-Date Mutual Funds, and make the most of the time your savings has to compound.
Goals within four years, and those beyond four years
The next 2 parts of the savings plan have a lot to do with your individual goals. Perhaps you want to accumulate a down payment for a house in 5 years, maybe you want to take a trip to Europe next summer, or maybe you are sweating bullets at night as you wonder how you’re going to pay for your kids’ college tuition. These are all important things to plan and save for, so you can ensure that they happen. The distinction of ‘within four years’ and ‘beyond four years’ has to do with where you place this savings.
We want our savings to capture as much growth as possible, but we don’t want to subject it to unnecessary risk if we’re planning to spend it in the near future. For long-term investments — like college tuition for your toddler — you’ve got lots of time for your money to grow, and you can wait out market dips, or even crashes. This is ideal for taking advantage of the compounding effects of the stock market — and you need to! No matter how frugal I am, there’s no way I’ll be able to save the $300K I’d like to have when my 3-year-old graduates from high school without the aid of the stock market. But by starting early, saving consistently, and investing aggressively in the early years, I have a fighting chance of achieving my goal.
However, if you’re looking to place a down payment on a home within the next four years, you’ll want to dial down your risk and transfer your savings into more conservative, protected investments. That money should be held in savings accounts, CDs, money market funds, or super safe treasury bonds.
Why the four year distinction?
It’s been shown that throughout the history of the stock market, downturns recover within 4 years. Mark Hulbert’s research outlined in his book Bear Markets May Not Be as Ferocious as They Appear, indicates that since 1926, it has taken an average of 3.3 years for stocks to recover to their previous highs during a typical bear market. What we all just went through in 2008 was not typical, and was in fact second only to the great depression in its ferociousness. We may feel like damaged goods coming out of it, but if we stick with a scared, and overly conservative investment approach, we’ll suffer from a lack of gains in the future. Think back to the hard-working, stand-up dollar with buckets of gold bullion — you want as many of those on your side as possible.
Alright already — let’s rope this pig and get to the point!
Remember this is all leading back to step #2 in Sm*artly’s 5 steps to dealing with a fluctuating income. This long and involved case I’ve been making is intended to inspire you to make saving your first expense! And the most-efficient, least-emotional way to do that is to make automatic monthly payments to your various savings accounts before that money hits your pocket.
Referring back to the pay yourself a salary plan, you’ve ideally got a business checking account where you deposit all of your income checks, so that you can periodically transfer set amounts to your personal checking account, which is where you pay for all your living and business expenses. From that same business checking account, you’ll also want to set-up automatic payments to your different savings and investment accounts, which have been established to achieve your different goals.
If you’re just starting out, it may be as simple as transferring your entire 15% into a linked savings account in order to build-up an emergency reserve. If you’ve already established a reserve, you can then change your auto payments to have 10% go to your retirement account, and the remaining 5% be split up into your other goals. Perhaps a portion of that 5% will go to a 529 college savings plan for your kid, or to a separate vacation savings account for your honeymoon next year, or to an investment account for that house down payment you’re planning on making in 5 years. [I know, I know, I’m going down a really nerdy road here, but keep your eyes open, because we’re almost at the last critical piece!]
The key to success is to make this process automatic, so you don’t even have the opportunity to divert those precious savings towards worthless consumer spending. It’s human nature to spend aimlessly on impulse when you’ve got money jingling in your pocket. But if your money never gets into your pocket, it’s less likely to dribble out through your fingers.
Once you have this system buzzing along you’ll be amazed at how fast your savings and investments grow, and it will motivate you to do more! I get so excited when I save — it’s like a power rush. The act of saving makes me feel smart, and capable, and in control. I want you to feel that power — I want you to experience the magic of a dollar saved.
Thank you for sticking with me through this incredibly long post. I’ll be filling in some of the gaps in future posts, so if you’re eager to learn more about asset allocation, inflation, and risk tolerance please stay tuned! If you have any questions, or if any of this resonates with you, please leave a comment, or email me directly at firstname.lastname@example.org.