Baby Steps for High Income Parents

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We all need an outline to base our financial decisions. We need a priority of each step in the outline. The famous quote goes:

If you fail to plan, you are planning to fail.

 

This applies to each area of our lives, but especially our finances.

Dave Ramsey has made his “baby steps” the backbone of his financial teachings. You might have heard of them. They are:

  • save $1000 emergency fund
  • baby steps for high income parentspay off all debt except mortgage
  • save 3-6 months of expenses
  • invest 15% of income
  • save for kids college
  • pay off house early
  • build wealth and give like never before

These rules are great for average income earners, but I think some of those rules are less valuable for high income earners.

What about HIP?

If you make $200k a year, it is much easier to save $1,000 than it is for someone making $35,000 a year. As high earners, we should have a higher savings rate than the average income earner. If you have a $100k in student loans or a $3,000 mortgage, $1,000 isn’t going to do much if you are living paycheck to paycheck. If you have a catastrophic emergency, $1,000 bucks won’t cover it. Also, if you have even an average emergency and need to cover a $1,000 cost, that could be a discretionary part of your spending for the month.

Our savings rate should be higher than 15 percent. If you aren’t saving 30 plus percent regularly, then you should reevaluate your priorities. You either have a ton of debt, a ton of house and cars, or a ton of discretionary spending.

baby steps for high income parents

Dial Up? I don’t think that’s what he meant.

So, lets dial these baby steps up to someone with an income in the top 10% of wage earners. These are more sophisticated and require more discipline. If you can’t trust yourself to handle some different accounts and tracking debt, then you can always go more conservative with the Dave Ramsey baby steps. If you have researched personal finance for a while, and want to step up your game, then you should be able to handle the HIP baby steps.

 

Save one month’s expenses.

If you are able to save 30% of your income, you will have this done in three months. This gives you a one month buffer in case something happens that you need to take a month from work.  If the income emergency is going to take you away from work for longer than that, then you have bigger problems than paying your debts and investing.

You would need to cut everything to the bare essentials until you can regain your income, or make some major lifestyle changes. This is possibly where your disability insurance would come in. Hopefully, you are further along with your steps if an emergency happens and you have more than one month’s cushion.

Pay off any debt above a 6% interest rate.

This will include credit cards and possibly student loans. 6% is my cutoff because a guaranteed rate of return of 6% at this time is hard to beat. This rate might change up or down in the future, depending on current economic conditions. Paying off any debt higher than this is a sure thing. This is going to make a big difference in your bottom line. If you can consolidate all your debt below this, without incurring expenses, then I would pay off my debt in this order:

  1. credit cards and other high-interest loans
  2. student loans
  3. loans with collateral (auto)

 Save 20% for a down payment to buy a home or save enough to buy a whole house with cash.

I would argue that raising a family and having some stability in a place you can call your own has a lot of benefits. Especially when the kids are young, there is a lot of comfort to knowing a landlord isn’t going to ask you to move. You can find a place that has the neighborhood and school characteristics you value. Some people really value owning their home, but I think the loss of potential investment returns over a preferably 15-year mortgage is harmful to building wealth as quickly. You can always put any extra house funds in a separate account, and invest those until they reach the value of your mortgage.  Then pay off the mortgage or keep letting the account grow.

I would argue the knowledge that comes with owning a home is also valuable. Home maintenance, light or even heavy remodeling (DIY) and generally teaching your kids to take care of something of value are wonderful opportunities for life lessons. It is difficult to put a value on that.

If the idea of a mortgage absolutely kills you though, by all means, save up enough money to buy a home outright.

 Invest at least 30% of income.

You want to maximize your tax-deferred space first unless you are very young and have a ton of time to recoup the taxes lost by investing in Roth IRA’s. You can do the calculations here. This is an excellent calculator at Betterment that allows you to change a ton of parameters to meet your specific situation. A good rule of thumb is if you plan on having a lower tax rate in retirement than now, then you probably will make traditional 401k or IRA contributions. You can track your investment acounts in a platform like Personal Capital.

When taxable account and Roth principal investments reach 6 months of expenses take the emergency month of expenses from earlier and include that with your investments.

If you have six months worth of expenses saved up in investments, most likely you will have some capital gains and dividends coming in that could be funneled to fund unexpected expenses. The cash would be better used by investing it. Also, with your savings rate at 30%, you can probably cash flow most expenses during that time.

If you have a big expense coming up like a bucket list trip, or home remodel, you can divert current savings to a savings account to plan for the future costs.

Some specifics of this are:

  1. Invest in tax efficient vehicles in your taxable accounts. The whole goal is to minimize taxes. If you are receiving a lot of taxable dividends into your taxable accounts, you are defeating the purpose of your tax-deferred investing accounts.
  2. Depending on your home value and state, you could look into a home equity line of credit to bridge the gap on expenses. This could buy you time while you are waiting for investment accounts to rebound, or avoid paying capital gains taxes on an account that has increased in value.
  3. You could also look at getting a 0% introductory credit card. This could bridge a large charge for a few months until you can pay it off with 0% interest. These type of cards can often be found with 12-18 month 0% introductory rates. This is risky because you must have the money at the end of the promotional period to completely pay the card off or you will be greeted with a huge interest bill.

Research, plan and teach your kids to go to the best value college and adjust the budget to plan for those expenses.

If you are being wise with your investments and teaching your kids along the way about managing money and getting the most value, then you will have a plan for higher education.  This could be a whole book unto itself, and it is in College Secrets: How to Save Money, Cut College Costs and Graduate Debt Free. Start early and train you future college students to pick a school not only on reputation but the financial aspects of attending that school.

You can also check out 160 Strategies to Conquer College Expenses. This is an article I wrote to get you and your children a jump start on saving money on college. 

Look for ways to use your credit to maximize profits and experiences.

This is an advanced part of personal finance. It comes with its own risks. I’ve taught my kids that there are only two things good about credit cards. If you use a credit card to pay for things, in this day of identity theft and fraud, it is only a matter of time before your number is stolen. If you use a debit card, it is much more nerve-racking to get your money back into your checking account and still meet monthly expenses.

The buffer of a monthly statement to clear fraudulent charges up with the credit card company gives peace of mind. The trick is to never even let the thought that you can delay payment enter your mind. Credit cards are to be paid in full at the end of each month.  If you can’t follow this rule, then don’t use credit cards. I often pay my credit card bill a couple of times a month. It has never negatively affected my credit score and I see my expenses come out of my checking account as I get them.

The other good thing about credit cards is they come with an instant rebate. Even the worst cards have a 1% cash back program, usually. With a little research and carrying a few cards, you can get up to 5% back in categories such as grocery, gas, and office supplies. There are several cards with 2% back on all purchases now.

If you are getting 2% back on yearly spending of $60,000, over 60 years of your life, that is $72,000. By applying for just two cards a year with $500 sign up bonuses, and meeting minimum spending, that is an extra $60,000 over the 60 years.  Why would anyone leave an easy $132,000 on the table for no cost? Did I mention it is tax-free? If you aren’t using your high income and good credit score to add some extra vacation money or increase your investment contributions, you aren’t maximizing your high income.

Bringing it Home

Let’s go through an example of a couple each making $100k a year. Let’s say your mortgage taxes and insurance are $3000 a month. You have access to and 401k and you max those out each year. You also carry out a backdoor Roth IRA and pay taxes of $35k a year. $2000 a year is the amount of the mortgage. $1000 is on taxes and insurance.

baby steps for high income parents

In retirement, those expenses disappear. You are effectively living on $200k minus ($35K-$24K-$60K). That is $81,000 a year. If you continue to live on that amount, in that tax bracket you can pay very little or nothing in taxes during retirement if you withdraw money appropriately from your different account categories (Roth, 401K, taxable). That means you need $2 million for retirement to meet your current expenses if you are okay with a 4% withdrawal rate. (I didn’t even include any social security as an extra buffer, because who knows what that will look like.) We didn’t even mention the kids leaving the house. That should cut your food clothing and activities budget, but we will pretend you use that money to go to Hawaii ever year. How long will it take you to get to $2 million saving $60k a year with a true 5% rate of return?

Answer: about 20 years

You can see how savings rate effects required years to work here.

Have a Plan

That isn’t in the super frugal, F.I.R.E. crowd but if you like your career, that’s not very long to work. By that time, you have your kids close to or through college. You have taught them the skills to become even more financially independent earlier than you all along the way.

I realize that everyone’s situation is different. The process of developing a plan and sticking to it will be the most important financial decision you make.  It all goes back to living on less than you make. The less you live on and the more you save, the faster you get to financial independence.

I think the trick is to do something you like that pays well. Then concentrate on enjoying the relationships and experiences along the way.

Even if you meet your goals a couple of years later than planned, there isn’t a lot of suffering involved. You were doing what you loved anyway, so why not do it a little longer. Sure there are some tedious aspects you would like to do away with, but those are part of life. There will be something else that has to be done that you don’t like doing, even in retirement.

If you would like a PDF print out of the Baby Steps for High Income Parents, fill out the for and I will send you an email so you can print it out and start the baby steps yourself. 

 

 



 

What do you think of the baby steps for high income earners? How would you change them to fit your specific situation? Let me know what you think.

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Tom
Tom is a doctor and father of five with a passion for parenting and finance. When he isn't skateboarding, riding BMX, or jumping on the trampoline with his kids, he is reading and writing about personal finance. He helps high income parents educate and mentor their kids to become financially, emotionally, and intellectually self sufficient.

9 Responses to “Baby Steps for High Income Parents

  • Great post, Tom.

    A few questions about the credit card section. Do you cancel any cards? That can add up pretty quickly (2 new card/yr)?

    And do you have a favorite cash-back card?

    • Thanks David.
      If the cards have an annual fee I will cancel them unless they provide a good day to day spending opportunity. For example, if a card has an initial sign up bonus but also provides 5% cash back at grocery stores, then I keep it and make that my main grocery card.
      Most of them I just fulfill the initial spending and then put them in a drawer until the next annual fee charges. Then I call the company and ask for the fee to be credited. If they won’t I just cancel then and they remove the fee then. You have a grace period for each card to refund the annual fee.
      Some people are worried about credit score, but I’ve been doing this the last five years and my score is still over 800.

      Tom @ HIP

    • Sorry, I forgot the cash back part.
      I have enough funds to get the 0.75% bonus with the Bankamericard Travel Rewards.
      It factors out to 2.625% cash back. You have to have preferred honors platinum status though.
      That just means you have to have enough funds across BOA or Merrill Lynch accounts.
      The USAA 2.5% limitless cash back is my second favorite. Not every state is eligible though.
      It’s a little more hassle, but if you want a straight 2% card the citi double cash is easy.

      Tom @ HIP

  • I love this souped up version of the Dave Ramsey plan!!! I think Dave does an excellent job of talking to the average American but the HIP needs some tailored advice for their situation which is what you’ve done. I will definitely be pushing my friends your way to read through since this definitely applies much more than Dave’s advice 🙂 Thanks for sharing!!!

    • Thanks Rob. I appreciate the kind words.
      Dave Ramsey is definitely good at getting the discussion going but just like you did in your financial peace university post, we have to step it up. That was awesome that you set everyone straight on investing. Have a great Easter.

      Tom @ HIP

  • Nice adaptation on Dave Ramsey’s baby steps. I also like to maximize my credit card rewards. I am a Chase guy, with the CSR, CF, and CFU.

    • Thanks WSP. With five kids chase is my friend as well. Transfers to Southwest and Hyatt have been a staple for vacations with our family.

  • It sounds like you may already be travel hacking, but if you aren’t, I highly recommend it.

    1. Tax free benefits for high income earners, you won’t get any tax free benefits anywhere else.
    2. Take more, longer, cheaper vacations.

    I started travel hacking in November, and we have been switching out cards each time we meet a minimum spend. I view large annual fees as “prepaid travel.” For example, the card I am working on now, the AmEx Business Platinum card, has a $450 annual fee. Sounds daunting? Not really. I got a targeted offer for 100,000 MR points after a 5k spend in 3 months. That fee is offset by two calendar years of $200 in airline credits. So the net fee becomes $50 per year, and that is prior to recognizing the extreme value of the 100,000 MR points, which can be used to purchase airline tickets with a 50% refund of points. After I am done with this one, we may do a second Chase business ink (I just met my spend bonus, but wife doesn’t have this card YET).

    Cheers

    • Taking advantage of a great credit score is another asset. Glad you are making the most of it and getting some awesome travel experiences with your family.

      Tom @ HIP

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