The Case for Paying Yourself First

Paying yourself first is a very popular phrase I came across when reading the Automatic Millionaire by David Bach. He also happens to be the one who created the movement around the “latte factor” but that’s one topic that deserves its own discussion. In any case, his book along with Ramit Sethi’s I will teach you to be rich talk in depth about the case for paying yourself first. These two books have been instrumental in my desire for reaching financial independence and in my opinion, are two solid resources you should add to your collection.

The concept of paying yourself first (PYF) is so simple, yet I’ve been stunned by the lack of consistency and misunderstanding of what it really means. Inconsistency is not necessarily a bad thing but I believe there are key elements around PYF you must capitalize on to take advantage of all the benefits that come with implementing this strategy.

Now, for what is worth let me share David’s definition: “Paying yourself first means what it says. When you earn a dollar, the first person you pay is you”.

Income, Invest and save then look at your spending money. The case for paying yourself first

So what is PYF in my own words? Basically the same thing; however, the kicker for me is the word AUTOMATION. A lot of people believe they are paying themselves first but the reality is they’re not. As long as you keep telling yourself you can do this without having an automated system in place then your chance of success will be pretty low.

Can I Actually Pay Myself First?

Heck yeah … I do it and so can you. Let me share how I’ve set it up and where the money flows:

Step 1: I enrolled in my company’s 401(k) that matches 100% up to 6% of my contribution. This means that for every dollar I contribute I get a dollar from the company up to the match. For instance, assume an income of $100,000/year, the annual contribution will be $6,000 and the company will give that employee an additional $6,000.

Wait, the company is just gonna hand out free money? … Yes!. A lot of companies do this in an effort to attract and retain talent. If you find yourself working for a company that offers a match for god sakes take it. Simply put, there’s just no better deal out there, this is free money you don’t want to leave at the table.

In my case, the options within my 401(k) plan are just phenomenal so instead of limiting my contribution up to the match, I push the % up to the annual limit which for 2017 is $18,000.

Step 2: I enrolled in my company’s high-deductible health plan to have access to a Health Savings Account (HSA) in which my company matches the first $1,500 in contributions. This type of account is simply the best retirement account invented by mankind so I save up to the annual limit currently at $6,750 (if you have a family).

An HSA is meant to be a vehicle used for covering qualified medical expenses, but I see it as a fantastic retirement account.  Think about it, you get to make tax-free contributions (Traditional IRA), if you invest the money then it grows tax-free, and if you need to use the money for a qualified medical expense, the distributions are also tax-free (Roth IRA). Oh, I almost forgot … you can take distributions at any given time (again as long as the money is used for a qualified medical expense).

I read the HSA Owner’s Manual; however, the madfientist wrote an article called HSA – The Ultimate Retirement Account that you definitely need to check out. I consider it the best article out there about HSAs.

Step 3. I’ve been praising you need to have an automated system in place so you can sort of set it and forget it. Basically, that’s what I’ve done with my 401(k) and HSA. I do pay attention to the investment options within each account, but once that’s set, I don’t have to do anything because the money for both accounts is withheld through payroll deductions. By the way, payroll deductions are the standard most (if not all) companies use so this makes the implementation super easy.

I finally get my take home pay and money hits my checking account, am I done with Automation? … Absolutely not.

Step 4. I automatically pay all debt and that includes bi-weekly mortgage payments, credit cards, and a car loan. I also contribute to a taxable investment account at Betterment and a 529. In addition, money is sent to Ally where we keep our emergency fund and also build capital for our next rental property.

Individual Retirement Accounts (IRA) are also part of my portfolio; however, my income limits my ability to fund a Roth IRA.  As a result, I contribute $5,500 per year to two Traditional IRAs and then use the Backdoor Roth IRA strategy. This requires lump sum investing to avoid tax implications.

The figure below further summarizes steps 1-4

Automation is key on supporting the case for paying yourself first

I also invest in alternatives such a peer to peer lending via lending club and individual stocks using Robinhood; however, these only represent ~ 5% of my portfolio.

Should You Pay Yourself First?

You might be thinking:

  • There’s no way I can follow steps 1-4
  • I don’t make enough money
  • My company’s 401(k) sucks
  • I don’t have an HSA
  • Let me get rid of debt and then we can talk
  • I’ll invest later
  • I have other priorities
  • Just forget it and leave me alone

I get it, even though this stuff seems straight forward, it requires discipline and leaving emotions out of the picture.

If you’re feeling frustrated please don’t be. I remember reading a post from a fellow blogger where she mentioned she was saving/investing more than 75% of her take home pay. Are you kidding me … 75%?. That day she crushed my world. I was feeling so miserable thinking here I am doing all these “amazing” things and I’m nowhere even close to where she’s at on the path for achieving financial independence.

After exchanging notes, I got to know a little bit more about her situation which happened to be completely different compared to mine. She reminded me we are all different and we deal with different challenges in life. My lesson through this experience is you can’t compare yourself to anybody nor you should. You are who you are!.

Why am I telling you this story? Quite frankly it came to mind when writing this post and I believe is a good segue to what I’m about to say.

Just because the steps I shared work for me, it doesn’t mean you have to follow them every step of the way. Personal finance, just as the phrase suggests, is “personal”, and the decisions you make should be driven by how much you know (information) about the choices you have and what you ultimately hope to achieve in life.

Priorities Around Paying Yourself First

Order of priorities will vary from person to person. The point remains the same, automation is a critical element of PYF.

One of the things you might be wondering is how could someone invest if they have a ton of debt … well, that depends on things like the type of debt (student loan?, credit card? Other?), the interest of that debt and your lifestyle. This in itself is an interesting topic that deserves its own post. But in general, these are the priorities I would invite you to consider and above all … MAKE THEM AUTOMATIC:

  1. If your employer offers a 401(k) match, invest to take full advantage of it and contribute just enough to get 100% of the match.
  2. If your employer offers a high-deductible health plan, you might want to consider signing up for it so that you can get access and the benefits of an HSA.
  3. Pay off your credit card and any other debt. Stay tuned for a post on how to pay credit card debt.
  4. Open up a Roth IRA and contribute as much as you can. If your income doesn’t allow you to contribute directly to a Roth, then I suggest looking at the Backdoor Roth IRA  strategy.
  5. Go back to your 401(k) and contribute as much as possible to it especially if the options within the plan are solid.
  6. If you still have money left to invest, open a regular taxable (nonretirement) investment account.

Final Thoughts

  • As human beings, we are tempted by our senses. When it comes to paying yourself first, money you don’t see is money you won’t miss.
  • Automation remains the cornerstone of a successful strategy for paying yourself first.
  • You will be surprised of the things you can get used to when you put your mind and soul into it.
  • Take one step at a time. Just like a diet don’t think you’ll lose all your weight in one day. Take little but solid steps, automate, get used to it and keep going.
  • Priorities will be different between individuals; however, get to know your options and take advantage of the ones that are in line with your personal goals.
  • Nothing will help you build or achieve wealth on your journey to financial independence until you pay yourself first.

 

4 comments

  1. This is a great comprehensive guide to paying yourself first! I recently looked back at my paycheck history and realized that the money going into checking was more than it is now 5 years ago… even though I have almost doubled my income. Why? Because I now have so much taken off the top for my 401K, HSA, DCFSA, and Savings accounts. These are all paid first before I get the check to spend on bills, food, etc.

    1. Mrs. Adventure Rich, appreciate you stopping by. I agree 100% … a lot gets taken off the top to the point that it might give us the impression our income is just stuck. However, once you take a look at your net worth the reality will be a different one and it should put a smile on your face.

  2. I agree with most of the post. However, this may not work for many families out there JJ, and I’m specifically talking about the HSA. Not until I had two medical emergencies in one year I realized HDHP + HSA health plan really sucks. For the sake of my family, my mental health, and my money, I decided to keep a premium health plan. I pay more monthly (much more), but I won’t run out of funds if something similar happens to my family in the future. As you pointed out, every case is different

    1. Hey Daniboy, thanks for stopping by. Sorry to hear the HSA plan is not working for you. As you mentioned all these stuff is personal but glad to see you’re doing your due diligence and doing what’s right for you and your loved ones. All the best JJ.

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