FI Step by Step: Step 3, How Did I Get Here? Tracking Your Income & Expenses

Step 3: How Did I Get Here? Tracking Your Income & Expenses

So far you have defined the reasons why you want to achieve financial independence (your why?) and determined your starting point (your net worth).  I believe the next step is to determine how you arrived at where you are today.  This is done by better understanding both your income and your expenses.  In order to reach FI, you need to have a very firm grasp of how money comes into your life, and how it leaves.  Too many people go day to day, week to week, month to month without looking at their finances.  Every year around tax time most people take a cursory look at their finances because they are forced to, but this is not nearly enough.  This is a recipe for drifting through your financial life with persistent debts, unnecessary expenses, and inadequate retirement savings.  

The best way to better understand something dynamic like your cash flow is to track and study it.  That’s right, STUDY IT.  If you want to reach FI, no more of this laissez faire attitude about your money.  You have to get serious about this and make it a priority.  If you continue to just let things coast as they are, or if you are living paycheck to paycheck, you are condemning yourself to a life of trading your time for money and always worrying about making ends meet.  So how do we track it?  As I mentioned in the last post on calculating your net worth, the best method is to use an automated app like Mint or Personal Capital.  It is possible to use a notepad or a spreadsheet and diligently record everything manually, but there are 2 big problems with this.  First, the likelihood you will consistently do this over time is very low, just based on human behavior.  Second, even if you record everything diligently, you still have to find a way to organize and categorize this data to make it meaningful.  By using one of the apps, everything automatically updates, saving more of your precious time for the things that are more important to you.  Furthermore, the apps make it extremely easy to categorize everything, making useful analysis of the data simple and intuitive.  

In order to capture all of your income and expenses in one of these apps, you are going to need to do a few things:

1. Make sure ALL of your accounts are linked up to the app: This one should be self explanatory, but it is extremely important so I want to make sure we cover it.  Every checking account, savings account, retirement account, investment account, credit card account, home mortgage, auto loan, student loan, other loan, etc. should be linked to the app you are using.  How do expect to get an accurate assessment of cash flow into and out of your life if all of your accounts are not linked?  You can’t.  Period.  So make sure you have EVERYTHING linked to the app.  There may be a select few accounts that won’t sync to the app.  If this is the case you will need to track these accounts by hand and enter the information from them manually into the app.  
2. Make all the transactions you can with a debit or credit card: I know this recommendation may suprise some people, but hear me out.  This is what I do and here are the 3 primary reasons I do it.  First, if you really want to understand your spending habits better, you need to track EVERYTHING you spend.  When something is paid for with a debit card or credit card, the transaction is automatically recorded in whichever account you used, and then it syncs up with your account on Mint or Personal Capital automatically.  You never miss anything.  This is why I automate payment of all of my bills to a credit card or my checking account.  Likewise, anytime I buy anything anywhere, I use a credit card if possible.  Second, if you have a family, it is not just what you spend that matters, but what everyone in your family spends.  I don’t want to have to pester my wife every day to see if she entered her expenses or wrote them down.  And now that my oldest son is driving, he has to buy gas for the vehicle I let him use.  With all of us using a debit or credit card, everything is automatically tracked.  Finally, another tremendous benefit is earning awesome credit card rewards with this system (more posts on this later).  Every year I get thousands of dollars in free travel and travel perks just by putting money I would have spent anyway on a credit card.  So, why would anyone not do this?  Well, there are at least a couple of good reasons to proceed with caution.  First, this is only a good idea if you are disciplined in paying your credit card balance IN FULL each month.  If you don’t pay the balance in full EVERY time, you will start paying high rates of interest, and this kills your progress towards FI.  If you have credit card debt problems, you need to get those fixed before putting all of your transactions on a credit card.  For those in this situation I would recommend using a debit card instead.  It may not have the rewards benefit, but it will keep you from spending more than is in your checking account, and everything will still be automatically tracked.  If a debit card is also a problem, then use cash and record everything manually until you have things under better control.  Second, studies have shown that we tend to spend more money when using plastic compared to handing over cash.  We all knew this to be true without the studies.  Think about it, it is a lot harder to hand over 5 twenty dollar bills to the cashier than it is to swipe a card for $100.  What is my response to this?  Suck it up and take charge!  It’s time to get more disciplined in your spending.  If you want to reach FI, you first need to learn self control.  Others may not be able to limit their spending when using a debit or credit card, but you are on a different path, the path to FI.  It’s time to shift your paradigm, change your habits, and work towards purchasing the ultimate luxury: your freedom.  Have a plan for what you need to buy when you walk into a store; be intentional in what you spend money on.  Create and work within a budget.  Don’t make major purchases on a whim.  There are plenty of strategies you can employ to control your spending (more posts on this later as well).  If you can pay your bill in full each month and be disciplined in your spending, I truly believe the benefits of this recommendation outweigh the risks (wow, that risk/benefit thing really sounded like a doctor, LOL).
3. Manually enter in the few expenses that you pay for with cash: When you use cash to purchase something, this obviously won’t show up on the app.  But we need that information with all of your other expenditures to give an accurate picture of how money flows into and out of your life.  There are a couple of ways to approach this.  Option 1: when you withdraw cash from the ATM or the bank, you can enter in the total amount withdrawn in the app and designate it for a certain category.  For example, I may withdraw $200 from the ATM and then designate all of it as lunch money for my four kids over the next month and distribute a little to them each week.  As long as I only use the money for this purpose, this will be accurate.  Option 2: manually enter all of the information for any given cash transaction in the app: date, description, category, amount, etc. Fortunately, you shouldn’t have to do this much if you are using a debit or credit card for most things.  

Now that we have covered how you will capture all of this information, let’s discuss how you will use it to better understand the flow of money in your life.  Let’s look at income first, and then expenses.

Income

Income is any way in which money comes into your life.  There are several sources of possible income and these vary based on your career choice, investments, and stage of life.  For most of us our primary source of income is in the form of a paycheck from our primary employment, so I will focus on that, but I will also touch on a few other key concepts.  

Paycheck

Your paycheck may seem straightforward since it is typically deposited in your checking account, and thus will be tracked in Mint or Personal Capital. However, there is so much that goes into your paycheck that needs to be understood. I want to break down the separate components of how you are compensated for your time.  To become more financially literate you need to understand how you are paid (hourly vs salary vs commission), what pre-tax deductions you have, what you are paying in taxes, and what post-tax deductions you have.  To do this effectively, I recommend you get a copy of your most recent pay stub, and better yet your last 3 pay stubs.  Most paychecks have 5 to 6 sections we should review.  I will use the sections in my own paycheck as an example:

Summary

As you’d expect, this is a summary of everything else on the paycheck.  My paycheck has the Total Gross (sum total of all sources of income on your paycheck before any deductions of any kind), Total Deductions (anything that is taken out of your paycheck, including taxes), and the Total Net (which would be the Total Gross-Total Deductions).  The Total Net amount is the number you actually see on the check you take to the bank or the amount that is direct deposited.  For each of these categories there are usually two columns: one with the amounts for the current pay period and another with the running totals for that year to date.  

Earnings

This is where all sources that contribute to your paycheck are listed.  Wages is likely the most common source; here you will see how much you earned based on your hourly rate.  For example, if you make $50/hr and worked 40 hours each week for the last two weeks (and you get paid biweekly), there should be a section for gross wages with a column for hours listing 80.00, a column for rate listing 50.00, and a total for current pay for the period which would be 4000.00 in this example.  Next to this, there should also be a year to date amount.  If you are salaried, your pay stub will likely show the portion of your salary you earned this pay period.  Even for salaried employees, there will often still be an estimation of an hourly rate based on a normal work week (this is what my pay stub shows).  Other sources of earnings listed here could include overtime, bonuses, and commissions on sales.  

Taxes

Here is a listing of what you pay the tax man.  For payroll taxes (Social Security and Medicare) this a fixed percentage of your salary.  For social security both the employee and the employer pays 6.2% of your earnings, for a total of 12.4%.  In 2019 this is capped at the first $132,900 of wages.  For Medicare both the employee and the employer pay 1.45%, for a total of 2.9%, up to $200,000 in 2019.  For high earners there is an additional Medicare tax of 0.9% for all wages over $200,000 in 2019.  This is not matched by the employer.  Next you will see the federal income tax that is withheld.  This amount is based on your earnings plus key pieces of information on your W-4 filed with your employer: your filing status (single, married filing jointly, etc.), number of withholding allowances you claim, and any additional amount you want withheld.  If you have income tax in your state, you will also see state income tax withheld based on your state’s version of the W-4 form.  For all taxes you should see amount paid for the current pay period as well as year to date.  If you are self-employed this is obviously very different and I will review this in a future post.  

Pre-Tax Deductions

This section includes items that are deducted from your paycheck before taxes are calculated and withheld.  This includes contributions to your tax advantaged retirement account (401k or 403b), deferred compensation plan (457b), and health savings account (HSA). It also includes any health insurance, dental insurance, and vision insurance premium payments.  It is very important to understand how pre-tax deductions affect you because most people will want to try to maximize these to reduce their tax burden.  Here is an example: To make the math easy lets say you are a high earner and that your total gross pay before deductions and taxes is $10,000 every 2 weeks.  We’ll also assume you have an effective tax rate (all taxes and rates combined) of 25% for easy math.  For this pay period if you contributed $750 to your 401k, $750 to a 457b, $250 to your HSA, and paid $250 in health/dental insurance premium payments, this would total $2000 in pre-tax deductions.  This would leave a taxable amount of $8000 in your paycheck.  So when your taxes are calculated at an effective rate of 25%, you would pay $2000 in taxes (25% of $8000) instead of $2500 (25% of $10,000).  Over 26 paychecks in the course of the year, this would save you $13,000 in taxes ($500 per paycheck).  

After Tax Deductions

These are the items that are deducted after your taxes have been calculated and withheld.  In my paycheck this includes items like an additional life insurance premium I decided to purchase through my employer, spousal life insurance, and the premium for an umbrella insurance policy.  Going back to our above example, we started with $10,000 total gross pay.  There were $2000 in pre-tax deductions, leaving $8000 of taxable income.  At an effective tax rate of $25%, $2000 of taxes were withheld, leaving $6000.  If there were $100 in post-tax deductions, the total net pay (the amount you actually see on your paycheck) would total $5,900.

Company Deductions

This is where your employer contributions to your 401k or 403b will appear.  Most employers will match contributions to your qualified retirment plan up to a certain percentage of your salary.  This is FREE MONEY!  So make sure you are contributing enough to your 401k or 403b to max this out (more on this in Step 6: Maximize Your Employment Benefits).     

That sums up the basic components of an employee paycheck.  Your personal pay stub may have some variations, but should have the same basic parts.  It amazes me how many people have never taken the time to work through and understand the details of their paycheck.  They are willing to trade their time for money, but not willing to put in a little effort to fullly understand how they are being compensated and how to optimize it.  On the path to FI, it is imperative to know this information.  If you are self-employed, this type of paycheck obviously doesn’t apply to you, but you better understand all of the pertinent details of taxes, retirement plans, and insurance options available to you. 

Tax Return

Since we have touched on taxes withheld from your paycheck, I think this is a good time to mention some of the basics of your tax return.  This is an important form of income (money flowing into your life) for many people.  I will discuss your tax return in great detail in a future post (I’m sure everyone is eagerly anticipating that [sarcasm]), but for now I want you to ask yourself a few basic questions.   Did I owe money or receive a return the last few tax seasons?  Am I witholding too much from my paychecks? Not enough? Is this a consistent amount?  What am I doing with this money each year?  

There are varying opinions about your tax return.  Many will argue that getting a minimal return and trying to pay the exact amount you owe is the best course of action.  They state that paying too much in taxes, and getting a return at tax time, is giving an interest free loan to government.  While there is some truth to this, I have a different opinion.  I like to overpay my income taxes and get a return each tax season (for me I would hate to owe more money every April).  I look at this as a little savings account for yourself.  I know, many may be gasping and saying you aren’t getting any interest on that, what about the opportunity cost?  Before you break out the tar and feathers, hear me out. Let’s look at the alternative; if less is withheld in taxes each paycheck so I don’t overpay and get a tax return, I will get a little more money every paycheck, which for me is 26 times a year sine I’m paid biweekly.  That sounds pretty good.  I could then invest that money and get a higher return.  While the math of this makes sense, I believe, at least for me, this is where human behavior becomes more important in personal finance.  Evidence shows that if we get a little more money each paycheck, we end up spending it instead of saving or investing it.  However, if we get a larger lump sum at tax time, most people use it to pay off debt, save it, or invest it, at least comparatively.  So this is what I do each year.  You have to decide what is best for you.  Once you know, you can adjust the amount withheld by changing allowances on your W-4 with your employer or requesting more or less taxes be withheld each pay period.  

Investments

Another source of income are your investments.  Your investments in the stock market pay dividends and your bonds pay interest.  As your portfolio grows, these amounts become more significant.  I didn’t realize these sources of income were really even present until I started using Mint, and later Personal Capital, to track my investments.  Every time you open the app, it refreshes any recent activity in your investment accounts.  Most investments pay dividends or interest on a monthly or quarterly basis.  So when these payments are made, they show up in the app under new transactions.  This was a bit of a revelation to me because it helped me better understand how my money was making money.  Conceptually I knew this was true, but when I actually saw this money coming in on a regular basis, it made it very real and increased my desire to invest more.  I could also compare it to the minuscule amount of interest my money in a typical savings account was earning.  

Other Sources of Income

Other sources of income could include cash flow from rental properties, businesses you own or are invested in, a side hustle, or other sources of passive income.  There are obviously too many possibilities to write about all of them here.  The important thing is to find a way to make sure you capture these sources of income with the app you are using to track your finances.

Expenses

How does money flow out of your life?  In several books I’ve read and podcasts I’ve listened to they use what is called the bucket analogy.  Income flowing into your life is like water going into a bucket.  This bucket, however, has leaks all over it where water is flowing out.  They are of various size and thus, water is flowing out at different rates.  These represent your expenses.  What are your biggest leaks?  What can you do to better plug them? It is difficult to plug the leaks if you don’t even realize where they are. And you don’t want to waste all of your time and energy trying to fix a few small leaks that are trickling while water is gushing out of others.  This is why tracking your expenses is so critical.  

In order to get an accurate assessment of your expenses, we need a fairly large sample.  A week or a month’s worth of expenses is insufficient.  I think the minimum is three months worth of data to really start to see true patterns in your spending.  And as you gather data beyond this, the spending habits and areas for potential improvement will become even more apparent.  

So what do you do now?  This is where you have to put forth some consistent effort.  It is also where the benefits of Mint and Personal Capital really manifest themselves.  I would recommend you record and review all of your expenses in the app you choose for 3 months and categorize them appropriately.  All of your bills should be linked to a debit or credit card and automatically appear when a transaction occurs.  For those you have to write a check for, the check will show up in the app and you just need to manually enter who it was paid to and the category of the expense.  Create categories that will be helpful to you.  For example, maybe you travel regularly. If so, you may spend money on airfare, car rental, hotels, etc.  Rather than making separate categories for “Airfare” and “Car Rentals” and “Lodging,” it may be more useful to put it all under one category called “Travel.”  This way when you analyze your expenses you can see how much you spend on travel as an aggregate rather than the separate components.  For some however, you may want the specific subcategories.  You decide.  As you create categories, you should also concentrate on areas of concern in your spending or weaknesses you suspect you have.  After you have done this for 3 months, here are some of the things I want you to analyze.

The Big Three

Most Americans spend the majority of their money on what are known as the big three: housing, transportation, and food.  Since these three areas are likely your biggest leaks, it makes the most sense to scrutinize them the most.  I’m not recommending you make any changes yet, just try to learn what is going on in your personal financial world.

What percentage of your income goes to your housing?  This doesn’t just include your mortgage or rent payment.  This also includes utilities, home or renter’s insurance, home maintenance, and home improvements.  If you have a mortgage, what is your interest rate?  Are you still paying private mortgage insurance?  Most financial experts recommend that your housing costs are 30% of your gross income or less.  First of all, I think 30% is too high for most people.  I think 25% is a better upper limit, and if you can keep your housing costs to less than 15 or 20% of your gross monthly income, even better.  The problem is that many people end up buying a house with a monthly mortgage payment right at their upper limit (some banks will approve you up to 40% of your gross income!), stretching them very thin financially.  They don’t take into account the other costs of owning a home, so total housing costs will exceed 30% of gross income, leaving the home owner feeling trapped, barely making ends meet.  This is where the term “house poor” comes from. 

Moving onto transportation, do you have a vehicle?  Two vehicles?  Three vehicles?  More?  Do you need that many vehicles?  Did you buy more car than you should have?  Is it worth the higher payments or did those luxury features lose their appeal over time and no longer bring you value?  Do you own your vehicles or are you making payments on them?  Are you financing or leasing your vehicles? How long will it take you to pay them off?  How much would you save if you sold one of the vehicles and used the money to pay off another?  How much is your auto insurance?  Have you shopped around for the best deal?  Do you bundle with other insurance to save money?  How much are you spending on gas?  Could you car pool or ride a bike to work from time to time?  Again, I am not recommending you change anything just yet, just look at where your money is going and ask yourself some honest questions.  

Finally, consider how you are spending money on food.  How often are you eating out at sit down restaurants?  Fast food?  Is your family’s schedule so hectic you find you are rarely eating home at the expense of your wallet, your waistline, and quality family time at home.  Is your grocery bill higher than you would expect?  Do you go to the grocery store prepared with a list of things to buy, or do you just buy anything that sounds good while you are there?  Have you tried buying items that you use regularly in bulk for a discount?  

Take the time to really learn about your spending habits in these three areas, because this is likely where you can change just a few things and get the most bang for your buck.  

Recurring Expenses

Next, look to see where you have recurring monthly or annual expenses.  Oftentimes these expenses go unnoticed because they happen automatically.  Do you have Netflix?  Hulu?  Amazon Prime?  YouTube TV?  All four?  Do you really need all of these services?  Would one or perhaps two be enough?  Look at your iTunes account. Are there recurring magazine or app subscriptions you don’t use anymore?  Do you have a monthly gym membership?  If you are using it then great, keep it up.  But if not, that is just money down the drain.  Many recommend cutting out cable services or your telephone land line.  If you don’t use these or if they don’t bring value to your life, then get rid of them.  Personally, I have intentionally chosen to keep cable TV, mainly for sports coverage and certain news, such as during election time.  These are things I enjoy.  I also am one of the few people that still has a land line.  My wife and I feel more comfortable having one for our children when they are home with a babysitter or on their own now that they are older.  The point, though, is that these are intentional choices, not recurring expenses I have forgotten about. 

Investment Expenses

Above we reviewed the income that your investements generate.  Remember that your investments also cost you money in the form of fees.  As you choose where to invest your money, you need to be aware of the expense ratio of the funds you invest in.  I will discuss this in great detail in future posts, but for now just realize that there are fees associated with investing, and these have a significant impact on the compounding potential of your money.  Regularly seeing the cost of your investments teaches you that the expense ratio of a fund is not an abstract principle.  It is a real thing that takes money out of your pocket on a regular basis.

Meaningless Expenses

Finally, look for any regular expenses that bring little to no value to your life.  I am not a believer in continually cutting costs until you are living like a monk.  A portion of your income should be spent on things that bring value to your life, meaningful experiences, or just having fun.  However, frivolously spending on items you really don’t care about is where we need to focus on cutting things out.  Just because those around you have something, or society expects you to live in a certain way, doesn’t mean you need to if it doesn’t add value to your life.  

Now you have some homework to do. Track your income and expenses for at least the next three months. Stay on top of all of your transactions. I would recommend reviewing everything for 5-10 minutes every 1-3 days. I personally do this every day, always making sure everything is accurate, staying on top of all of my bills and accounts, and looking for ways to improve. Once you have completed this, move on to Step 4: Where Do I Want to Go? Developing a Financial Plan.