Automatic Deductions – A Struggler’s Tool for Building Wealth

19 years.


That’s how many years I’ve spent in the education system.  As of today, that represents 65.9% of my life, but who’s counting?  Throughout all that time, it never ceases to amaze me how little I’ve learned.  Okay, let me rephrase that.  I learned a lot, but very little of it is relevant and applicable to my life.  Yes, math, science, history and English classes are all very important, but why does the public school system ignore teaching basic life skills?  A career, at its core, is simply a way to earn a paycheck.  If school is preparation for a career, then school is nothing more than an attempt to optimize your earning potential.  (Yes, to some people their career is more than a paycheck and has real meaning to them, but if they were not born of wealth and were not paid to do their job, they probably wouldn’t be spending 40+ hours a week doing it.)


So why does school teach us next to nothing on how to manage our finances and invest in our future?  What is the point of earning a paycheck only to die impoverished?  A person with lower earning potential and a great investment strategy will outperform a person with higher earning potential and no investment strategy.  Why are basic investing and accounting concepts not taught to students so they have the knowledge to maintain their own fiscally sound balance sheet?  After all, our household should be run like a business.  It is hard to make the mortgage and utility payments on time if your balance sheet shows more debt than equity and cash flow is struggling.


When I graduated college in 2009, I struggled to formulate some kind of plan for myself.  The only investment knowledge I was armed with was from an elective course I took my senior year of high school called “Stock Market.”  To this day, that one class was the most important class of my life, including every course I took in college.  That course should be mandatory in every public high school across America.  Stock Market I-IV.  Whoever runs on that platform gets my vote.  Our children’s futures are at stake.


According to Deutsche Bank Chief International Economist Torsten Slok, 47% of US households save NOTHING out of their current income.


FRB US Household Savings


Sit back and take that in for a moment.  That is astounding.  Statistically, if you are reading this, there is nearly a 1-in-2 chance you are part of this statistic.


The Pension Phase-Out


It used to be that when you got a job in America, you stuck with that company for a long time.    It was not uncommon 50+ years ago that a person would graduate high school, get a job and work for that company for the next 30+ years until retirement.  It was a simpler time, and not only were Employees more loyal to their Employers, but Employers were more loyal to their Employees.  It was the norm for Employers to offer their Employees Pensions, which are also known as “defined benefit plans.”  Pensions are structured where the Employer has complete control over the Employee’s investments.  Contributions would be made by a regular basis from either the Employer and/or the Employee to an investment portfolio controlled by the Employer.  For the contribution, the Employer promises the Employee a defined, regular (typically monthly) benefit upon retirement.  This regular benefit is calculated using a predetermined formula that is based on the Employee’s age, years of service, earnings history, etc.  There are risks, of course.  If the Employer goes belly-up, the Employee’s benefits could be greatly reduced.  But the goal of a pension plan is to provide the Employee with some sort of guaranteed income stream for the rest of their life.  These programs are still popular in government jobs, and are often based on an Employee’s final salary (which is why it’s so common to see folks like police officers pick up lots of overtime their final year on the job to pump up their pension benefits as much as possible).


While this method of retirement savings is probably not going to allow you to retire rich if this is your only income stream, it at least guarantees some type of passive income for your future.  Ultimately, it was successful because individuals tend to not be such good investors, and this approach takes the individual out of the equation completely.


Pension Stats


Employers have been phasing out defined benefit pension plans for decades.  While still popular in the public sector, private sector employers have overwhelmingly scrapped pension plans and replaced them with 401(k) programs.  This is not necessarily a bad thing.  If you are a reasonably knowledgeable investor, 401(k) plans can provide much, much higher rates of return when compounded over decades than a pension plan ever could.  A pension plan may have you retiring comfortably, but a 401(k) plan could potentially have to retiring rich.  However, a 401(k) plan also has the potential to have you retiring dirt poor.  401(k)’s are elective contribution plans for the Employee, and although some Employers provide an automatic percentage of salary deposited into your 401(k) plan, if you have an Employer that provides match contributions, if you contribute nothing you get nothing.  Even if you are getting a percentage of salary, it won’t be nearly enough to comfortably retire on.  If 47% of Americans save none of their income, the 401(k) experiment for this country will end in complete disaster for the typical American worker.


If You Won’t Live Below Your Means, Reduce Your Means By Which You Live


We have all heard the abysmal statistics of the number of Americans living paycheck-to-paycheck.  What are the most recent statistics, now?  CNN said back in June of 2013 that 76% of Americans are living paycheck-to-paycheck.  Two years later, I doubt the statistics have changed all that much.  From this data, I surmise one thing:


Money burns holes in American’s pockets.


We live in an “I want it now” culture.  Once you get that money in your hand, you’re going to want to spend it.  If you are earning $800/week after taxes, you’re probably going to structure your life to accommodate $800/week’s worth of spending instead of, say, structuring your life to live at $650/week while investing the remaining $150/week as you should be doing.  A fantastic strategy to get around that is to simply have the funds auto-deducted from your check into an investment account so they never show up on your paycheck.  That way, you can only spend what you have available while the rest is tucked away into an investment account, slowly and silently compounding into a nest egg for yourself as you grow older.


This is where the 401(k) shines.


1.) You can have your Employer deduct a flat amount or percentage of your paycheck each week into a private investment account without you ever realizing so you cannot spend that money.  It’s much easier to save money you never had than to take money out of your pocket and tuck it away.

2.) If your employer offers matching, it could be an automatic 50-100% return on your investment.  FREE MONEY!  If your employer offers 401(k) matching and you are not at least contributing the maximum amount of your paycheck to receive the matching, you are missing out on the greatest investment opportunity you probably will ever have available to you.

3.) 401(k) contributions (up to a certain amount allowed by the Government) are tax deductible.  That money is deducted from your income and you do not have to pay taxes on it for that fiscal year.  That means if you make $50,000/year and you deposit $5,000 of your own money into your 401(k), you only pay income taxes on $45,000 that year.


Between employee matching and the immediate tax benefit, you could be seeing as high as a 120-130% instantaneous return on investment before your money even touches the market.  If you start in your 20’s or early 30’s simply investing in basic, low-cost index funds, over a 30 year period at typical market returns, that investment could be massive.  And it is so easy.  You don’t have to lift a finger.  It is all done for you.  All you have to do is show up and earn a paycheck.  I have nothing more than a median income salary, but I deduct $100 from my paycheck and into my 401(k) plan every single week.


Of course, 401(k) plans are not the only way to auto-deduct money from your income.  Many strategies exist.  Some of the most popular are IRA’s, and one of my favorites, Dividend Reinvestment Plans (DRIP’s), one of the greatest potential wealth building tools you’ve probably never heard of.

All information found herein, including any ideas, opinions, views, predictions, commentaries, forecasts, suggestions or stock picks, expressed or implied, are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. I am not a licensed investment adviser.


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