Budget - A Building Block of Financial Independence by the Cashflow Cop

FI Building Blocks:

Introduction

The second Building Block to FI is the Budget. If you have come here without reading the first step, then go back to the FI Building Block: Earn.

From my experience, the word ‘Budget’ turns a lot of people off. I’m not sure why that is, but I think it is because it requires an honest assessment of their financial position. Why? Probably because what they discover will mean they have to take some sort of action. So the best way to avoid doing anything is to not know about it in the first place. Perhaps I am being overly critical here, but to really gain control of your finances, you need to understand your current financial situation.

Your Money Performance Review

Treat your money like a bad employee. What I mean by this is to make your money work hard for you. Don’t trust it. Watch it like a hawk. Understand it. Know what it is doing for you and what it is not doing for you. Give your personal finances a performance review. Sit down and list all your income in one column and all your expenses in another for at least the last three months. Keep it under constant review as if it is forever on a probationary or trial period. Know how much it is you spend on fuel, food, bills, debt, entertainment and so on. Now, if for each month, the income column is more than your expenses column, then you’re doing better than most people. If on the other hand, the income is less than your expenses, then you need to start thinking about where you can trim your expenses or how you can increase your income. The best way is to do both. If you don’t, the only way you can possibly continue living the way you are is by taking out more credit cards and getting into more debt.

This is possibly the most difficult step to take. Out of sight and out of mind is one of the reasons why many people are so bad with money.

Give Your Money a Clear Job Description

Now that you have a clearer picture of your financial situation, the next step is to decide what are compulsory expenses and what are discretionary expenses. In other words, differentiate between a ‘need’ and a ‘want’. This requires complete honesty. Don’t confuse a want with a need. Don’t convince yourself that a certain luxury item is an ‘investment’.

The best case scenario is to eliminate all your wants. However, living life like a monk is not for everyone. So reduce it the best you can. You are not setting a budget to be in deprecation but to live life more intentionally. Do you really need the cable TV contract? Do you need the gym membership? Do you need the expensive mobile phone contract? You know what, it is okay if you decide you want to have some of these extra things because it gives you some value which you feel is worth paying for. However, accept that it is something you want and not something you need.

Now onto your needs. Mortgage, food, utilities and so on. Are you on the best mortgage deal? Are you switching energy providers to ensure you are on the cheapest tariff? Are you eating all your food and not wasting any? Can you replace your branded groceries to cheaper supermarket brands? Could you make it to the supermarket just before they close to grab their heavily discounted food? Could you take public transportation or even cycle to work instead of driving your own car?

The goal here is to strip away the noise, the abundance and the excesses so that what you have left is a clear picture of what it is that you need to live with and what you can live without. Give every single one of your pound or dollar a clear job to do and if it is not doing as it should, take action.

“Take care of the pennies and the pounds will take care of themselves” – adapted from Lord Chesterfield, 1747

Turbo Charge Your Savings Rate

Aim to spend far less than you earn. The goal is to have more than 50% of your income left over at the end of each month. It may sound unachievable, but no one expects you to just simply flip a switch. Take it one step at a time and slowly trim away.

In the UK, the average household savings rate was only 7.1% for 2016 (Office of National Statistics) and even lower in America at 5.4% (Bureau of Economic Analysis). With such low rates, it is no wonder people work into their old age. Understand that financial independence is a simple function of mathematics and time.

Spend far less than you earn – i.e. Income > Expenses = Savings
Let compounding work its magic by investing your savings.
Grow your investment to a point where it produces enough income to cover your expenses in perpetuity.

Don’t forget it is not just about reducing your expenses. Remember that the other side of the equation: Income. So to really boost your savings rate, you need to reduce your expenses and boost your earnings (see first Building Block).

Paying Yourself First

Increasing your savings rate takes discipline and practice. Don’t give up at the first hurdle. It is about paying yourself first because every expense is you giving away your wealth and means you need to work longer. Strictly speaking, paying yourself first means setting money aside to save and invest before paying for anything, including your bills. This puts pressure on yourself to really cut your expenses and think of ways to boost your income. Now, I am not advocating defaulting on your debts. Those must be paid. But by prioritising paying yourself first, it changes how you think about money and forces you to adjust your spending accordingly.

“Pay yourself first and invest in your future self.” – The Minimalists

Spending £4 buying a pre-packed lunch at work now means you are actually spending £5 of your pre-tax income if you’re a basic tax rate payer and £6.67 as a higher rate taxpayer. If you were to invest the £5 in your pension, then that £4 lunch is potentially taking £38 away from your future self. How did I get this figure?

Starting Lump Sum Investment = £5

Interest Rate = 7% (this is the average performance of the FTSE All-Share Index over the last 100 years from 1917 to 2017)

Length of Investment = 30 years

Frequency of Compounding = Annual

Return = £38

Here is the proof: £5x(1+0.07)^30 = £38 (full working out here)

If you were to buy yourself lunch three times a week over a 30-year career, then you are potentially depriving your future self of over £70,000 (full working out here). That’s not a typing error. I really do mean seventy-two thousand pounds! The maths does not lie.

This is the power of compounding. This is how banks can make their money, by charging what may first appear as small fees but in actual fact compound over time. Multiply this by the thousands and millions of customers they have, and what you have is a money making machine giving them billions a year. Now it’s your turn to make compounding work for you.

There is always an opportunity cost to the money you spend now. On this occasion, the opportunity cost is making your future self significantly poorer. Those sandwiches or those daily coffees are costing you a lot of money.

This concept of making a small lifestyle change touches on the topic of the ‘aggregation of marginal gains’. This phrase was coined by Sir David John Brailsford who led Team GB cycling to success. At the heart of his philosophy is that by achieving a very small improvement in every aspect of cycling led to significant increase in performance when put together. In finance, by breaking some of those bad financial habits which may seem small by themselves but will all add up together to have a really big impact on your wealth.

For me, ever since I joined the Police, for every pay rise I got, I immediately took out regular savings contracts which are taken directly out of my wages before the money even hits my bank account. Back then, I did not know as much as I do now and those regular savings contracts are expensive and provide a poor return. However, it has made me become accustomed to living on what I earned 10 years ago. That in itself is invaluable. As a line manager, all the detectives I supervise actually take home more money than I do because of all the additional pension and savings contributions I make. If you are bad with money and lack discipline, I encourage you to see if your work place offers a savings plan that takes money directly from your salary. Just bear in mind that they may have high fees and poor return. Once you get used to the idea of saving and not succumb to lifestyle inflation, you could then look into proper investment strategies (FI Building Block: Invest). I subscribe to the philosophy that it is better to save some money now, than not at all because you’re so busy trying to figure out what is best way to do it.

Tax Optimisation

Tax can be a large expense which needs to be budgeted for. If I were to tell you that you can decide how much tax you pay, you’d think I am making it up. It is actually true. With careful planning, you can really plan how much tax you pay. There are some people in the FI community who have optimised their tax affairs so much that they effectively pay zero income tax! This will be different depending on the country you live in. It is not about evading tax (that’s illegal in case you didn’t know). It is about not paying more than you should. Tax is important in every society. It helps run all the services we can take for granted and can act as a way to redistribute wealth (fairly or otherwise). However, you need to be aware of all the allowances you are legally entitled to and plan your finances to reduce the overall amount of tax you pay. Doing so ultimately increases your income and can help to improve your savings rate.

Company Pension

In the UK, one way to ensure you minimise the amount of income tax you pay is by paying more into your pension. This is because income tax is calculated after pension contributions. If you are part of a company pension scheme, then chances are that your pension is deducted directly from your salary. As a result, your end of year P60 will have the total income you received that year from your employment excluding any pension contributions. If you ever wondered, this is why your P60 taxable income for the year is always less than the salary agreed to in your contract. In the Police, I am able to make additional voluntary contributions towards my Police pension scheme. I will talk about the benefits of this more in another article, but the main benefit here is that it reduces your taxable income (the amount you pay in income tax).

Self Invested Personal Pension (SIPP)

Outside of a company pension, there is the Self Invested Personal Pension (SIPP). You can apply for one of these accounts and invest money in it towards your pension. This is a separate pot of money to your company pension. The money can only be accessed 10 years below the state pension age, so at the moment, 55 is the earliest you can access it (rising to 57 in 2028). As you are putting money into your SIPP using income which you have already paid income tax on (after-tax income), the government would reimburse this money back to you by topping up your SIPP by your relevant rate. This will effectively mean you have invested in your pension using pre-tax money. This is very generous and is a way in which the government is trying to encourage people to save for their future retirement. I plan ahead every year to ensure that I never enter the higher rate tax band (40% tax) by paying more into my Police pension and my SIPP. My wife is also paying extra into her military pension. Bear in mind that any money you withdraw from your pension in the future may be subject to income tax, although this may be minimised or eliminated altogether with careful planning.

Note: although not exactly the same, the nearest US equivalent to a UK SIPP would be Traditional IRA and 401k.

ISA & LISA

There are also ISA (Individual Savings Account) and LISA (Lifetime Individual Savings Account) to be considered. These accounts use after-tax income to invest but when it comes to taking the money out, it is tax-free. Whereas with a SIPP, you are using pre-income tax money to invest which may be subject to income tax when you draw from your pension in the future, it is the reverse with an ISA or a LISA. The combined total amount that can be paid into an ISA and a LISA in a given tax year (based on 2017-2018) is £20,000 per person (not per household). So, as a married couple, you can invest up to £40,000 tax-free. With a LISA, the maximum allowed is £4,000 per year, leaving up to £16,000 to be placed into an ISA. The main difference between a LISA and an ISA is that an ISA is an instant access account (you can withdraw money anytime) with no government top-up (free money), whereas a LISA can only be accessed at age 60 or when you buy your first home, with a 25% government top-up. For example, if you max out your LISA for a given year with £4000, the government will add an extra £1000 to it for free. Again, it is another way the UK government is trying to encourage people to save.

There are lots of resources online which discuss in detail the features of SIPP, ISA and LISA. Rather than duplicating it all here, you can search for the specific details online. I am just pointing these out to you to let you know how they can be used to reduce the tax you pay and that some of these accounts are actually giving you money. One final point about these accounts is that for financial independence, it is about investing the money in the stock market to gain compounded returns. So leaving the money in the accounts as cash is not something I would do unless you need the money in the short term.

Note: although not exactly the same, the nearest US equivalent to a UK LISA or ISA would be ROTH IRA or ROTH 401k.

Property Tax

In relation to income from property investments, the changes in BTL (Buy to Let) tax calculations is something to be carefully considered. What’s happening is that mortgage interests used to be treated as an allowable business expense, so there is less profit to tax. However, this is no longer the case and ‘profit’ is treated as before mortgage interest. This has affected a lot of inexperienced property investors, particularly those with large portfolios who are highly leveraged (high loan to value, in other words, have large mortgages). This meant that whereas before they would be cashflowing (making a profit after taxes and expenses), they could now be making losses every month. As a property investor myself, it meant I had to plan ahead and only invest in properties which would provide an acceptable return and fits into my plan for financial independence. As the new BTL tax rules do not affect basic taxpayers, we ensure that we are never higher rate taxpayers by paying more into our pensions. This means that not only are we able to reduce our income tax bills but we are also investing money in our pensions at the same time. A double win in our opinion. Furthermore, because we have a family, ensuring that our individual incomes do not go over £50,000 per year means that our child benefit allowance (money from the government to help support bringing up a family) is not affected.

Inheritance Tax

It is important to plan ahead to ensure that your family gets most (if not all) of what you intend to leave behind. Failure to do so may well result in them paying 40% inheritance tax on it. That’s a lot of your hard earned money to give away to the government when it could be passed on to your family. The use of Trusts and gifts are two ways to do this. However, inheritance tax planning is a complex area and I recommend getting specialist advice to ensure you are doing it correctly. For example, just by gifting a property and waiting for the 7 years to expire does not always mean it will be inheritance tax-free. There are conditions to gifting a property, such as a person giving the gift cannot continue to benefit from it without paying the market rent. So gifting a property for your children but you continue to live in it may still result in that property being treated as part of your estate. Being frugal does not prevent me from paying for valuable advice when I need it because it will ultimately save my family thousands of pounds in the future.

Income Equalisation

If you are married and have other business interests giving you multiple income streams aside from your usual job, then first of all, well done. It really will help you on your journey towards FI. Secondly, it could make sense to arrange your finances so that the total income is shared equally among partners. This helps if say one partner is a higher rate taxpayer because of rental income (or other forms of income) and the other partner is a lower rate taxpayer (perhaps in a less well-paid job). If we stick with rental income, if some of the properties were transferred over to the partner in the lower income tax band, then this could mean the income falls to a lower tax band for the higher rate tax paying partner. In the UK, the transferring of properties between married couples do not incur any capital gains tax so it really is a useful strategy to reduce the total amount tax you pay as a family.

Tax is a very big topic and changes often. It is just an area of interest for me and not my field of expertise. It is the one area where careful planning and knowledge pre and post FI will save you and your family thousands if not hundreds of thousands of pounds. As a result, paying for good specialist advice may actually allow you to reach FI sooner.

All Debt is Bad

That’s quite a statement isn’t it. Yes, I really do mean all debt is bad. Don’t misunderstand, I accept that there are some debt better than others. Just like all criminals are bad, some are nicer and won’t spit in your face whilst on duty. If I were to rank some types of debt on a scale of badness, where one is the absolute worse, then it will be something like this:

Loan sharks
Pay day loans
Credit cards
Personal bank loans including car finance
Mortgage
Student and Business loans

I can already hear some of you shout at me through your screens or tapping furiously to respond:

“Large companies, even successful ones like Apple have significant amounts of debt. Governments carry debt. A mortgage for my home is good debt because it’s an investment.”

First of all, repeat after me: “My home is NOT an investment”. I will go into why I believe that is another time, but put simply, if your home is not earning you an income, then it is a liability. I intend the FI Building Blocks to only be an introduction, so I do not have the space to go into the details here. However, I strongly believe that all debt is bad due to the obligation it creates. It is money that does not belong to you, used for something which in some cases, will not generate an income (car, furniture, holidays, certain university degrees), and in other cases, the income you hope to generate (even with a good business plan) is not guaranteed. There is this public perception that there is such a thing as good debt and bad debt. I think using a positive adjective to describe what is effectively financial self-subjugation misleads people. The majority of whom already have poor control of their finances and do not adequately understand how money works. I am not saying don’t ever take on debt. Many entrepreneurs rely on debt to start a business. Doctors need a student loan to get through university. You want to own your own home. What I am saying is to treat debt like a grenade, get it out your hands as quickly as possible to reduce the amount of interest you pay. This will give you more freedom to manoeuvre without having this debt ball chained to your legs if your circumstances were to change.

How you go about paying off your debt can be divisive. Mathematically, the optimum way is to focus paying off your highest interest debts first then move along to the second highest. However, this may not have the level of ‘feel good’ factor as you would hope if the debt is large and take a while to pay off. As a result, some argue that using the “debt snowball” technique is more effective as it keeps you motivated because you can see the debt disappear quicker. This takes into consideration the concept of ‘behavioural finance’. The debt snowball method involves tackling the smallest amount of debt first regardless of interest. This way, as soon as you pay it off, you can focus your efforts on the second largest and so on. This then snowballs as, by the time you reach your fourth or fifth debt pile, you are making payments of at least the sum of the other debt payments you had already paid off (assuming you haven’t gone out to make more purchases with the money you have not saved). By the way, make sure you have an emergency fund first before you start paying off debt (see FI Building Block: Protect).

Geographic Arbitrage

Geographic arbitrage is a term that has been coined to describe re-locating to another area or country to take advantage of lower living costs. As a Police Officer, I regularly hear stories of colleagues relocating up North because it is so much cheaper to live up there, whilst still earning the same amount of money. Some officers receive an extra payment called the London Weighting or the South East allowance to try and mitigate the higher living costs in those areas. However, they are nowhere near enough, particularly with the disproportionately high house prices and childcare costs. This is geographic arbitrage. It doesn’t have to mean moving to somewhere like Thailand, although it can be if you want. This is possible if you are in a role that allows you to work anywhere.

Key Points:

Treat your money like a bad employee.
Give your money a clear job description.
Reduce your expenses to turbocharge your savings rate.
Optimise your taxes.
Treat debt like a grenade.
Make your money go further through geographic arbitrage.

I don’t underestimate how difficult this step is for most people. In fact, I suspect most will throw in the towel here. Normality is to spend your money, enjoy life: YOLO (You Only Live Once) and all that. Whilst I’m on it, I just want to point out how much I detest that phrase. It is normally said immediately before, or after an unnecessary purchase in a poor attempt to justify a bad decision. I admit, there will be exceptions, but in general, I still stand by this view. For me, after a certain level of comfort, there is no longer a direct correlation between the amount of money you spend and the amount of pleasure you have in life. What I mean by this is that the pleasure rate of return for your money reduces drastically after a certain level. It will take more and more money to get an extra increase in pleasure. After a certain point, no matter how much money you have, it will not give you any more pleasure because you’ve become accustomed to it. Notice I’ve not used the term happiness. That’s something completely different. Think of it as a drug addict. After a while, they need more and more to get the same level of high or kick out of it. They keep chasing this high and it eventually destroys them.

This section is about learning to control your money and not let it control you. Now that you understand how to maximise your income and have a clear plan for that income, lets move onto the next FI Building Block: Protect.