What is financial freedom?
Ask a room of people to define financial freedom, and you’re likely to get a dozen different answers. For some, financial freedom means being able to pay the bills with money left over each month or having a fully funded emergency account. Others may want to retire early and travel extensively.
Regardless of how you define financial freedom, everyone can benefit from taking a comprehensive approach to money management. “It’s important to think about your finances holistically,” says Elisabeth Kozack, co-head of consumer lending at Marcus by Goldman Sachs.
The following 12 steps will help you achieve your vision for the future.
Commit to living within your means.
The path to financial freedom begins with a step many people overlook. It starts by developing a mindset in which you prioritize building a strong financial foundation of savings before you move on to spending and investing. “You’ll never get ahead if you’re always putting the cart before the horse,” says Charles Czajka, CEO of Macro Money Concepts in Stuart, Florida.
People need to analyze their beliefs about money and examine their relationship with it. Rather than assuming wealth is something attainable only by those with high incomes, recognize that even middle-class families can move from living paycheck to paycheck to a financially comfortable lifestyle so long as they spend less than they earn.
Know your current financial situation.
Regardless of whether you are just out of college or getting ready to retire, its essential to understand where you stand financially right now. “Completing an honest assessment of your personal financial situation is a critical first step on the journey to establishing financial well-being,” says Dave Kilby, CEO and president of FinFit, a financial wellness employee benefits platform.
That means adding up debt, calculating expected income and identifying holes in your financial picture, such as a lack of insurance or emergency savings. Consulting with a professional may be helpful in this process, particularly if you have complex finances or are approaching retirement.
“I think everyone should have a financial advisor,” says Wilson Coffman, president of Coffman Retirement Group in Huntsville, Alabama. These professionals have experience and expertise that other individuals may not. What’s more, they aren’t emotionally invested in your money, which means their advice should be neutral and objective.
Open the right accounts.
There is no one single account that is right for all your money. Cash for retirement should be placed in a tax-favored 401(k) or IRA account, while college savings are usually best kept in a 529 plan. Those with high-deductible health insurance plans can open health savings accounts to pay for medical expenses.
Meanwhile, you’ll want your emergency fund separate from your other savings to avoid dipping into it unnecessarily. High-yield savings account are usually offered by online institutions such as Marcus by Goldman Sachs and Discover Bank, and these can ensure money earns some interest. However, the most important consideration for an emergency fund is that it is liquid and insulated from market losses. “We’re not interested in the rate of return with this account,” Czajka says.
Set up a deposit schedule.
Once you have your accounts set up, create a system for ensuring they are fully funded. Many employers will direct deposit paychecks into multiple accounts, so you can divert a portion of your income to checking, regular savings and your emergency fund. You can also contribute directly to your 401(k) through a payroll deduction.
For other savings goals, you may be able to set up automatic, regular transfers from your bank account to other financial accounts. Finance experts often recommend saving 10% of your income for emergencies or other goals and another 10% for retirement.
Monitor your credit.
A person’s credit score can determine whether they have access to loans and what interest rate they receive. In some states, employers can review a job applicant’s credit history when making hiring decisions, and insurance companies in certain areas may use credit to set policy premiums. Reducing debt and paying bills on time are two ways to boost a sagging credit score.
“It’s important to keep a pulse on your finances,” Kozack says. Federal law allows consumers to request a free copy of their credit report once each year using the website AnnualCreditReport.com. During the pandemic, credit reporting companies Equifax, Experian and TransUnion began voluntarily offering free weekly reports as well. Credit scores can be accessed for free through a variety of credit card issuers and finance websites such as Credit Sesame and Credit Karma.
Track your spending.
If you’re currently living paycheck to paycheck, setting aside money for emergency and retirement savings can seem daunting. To find out exactly how much you can save, you first need to understand how much you spend. “If you don’t know where you’re spending your money, it is very difficult to know where you have opportunity to make adjustments,” Kilby says.
Take a month to track where your money goes, from major bills to the couple bucks spent on coffee in the morning. Using a free app like Mint or Marcus Insights can make it easy to collect and categorize spending data. These apps can also help you pinpoint hidden expenses. “(Such as) that one time you set up Hulu to watch the Golden Globes and then ended up paying for it month after month,” Kozack says.
Trim your budget.
Now that you know how you’re spending your money, it’s time to trim wherever possible. That doesn’t necessarily just mean cutting your morning latte or gym membership. Instead, people should think beyond the small expenses and consider major lifestyle changes to make a considerable change in their financial situation.
Selling your house or buying a cheap, used car may seem like a significant sacrifice. However, it can be worthwhile if it helps achieve your ultimate goal of lifelong financial independence.
Create a debt payoff plan.
For most people, financial freedom means eliminating debt. While it can be difficult to own a house without a mortgage, getting rid of credit card debt or even car loans can be more achievable. “You can do a lot when you’re debt-free,” Coffman says.
It’s easier if you start by focusing all your extra money on one debt while making minimum payments on the rest. From a mathematical standpoint, it may make the most sense to start with the debt charging the highest interest rate. However, some finance experts suggest paying off the debt with the smallest balance first to build momentum and motivation. When you pay off that debt, don’t let the money you had been paying toward it get absorbed by your budget. Instead, take that payment amount and apply it to the next debt on your payoff plan.
Build an adequate emergency fund.
It can be tempting to deplete savings in order to pay off debt more quickly, but that approach can backfire. Without an emergency fund, you risk going into high-interest credit card debt should an unexpected expense occur. Instead of prioritizing debt over savings, or vice versa, direct a portion of your available cash to each priority every month.
For those who can afford it, Czajka recommends saving 15% of every dollar in an account until its balance equals 50% of a person’s annual income. Once that savings account is fully funded, money can be diverted to other needs such as retirement and college savings. If needed, money from the account can also be used to purchase other essentials, such as life insurance.
Evaluate your career options.
Don’t overlook the importance of your job when it comes to how to achieve financial freedom. While income is obviously important, there is more to a job than the money you bring home each week. “When considering your overall compensation package, you need to consider all benefits provided by your company,” Kilby says.
Employers may match contributions to retirement funds, provide access to a variety of insurance products and even connect workers with financial advice and money management tools. Just as importantly, the right job may provide options such as flexible scheduling and remote work that can support overall wellness and personal goals. That, in turn, can alleviate stress and may make it easier to stick to financial plans.
Invest for the future.
Many people assume they need a large income to achieve financial freedom, but that isn’t necessarily true. Some households with high incomes may carry substantial debt, ensuring they will never be wealthy. Meanwhile, other wealthy families may have modest incomes. Rather than amassing wealth through their income or an inheritance, many people become wealthy because they save and invest money consistently throughout their lives.
“Our research shows many consumers find investing to be intimidating,” Kozack says. There are a number of investing options including bonds, stocks, mutual funds and annuity products, which can be confusing. A financial advisor can help you select the right investments, or online advisory firms can simplify the process for those without access to an advisor.
Prepare your legacy.
This final step isn’t so much about creating your own financial freedom as much as ensuring that of your heirs. After a lifetime of managing money correctly, you don’t want your money to end up in the pockets of relatives you didn’t intend or, worse, Uncle Sam.
Create a will, update the beneficiaries on financial accounts and, if your assets are considerable, talk to an attorney or certified public accountant to discuss strategies to minimize estate taxes. Beyond that, regardless of your income, you’ll want to maintain adequate life insurance to support your loved ones in the event you die unexpectedly.
It’s important that you continually update your financial and estate plans too. Throughout the years, your life will change, and tax laws will change. Your financial plans need to change along with them.
12 steps to financial freedom:
— Commit to living within your means.
— Know your current financial situation.
— Open the right accounts.
— Set up a deposit schedule.
— Monitor your credit.
— Track your spending.
— Trim your budget.
— Create a debt payoff plan.
— Build an adequate emergency fund.
— Evaluate your career options.
— Invest for the future.
— Prepare your legacy.
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Update 04/26/21: This story was published at an earlier date and has been updated with new information.