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Financial Advice: How to ‘Pay Yourself First’
Are you thinking about planning for retirement? One of the most effective retirement savings strategies is to pay yourself first.
This concept involves prioritizing your savings by automatically setting aside a portion of your income for retirement before covering other expenses or spending money on unnecessary things.
By saving and investing consistently over time, you can build a solid nest egg, harness the power of compound interest, and set yourself up for a very comfortable retirement.
What does it mean to “pay yourself first”?
The term is often used in the world of business and entrepreneurship. In an effort to constantly grow and expand, many small business owners reinvest every dollar they earn back into their business, often leaving their own savings dry.
However, this principle applies to both retiring employees and small business owners.
Last year, 49 percent of Canadians failed to save anything for retirement, according to a study recent research by the Health Ontario Pension Plan (HOOPP).
To be fair, the rising cost of rent, groceries and other living expenses has been disproportionate to the increase in income, leading six in ten Canadians to question their ability to keep up with the cost of living, Statistics Canada.
I would argue, however, that this makes it more important than ever to pay yourself first.
Automating your savings
One of the easiest ways to ensure that you always have something to contribute to your savings is to automate your savings. This ensures that no matter what happens, you’ll always be putting something toward your future — even if it’s just a small percentage of your weekly paycheck.
Most banks, savings accounts, and investment accounts have settings that allow you to set up recurring deposits on specific dates, so that funds are automatically withdrawn as soon as your paycheck arrives.
I like to think of automating savings as creating a habit with as little friction as possible. It’s a lot like going to the gym. If your gym is a block away, you’re much more likely to stick to a regular exercise routine than if it’s a 30-minute drive away. Likewise, if you have to manually calculate and transfer money every time you pay your bill, you’re much less likely to save than if it were automatic.
Combine strategies
The number one way to get ahead is to start early. The sooner you can take advantage of the effects of compound interest on your retirement savings, the more you will have saved by the time you retire.
Here are some other tips to help you maximize your retirement savings.
Maximize employer contributions
Many employers have retirement programs that offer to match a certain amount that each employee deposits into a Registered Retirement Savings Plan (RRSP). It’s usually a good idea to contribute enough to maximize your employer’s contribution, since it’s essentially free money.
Maximize tax-free accounts
Tax-Free Savings Accounts (TFSAs) are by far one of the best savings and investment vehicles available to Canadian residents. These accounts can be used to hold investments that earn compound interest or pay dividends over time.
The best part about using a TFSA for your retirement savings is that you are not required to pay any taxes on capital gains, interest or dividends on the money earned inside a TFSA.
You can combine the pay-yourself-first method with these strategies; for example, you could set up automatic payments into your employer’s RRSP or your TFSA.
Lower your lifestyle
If you find yourself just staying afloat and controlling expenses, with little money left over to save or invest, you are not paying yourself first, but rather paying for your lifestyle first.
For many, the simplest strategy to start paying yourself first and investing for retirement is to change your lifestyle.
I’m not saying you should adopt an entirely Spartan existence, devoid of creature comforts. However, some simple ways to reduce your cost of living while still maintaining a decent standard of living include:
- Trade in your car for something with a lower payment or use public transportation
- Downgrade your apartment or house or get a roommate to share living costs
- Preparing your lunch and dinner to save on eating out
- Adopt a more minimalist lifestyle and find lower-cost forms of entertainment
- Buy your clothes at discount retailers
I recommend keeping track of your spending so you can see the difference. Then, all you have to do is take the difference and commit to putting it into a retirement savings account or investment.
How much should you save?
The amount you need to maintain your quality of life in retirement depends on how you plan to retire.
Financial planners generally suggest that the cost of maintaining your current lifestyle will be around 60 to 70 percent of your cost of living.
Canada’s Retirement Hub offers a helpful tool calculator to help you calculate how much you should save based on your current income and retirement goals.
Continue reading to more money saving tips to help you better plan for your retirement.
Christopher Liew is a CFA Charterholder and former financial advisor. He writes personal finance tips for thousands of Canadian readers daily at Financial Project.
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