Basic Financial Terms You Should Know
As someone who is changing my financial path drastically, I have come across a significant amount of basic financial terms that I think everyone should know.
My Not So Stellar Past Financial Experience
I used to have a job working as a Legal Assistant to a Social Security Disability Attorney. The pay wasn’t high, but he would occasionally slip us some extra money when we were leaving for a vacation or at the holidays. One time he gave myself and another co worker an “extra paycheck” and told us to go to the bank and tell them we wanted to open up a ROTH IRA. The attorney I worked for is well off and I’m sure taught his children terms such as ROTH IRA, but damn, I wish he would have told me what I was doing.
I did as I was told and walked into the bank literally never even hearing of the word ROTH IRA, and advised the banker I’d like to open one. I remember the banker asking me questions of what I wanted to invest it in. He might as well have been speaking a foreign language. Something along the lines of “I have no idea what this is, but my boss told me to open one” came out of my mouth! He did as instructed but because I had no financial literacy, I eventually took the money out, penalty included. This money helped in putting down a large down payment for my car. If only I knew to keep that in there…and watch it compound.
Disclaimer: I am not an accountant, a CPA, a fiduciary, or licensed in anyway to provide professional financial advice. I am simply documenting the knowledge I have gained through podcasts, books, and blogs about personal finance. Seek professional advice for your specific situation.
Some Terms I Wish I Would Have Known Include:
ROTH IRA: After tax money an individual can set aside for retirement. Earnings and withdrawals after the age of 59 1/2 are tax free. The max a person can contribute each year is $5,500 if 49 and under. After 50, you can contribute up to $6,500. This is a good option for those who are not offered a 401K plan at work. It’s something that you can easily open yourself. But be aware, there are limitations based on your income. If you make more than 120K, single, you are no longer eligible. If you are married filing jointly, and make more than $189K, you are no longer eligible. *See back door ROTH IRA.
BACK DOOR ROTH IRA: If you find yourself with too much money to contribute to a ROTH IRA, either single and making more than 120K, or married filing jointly making more than $189K, enter a Back Door Roth IRA. Because there are no limitations on Traditional IRAs, a Back Door Roth allows you to place after tax money into a Traditional IRA then convert it to a ROTH IRA. Right now this is option is legal, but as always, policies can change.
401K: An employee sponsored retirement account. If eligible, an employee may make salary deferred contributions towards their retirement. Any earnings on a 401K grow tax deferred. Employers may also elect to match up to a certain amount of your contribution. If this is the case, definitely sign up!
For example, my employer matches up to 3% of my contribution. If I put in 3%, she puts in 3%. If I only elect to put in 2%, she will only match at 2%. BUT, I can always put in more for myself. If I elect to put in 7%, she will still only match up to the 3%. Get it?
The cap contribution for those under 50 years old for a 401K is $18,500 (effective 2018). For those 50 and older, the IRS will allow a contribution of $24,500 in order to allow those nearing retirement to “catch up.” Some financial experts discourage using a 401K until all debt is paid off, but I personally believe you if you receive an employer match, you should at least contribute up to the match while paying down debt! This is literally free money you’re receiving.
EMERGENCY FUND: Money set aside in an accessible savings account that is only to be touched in the instance of an actual emergency! Not a fake emergency. Not an ‘oops I want to go out for drinks I didn’t budget for emergency.’ An actual emergency. This may consist of car troubles, an unexpected flight home for a funeral, a pet illness. Some experts suggest putting $1000 aside for this account. I encourage more as one emergency could deplete $1000 immediately.
I would suggest 3-6 months of your living expenses set aside. In order to obtain this number, calculate your monthly expenses and multiple that by 3 or 6. Basically the number you are most comfortable with. The number that will help you sleep at night. It is beneficial to have this amount set aside for the true emergency of being out of work and not going into debt, while you search for another source of income.
If you’re having troubles keeping your hands off that money, put it in an account that isn’t accessible by your debit card to make it an inconvenience to obtain. I’ve even heard others go to the extreme of freezing the cards in an bowl of water so it’s difficult to retrieve the money, but can be done if a true emergency presented itself.
Emergency Fund money should not be invested. This money needs to be accessible at any givens notice. Not in 3 days from the emergency. This money is not intended for growing interest other than what measly amount you receive from your bank.
COMPOUND INTEREST: One of the easiest ways the rich get richer! Compound interest is basically interest paid on the interest earned. Let’s say you invest $100, on an 8% interest rate after a year, you now will have $108 invested. In the following year you earn that same 8% interest rate, but it’s now on $108 dollars so after the second year of having $100 initially invested, you will have $116.64. Third year with following the same 8%, your $100 has now turned into $125.97. Think if this $100 was a monthly contribution, or even on a larger scale of $1000 per month. You’re earning interest on your interest! Starting young is KEY to experiencing the best returns, but NOW is better than NEVER if you haven’t started yet! Hop to it!
BUDGET: Simply you telling your money where to go each month. For example, rent, electric, water, gas, clothes, savings, retirement. Budgets are not only for the poor. Budgets are for everyone! It’s super important to know where your money goes each month, because it’s easy to lose track!
FU MONEY: Where you financially feel you have enough money set aside that you can tell someone FU and still be able to survive! This could be a moment where you’ve had enough of your boss and you don’t financially NEED to work the 80 hours a week at a job that is taking your soul. You are to the point where you are secure without the next paycheck and that right there is a good feeling. Take that 6 month sabbatical, go visit your family, start your own business. You can do all these things because you simply don’t need that next paycheck!
FI/RE: Financially Independent Retire Early. It’s a movement. It’s the point to where you have enough money saved up in different financial accounts to where should you want to, not have to work another day in your life because compound interest and passive income will take care of that for you. This number will be different for everyone. It will completely depend on what you want your lifestyle to look like once you quit working. Does your lifestyle only require 25K per year? Or would you feel more comfortable spending 60K per year? This number is totally dependent on you and your life and that may change over time, which is also okay!
Many who choose to Retire Early because they are FI, do so not to actually stop working, but to start working on their passion projects full time. This could be a side hustle of jewelry making, volunteering overseas, starting your own business, or simply working out, blogging, and traveling the world. And you know what? It doesn’t matter what you do, because you’ve done the work already to put you in a place financially where you don’t have to worry about where your next paycheck is coming from, if any paycheck at all! And now I can’t help but think of my girl Alicia Keys. For dance party blogging break, go here.
I hope you have found these terms useful as they are key to a successful retirement regardless at what age you plan to do so! It’s knowledge that, in my opinion, should be taught in school, rather than us all finding it on our own terms, but here we are! My husband and I are on the track to FIRE and to be honest have no idea what our “number” is. But I believe we are half way there. We aren’t gazelle mode but also know we don’t want to work in our said careers forever so eventually we will get all of our ducks in a row! Until then, I’ll just keep blogging about it!