The Secret to Building Wealth? Know How Your Cash Is Flowing

Do you feel like you’re bombarded with financial advice from family, friends, and social media influencers? However well-intentioned, conventional wisdom such as paying off your mortgage quickly or maxing out your 401(k), can be too shortsighted and lead to significant problems down the line. For instance, retirees who have aggressively paid off their low-interest mortgages may regret missing investment opportunities to grow their wealth when interest rates rise. And those who deferred taxes through retirement savings may face substantial tax burdens in their golden years.

Cash flow: The basic building block of money management

From maintaining a basic quality of life to building wealth, earning enough money, and spending within your means is critical. Financial security requires managing your cash flow – the money you have coming in and going out. Cash flow can be the most challenging aspect of financial planning. However, mastering your cash flow doesn’t have to be impossible if you follow the right strategies.

How is your cash flowing?

The first step to wealth building is understanding your cash flow. It’s important to note that cash flow is not monthly budgeting. Cash flow is a process of assigning your resources to specific priorities that help you move closer to your goals. Think of it as a road map outlining where your money will go, including savings, investments, and day-to-day expenses.

Two powerful financial principles

To understand the importance of finding, increasing, and saving cash flow, we need to review two important financial principles.

The power of compounding. You may have heard this described as “money growing money” but most people don’t understand the power and importance of compounding.

“Warren Buffet’s $300,000 haircut” illustrates the power of compounded earnings over time. Buffet is known for his thrifty lifestyle, considering his wealth. When he was a young man, he calculated that if he continued to spend the amount he did on a haircut, it would cost $300,000 during his lifetime. (Hence, the hypothetical question of “Would I spend $300,000 on a haircut?”). He realized that if he spent half the amount for a haircut, he could save $150,000 just from this simple action. He then started to apply this lesson to his spending and investing.

Let’s look at a practical example. How much is your monthly cable TV or subscription service bills? Many people spend at least $200. Over a year, that amounts to $2,400. Over 10 years, it turns into $24,000 (assuming no inflation but we all know that prices only go up). Over 30 years, this amounts to $72,000 (30 times $2,400). If you cancel these services and do nothing with these savings, at the end of 30 years, you’ll have $72,000. But if you decide to invest the money instead, depending on the rate of return, it could grow to more than $150,000 in 20 years. If you keep contributing $200 each month for another 20 years while generating the same average annual return on your investments, you could have more than $1.2 million. The difference in earnings between doing nothing and investing is due to the power of compounding. Making prudent cash flow decisions, even in later years, can have a profound effect on your wealth and your lifestyle.

Make income taxes work for you. Managing taxes is an essential aspect of wealth management. Depending on your level of wealth now, or in the future, taxes can be anywhere from 10% to 40% of your income. Knowing how to help mitigate tax liabilities is an essential aspect of building and keeping wealth. Allocating assets to mitigate tax liability requires an understanding of your entire financial picture. This includes knowing how to title assets, where to save money, and which investment vehicles to choose or avoid. Here are some ways to make taxes work for you:

• Save as much as you are allowed in your employer-sponsored 401(k). If your employer matches your contributions, don’t leave free money on the table. This can translate into thousands of dollars and help you save tax dollars of 40% or more (depending on your tax rate) on your contributions.
• Contribute to an individual retirement account (IRA). A Roth IRA can be an essential financial tool at any age. There are different options with IRAs so talk to your advisor about which makes sense for your financial goals.
• Other tax actions include meeting with your CPA or tax advisor at the start of each year to review your tax situation. Let them know your goal of wanting to save tax dollars. While some limits may apply, your charitable contributions and retirement savings may help save a lot of tax dollars.

Check your spending habits to increase cash flow

A common question I hear is, “How can I increase cash flow?” The first step is to determine how much money is coming in and going out every month. First, add up your paychecks for the month. Next, find your beginning cash balance at the start of each month and add your net earnings to the beginning cash balance amount. At the end of the month, look at your cash balance. Is your ending balance higher or lower than your beginning balance? If your ending monthly balance is higher, that means you spent less than you earned. If your ending monthly balance is lower, you spent more than you brought in.

Once you know where your money is going, you can predict and target your spending. List out your spending by categories (groceries, entertainment, gym membership, etc.) for the month. The point is to know what and how much you are spending. Remember, saving $100 per month can mean saving over $150,000.

If you have a spouse or significant other, I encourage you to track your spending together to understand where the money goes. Use this time to support each other and compromise.

Other places to find your cash flow savings

Once you start tracking your spending, you may find more ways to save, including:

• Refinance your mortgage. Historically, the rule of thumb is that refinancing is a good idea if you can reduce your interest rate by at least 2%.
• Reduce credit card balances. Inflation has resulted in sharply higher prices across everyday items. If you’re relying on credit cards, consider taking out a home equity loan or personal loan to pay them off. It will likely cost less in interest.
  • Whether you have a home equity loan or not, contact your credit card issuer to negotiate a lower interest rate or monthly payment (this can be especially helpful during poor economic times). If they can’t accommodate you, switch to another company that offers a better rate/payback terms.
• Budget-friendly binging. How much are you spending on your monthly cable TV subscription? If you want to save money, cut the cable, and choose a streaming service.
• Audit your subscriptions. Are you still subscribing to magazines or other services that you’ve forgotten about or no longer use? If that subscription or membership isn’t changing your life and you’d rather have that money in your bank account, cancel it.
• Seek out price reductions and discounts. Negotiating when buying a car is common knowledge, but you can also apply this approach when making other purchases. Just make it a habit to ask for a discount anytime you are purchasing something. Then save the savings!

Negotiate a raise (or look for a higher-paying job)

Finally, don’t forget to assess your current employment situation. If you believe you should be paid more, you have two choices: find a higher-paying job or ask for a raise. If you like your current employer and career path, it’s often a good idea to ask for a raise. After all, your employer may not know you are dissatisfied with your current pay unless you speak up.

Let’s say you asked for a raise and received an additional bump of $24,000 per year. If you saved this money over 35 years, you would have $700,000. Applying the powers of compounding, if we assume an investment return of 6%, that $700,000 would be almost $1.4 million!

Ultimately, consulting with a financial advisor can help you tailor a wealth building strategy that aligns with your unique financial goals and circumstances. For more information, contact your wealth advisor. If you are not a client but would like to learn more, contact us.