Personal Finance for Beginners

This is Part 3 in a free five-part training series on personal finance. The other parts of this course are coming soon. If you’d like to be notified via email when they become available please click here and register for updates.

If you are a literalist, it may seem to you that getting out of debt and plugging all the holes in your financial bucket must be fully accomplished before actually saving up cash and investing.

What we advocate at Online Option is accumulating money while you are plugging the holes in your debt bucket but doing it modestly.

First by building $1,000 in your contingency fund and gradually working up to an amount that covers at least 3 months of basic living expenses.

This will be explained below.

Though this start may be very humble, that is no reason to forestall it.

Saving and investing money is a habit that simply cannot be started too soon or strengthened too long.

If you are in consumer debt, then of course you want to complete the process of retiring those debts as I explained in part 1 of this course.

You will have started by now or you will start right away… correct?

The Contingency Fund

The first goal in cash accumulation is to reach the goal of $1,000 in an account that you can tap into immediately if needed.

This is the beginning of a growing buffer between you and the temptation to use credit cards to finance those unforeseen expenses that inevitably pop up.

If you have this level of buffer in place already that’s great.

Just move on to the next step.

As your list of debts is being reduced as discussed, gradually increase the basic $1,000 of contingency money to the amount necessary to live for one month with no additional income. 

If you want to stash this money in a can and bury it in the backyard, that’s fine by me yet a high-yield online savings account might be best.

Just get started.

If you can only spare $5 a week to direct to your eventual financial freedom, that is wonderful.  We both know you can do better than that, but let’s just be general for now.

The intent, action, eventual habit and ultimate way of life directed toward the goal is far more important in the early stages than the number of dollars you’re able to put in your contingency fund.

The can in the backyard approach might not be the best if you live in a moist climate.

The idea is that you want to be able to get at this money if there is truly an emergency. Most folks will keep their contingency fund in a savings account at their bank. 

As long as you can access this money quickly the objective is accomplished.

“Won’t I be losing interest by just putting my money in a savings account?”

Please understand that the contingency fund is not an investment vehicle.

It is cash you can put your hands on quickly.

Bank accounts, CD’s and money market accounts pay almost nothing by way of interest at present.

So, the supposed loss is really a non-issue.

Your contingency fund is there to pay you in peace of mind, stress reduction, and security.

Fear not.

This is just the beginning.

Once you have gathered one month of expense money the contingency fund job is not finished yet.

You will gradually work toward two months, then three.

This is done slowly as you are paying off the consumer debt as we discussed in part one of this course. 

Once you have those debts handled then you can fully build out your contingency fund.

The final goal in this area is to have three to six months of cash reserve available.

In case of injury, illness, economic fluctuations, job loss, exploded water heater, transmission on the freeway, or other potential money challenges that come your way, you will be in a good place to cope.

Another benefit of having cash reserves is that the need for certain insurance coverage decreases.

5 Benefits of Having This Cash Reserve

• First, it provides a certain confidence. You won’t be worrying about not having the money when a short-term financial challenge comes along.

• By having a good cash reserve, you move from a mental and emotional state of “lack” toward an outlook of “prosperity.” This is critical.

• As you move away from devoting a large part of your attention and focus to what you need today to what you desire for tomorrow, you become freer. You’ll find that you have more energy and ability to be creative in obtaining what is required for ultimate financial freedom.

• You will have more respect for yourself. Knowing that you have taken positive control of your financial security and or your future is fantastically empowering. Standing upon the higher ground of self-control, you will see vistas that are either new to you or long forgotten.

• You will have greater hope for the future.

A Financial Emergency is Usually Nothing More Than a Common Occurrence of Life that was not Adequately Planned for.

Socking it Away for a Rainy Day

It has been recognized by economists and politicians that individual savings rates are an important measure of a core part of a country’s economic health.

Moreover, individual savings rates can provide in a general way, a measure of personal freedom, satisfaction, peace of mind, and potential for upward financial mobility.

Until the late 1970s Americans, on the whole, enjoyed rising rates of personal savings.

Savings rates peaked at about 11% of income in the early 1980’s.

Since then, the trend of personal savings has been markedly downward overall.

By 1992 this important indicator went almost straight down as the following chart shows.

Lowest Savings Rate

In the next chart, you’ll see that personal saving rates stayed essentially flat during the 1990’s.

2020 Savings Rate with Covid

During the 1990’s in contrast to flat personal savings rates, personal income rose substantially.

1990s Personal Savings Rate

Over the decade of the nineties, there was little correlation between rising income and personal savings rates as we might expect. No doubt a cohort of sociologists and economists would be able to offer reasons why individuals were not individually responsible for this disconnect.

Now take a look at what happened with median household income during the following decade from 2010 through 2019.

2010-2019 Personal Savings Rate

One of the great motivators that spurs us into action is fear.

Fear and concern about the future are powerful.

Take another look at the savings rate chart which covers both the 1990’s and 2000’s.

Notice that the savings rate bounced up during the Financial Crisis and Great Recession period beginning in 2008. 

The savings rate absolutely went ballistic in early 2020 as concern for what Covid-19 and shutdowns could mean.

Here’s what it looked like again…

2020 Savings Rate with Covid

Consider this.

The seasonally adjusted unemployment rate in the United States since 1948 has averaged 5.77%.

In April 2020 the unemployment rate steaked up to 14.7%.

Fear inducing, yes?

April 2020 Unemployment Statistics

It is interesting to see that during times of high unemployment and recession individual savings have moved up.

During periods of increasing household income, the savings rate went flat.

If You Do What Most People do, You Will Get Similar Results to What Most People Get.

Rather than freaking out when times get tough with the herd, why not gradually and steadily prepare for the inevitable?

Most people don’t.

This is an excellent point at which to ask, “am I willing to just do what most people won’t do when it comes to money management?”

If you want different results in your life, if you want to attain a level of financial freedom that most people never reach, then you must not follow the crowd.

Observe what most people do with their financial resources, and then do something different.

Start Building Your Financial Freedom Machine

In the United States and a number of other countries, the government provides an avenue to encourage personal savings and investment.

In the U.S. it is often referred to generally as the I.R.A. (Individual Retirement Account).

In Canada, the corollary is the R.R.S.P.

The concept behind these programs is to stimulate private savings and investment by offering tax advantages to the saver/investor.

These programs alter how taxation is handled when money is contributed and withdrawn. We’ll look at the various government created retirement accounts individually.

The Traditional IRA

    • Available to anyone who receives a W- 2 at the end of the year.
    • Individuals may contribute up to $6,000 per year or if over age fifty, $7,000.
    • Both working spouses may have their own IRA’s.
    • Each spouse may make a full contribution.
    • Contributions to this account are not subject to income tax.
    • Beginning in 2020 there is no age limit on making regular contributions.
    • You can begin taking money out of the account beginning age 59 ½.
    • Withdrawals are taxed at the then current rate.

This is the most popular personal retirement account format but, in my opinion, not the best.

As you contribute money to such an account you actually reduce your taxable income which is what makes the Traditional IRA popular.

For example, if you contribute the full $6,000 this year, that amount would be taken directly off your gross taxable income.

This of course would reduce the income tax you pay by, your tax rate X $7,000.

The Roth IRA

  • Contribution limits are the same as the Traditional IRA, except as specified in the following table from

Roth IRA Contribution Limits

    • After age 59 ½ withdrawals are non-taxable as long as the account was established for 5 or more years.
    • Both working spouses may have their own Roth IRA(s).

Traditional IRA vs Roth IRA – 2 Major Differences

First – the manner that taxation on contributions to the two is handled.

    • In the Traditional IRA, your contributions are made with pre-tax dollars.
    • With the Roth IRA contributions are made with after-tax dollars.

Second – Under the Roth IRA rules, no tax consequence is incurred upon eventual withdrawal.

    • With the Traditional IRA, you must pay the applicable taxes upon withdrawal.

These are major factors to consider.

Should I Use a Traditional IRA or a Roth IRA?

Although investors can certainly open both traditional and Roth IRA’s, my preference is to use Roth accounts to their fullest in order to take advantage of the Roth’s long-term benefits.

Note: You may open as many IRA and/or Roth IRA’s as you like. You are, however, limited by the yearly contribution amounts as shown above. For example, one might have 6 different IRA accounts and contribute $1,000 into each, or $3,000 in two, or any combination desired.

The argument for why I like the Roth style of IRA is simple.

There are only two prongs to it.

1. I am confident that in the future, income tax is far more likely to be higher than it is now, rather than lower. I would rather pay the tax on the way in instead of the way out.

During a person’s working life, they are better able to make adjustments in order to pay the tax on an IRA contribution. In most cases after retirement, options are limited by health concerns, employability, or a host of other possibilities.

2. No income tax later.

I want as much tax-free income as I can get for the retirement years.

A Bonus Reason to Use a Roth IRA vs a Tradtional IRA

Required Minimum Distribution’s (RMD’s)

Traditional IRA rules have something in them that is often overlooked. Required Minimum Distributions are a mandatory withdrawal rule that forces the IRA holder to both withdraw and pay tax according to a schedule you’ll see below.

Roth IRA’s have no RMD.

According to “You cannot keep retirement funds in your account indefinitely.”

That’s right.

It’s “your” account but only at the good graces of the tax and policymakers.

RMD’s are required on all these retirement various accounts:

  • Traditional IRAs
  • SEP IRAs
  • 401(k) plans
  • 403(b) plans
  • 457(b) plans
  • Profit-sharing plans
  • Other defined contribution plans

But not Roth IRA’s.


Here is How These RMD’s Work

At 70 ½ years of age, the IRA holder is required to withdraw a percentage of the account which is derived from the Uniform Lifetime Table. 

This is what it looks like.

The IRS calculation for how much money you are required to withdraw is as follows:

The balance of the IRA account divided by the distribution period. 

Distribution Periods

If your IRA account balance is $100,000 at age 70 the RMD requirement would be $3,649.

$100,000   =  $3,649.64

When this money is withdrawn it then becomes taxable.

So not only are you required to take money out whether you want to or not, your taxable income is also increased.

The deadline to pay your RMD’s is April 1st of the following year.

What if I Am a Rebel & Don’t Take Out the Mandated RMD Amount by the Deadline?

The answer is simple.

The IRS will punish you like this.

For every dollar, you didn’t take out according to the IRS schedule and timetable they will penalize/fine you an additional 50%.

The IRS refers to this as an excise tax.

You can pay it by filling out the IRS Form 5329 along with the number of dollars they want.

If you missed the deadline and think you have a valid reason beyond rebelliousness, there is a waiver procedure that you may embark on.

It will ask you to provide a letter of explanation as to your deviant behavior.

Should you find yourself in this situation I wish you good luck and smooth sailing.

Hold the Press

The rule has been that the RMD would be invoked when the account holder turned 70 ½ as I said before.

As of December 20, 2019, this age threshold was changed to 72 years as part of the SECURE Act which became law on December 20, 2019. A

s long as you did not reach the golden age of 70 ½ before December 20, 2019 you have an RMD reprieve until you make 72 years of age.

Additional Retirement Plans for the Self-Employed

In order to keep you reading and allow us to remain friends, I’ll not go into so much detail on the following plans. If you think one of them may be appropriate for your situation more details are available here.

Simplified Employee Pension (SEP)

  • You can contribute up to 25% of your net earnings from self-employment up to $58,00 for 2021 ($57,000 for 2020).
  • To establish a SEP use IRS form 5305-SEP and open a SEP-IRA with your broker or financial institution.

401(k) plan

  • You can make salary deferrals up to $19,500 in 2020 and 2021.
  • If age 50 or older an additional $6,500 in salary deferral is available.
  • Contribute up to 25% of net earnings from self-employment net earnings for total contributions of $57,000 for 2020 and $58,000 for 2021 including salary deferrals.
  • Possible to structure in order to allow access to the account balance through loans or hardship distributions.

One-participant 401(k)

Also referred to as a solo-401(k) or individual-401(k)

  • Generally the same as a 401(k)
  • Used when there are no employees other than yourself and your spouse.

Simple IRA Plan

(Savings Incentive Match for Employees).

  • This is a small company version of a 401(k).
  • Similar rules as an individual IRA.
  • Allows eligible employees to invest a portion of their pre-tax salary into an individual account and receive a mandatory employer contribution.
  • Easier to set up than a 401(k).
  • The employee contribution limit is $13,500 for 2020 and 2021.
  • For employees age 50 or older another $3,000 of contribution is allowed.
  • The employer must either be making matching contributions up to 3% of the employee pay or make a non-elective contribution equal to 2% of the employee’s annual compensation.

Profit-sharing Plan

  • Allows you to decide how much to contribute on an annual basis, up to 25% of compensation (not including contributions for yourself) or $58,000 for 2021 ($57,000 for 2020).

Money Purchase Plan

  • Allows you to decide how much to contribute on an annual basis, up to 25% of compensation (not including contributions for yourself) or $58,000 for 2021 ($57,000 for 2020).

Defined Benefit Plans

  • Employer-sponsored pension plan with a stated annual benefit you will receive at retirement, usually based on salary and years of service.
  • Benefit may also be defined based on a cash balance formula in a hypothetical individual account (a cash balance plan).
  • The maximum annual benefit can be up to $230,000 for 2020 and 2021).
  • Contributions are calculated by an actuary based on the benefit you set and other factors no other annual contribution limit applies.

The 403(B) Plan

The 403(b) is a tax-deferred investment and savings program for employees of certain tax-exempt employers. It allows employees of hospitals, educational institutions, and other non-profit organizations to save and invest for their own retirement.

Depending on your program, you authorize pre-tax payroll deductions to be invested in a tax-sheltered annuity (TSA) contract or in a custodial account made up of mutual funds offered by your organization. Both the contributions and the investment earnings can grow tax-deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income.

403(b) was established by the federal government to encourage workers in certain tax-exempt organizations to establish retirement savings programs. The name refers to the relevant section in the Internal Revenue Code.

403(b) plans are used primarily by public schools and certain 501(c)(3) tax-exempt organizations.

The chart below provides a comparative illustration of what one might expect the final tally to be using the plans we’ve discussed.

There are variables that are not practical to attempt to consider here such as employer match levels and investment returns.

2k Invested Yearly

As you compare the ROTH to the Deductible (Traditional) IRA please recall that the ROTH provides non-taxed dollars at retirement whereas the Traditional IRA is both taxed and subject to Required Minimum Distributions.

Before moving on from the broad topic of tax-deferred/free savings plans we should also consider two that are specifically directed toward education.

The Educational IRA/Coverdell Education Savings Account/ESA)

This is an Education IRA (EDIRA), also referred to as the Education Savings Account or Coverdell Education Account or ESA.

It allows you to contribute up to $2,000 each year for anyone under the age of 18. When the beneficiary later withdraws the money to pay for qualified higher education expenses (tuition, fees, room, and board), the withdrawals will generally be tax-free.

If you know how a Roth IRA works, then you have a pretty good idea of how a Coverdell education savings accounts operates. They both allow you to make an annual non-deductible contribution to a specially designated investment trust account.

The account will grow free of federal income taxes.

Withdrawals from the account will then be tax-free as well.

The following conditions apply:

  • If your adjusted gross income exceeds $220,00 (joint returns) or $110,000 (all others), the amount of contribution that you can make begins to be phased out.
  • A trust or corporation may make contributions in behalf of an eligible student.

In 2002, the Coverdell education savings account became a very attractive college savings vehicle for many people including families that wish to save for elementary and secondary school expenses.

In fact, even if you like the 529-plan (see below) you may still decide to contribute the first $2,000 of savings for each child into a Coverdell account.

The 529-Plan

This is an investment plan operated by a state and is designed to help families save for future college costs. These plans are professionally managed. As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to you, the plan participant (Section 529 of the Internal Revenue Code).

Every state now has at least one 529 plan available.

There are two general types of 529 plans: prepaid programs and savings programs. The states offering prepaid tuition contracts covering in-state tuition will allow you to transfer the value of your contract to private and out-of-state schools (although you may not get full value depending on the particular state).

If you decide to use a 529 savings program the full value of your account can be used at any accredited college or university in the country.

There Are 4 Main Advantages to 529-Plans

1. The tax breaks are significant.

The money you invest grows tax-free for as long as that money stays in the plan. When money is taken out for college expenses it is also not subject to federal tax. Your own state may offer some tax breaks as well (like an upfront deduction for your contributions or income exemption on withdrawals) in addition to the federal treatment.

2. Second, because you fund the account you retain control. With few exceptions, the named beneficiary has no rights to the funds. You decide when withdrawals are taken and for what purpose.

Most plans even allow you to reclaim the funds for yourself any time you desire, no questions asked. (However, the earnings portion of the “non-qualified” withdrawal will be subject to income tax and an additional 10% penalty tax).

Compare this level of control to a custodial account under the Uniform Transfers to Minors Acts (UTMA).

3. The 529 plan can provide a very easy hands-off way to save for college. Once you decide which 529 plan to use you then complete a simple enrollment form and make your contribution (or sign up for automatic deposits).

Then you can relax and forget about it if you like. 

The ongoing investment of your account is handled by the plan, not by you. Plan assets are professionally managed either by the state treasurer’s office or by an outside investment company hired as the program manager. You won’t even receive a Form 1099 to report taxable or nontaxable earnings until the year you make withdrawals. 

If you want to move your investment around you may change to a different option in a 529 savings program every year (program permitting) or you may rollover your account to a different state’s program as often as once every 12 months. (There is no federal limit on the frequency of these changes if you replace the account beneficiary with another qualifying family member at the same time.)

4. Finally, everyone is eligible to take advantage of a 529 plan and the amounts you can put in are substantial, over $200,000 per beneficiary in many state plans. Generally, there are no income limitations or age restrictions. That means that if you are planning to go back to school yourself you can open a 529 Plan for your later personal use.

Action Steps

1. If you have not done so, establish a retirement account right away. Choose the most appropriate from those we’ve looked at.

You can get excellent information from the established brokers like eTrade, Fidelity, and Schwab that cater to retirement accounts.

2. Based on where you are with paying off consumer debt work toward fully funding your account.

The deferral on capital gains tax available to you is a very important factor in accumulating long-term wealth. Take full advantage of this by contributing the maximum allowed.

3. Set the process on autopilot. If you are working with a 401-K for example, this will easy to accomplish. Simply specify to your employer the amount of contribution to be taken out of your paycheck.

If you have established a Roth IRA or other form of individual retirement account, you can divide the maximum allowable contribution by 12 and then instruct your bank to send that amount to the IRA holder each month

The 10% Rule

When I was a kid my dad used to tell me, “Stephen, if you’ll save just 10% of the money that comes to you, when you are my age, you’ll be a wealthy man.”

No, I was not smart enough to take heed.

I had to learn it on my own.

It took me years of experience to realize what simple and powerful council that was.

Why is it that children don’t listen to their parents, even when they are right?

There must be a good reason.

I’m not your daddy so listen to me.

If you will get in the habit of paying yourself first, you’ll grow to be a wealthy man or woman.

6 Steps to Take Before Implementing the 10% Rule

  1. Get your spending under control.
  2. Pay off your consumer debt.
  3. Open an IRA or other appropriate retirement account.
  4. Work to fully fund that account.
  5. Put the contributions on auto-pilot.
  6. Save 3-6 months of living expenses in your contingency fund.

Once you get through these first 6 steps, I suggest that you begin to get your mortgage paid off.

One straightforward approach is to use the money that is now available after becoming debt-free (except the house you live in) and have a fully funded contingency fund is to split your excess dollars ½ into long-term investing and ½ into mortgage retirement.

Once you have gotten your money life in order, it is time to start living the 10% Rule.

(If this is not applicable to you just take a break while I finish preaching to the other guys and gals.)

You need to get your finances straight first because you previously obligated yourself to pay back the money you borrowed.

You chose to put someone else in the top priority position.

Instead of placing yourself in the first position, you gave it up in favor of quick gratification.

When I say, “you” I am really referring to you and those who depend on you.

Now is the time to start showing yourself more respect.

Do what is best for your future.

The 10% rule is a very simple concept.

It is a matter of putting what is most important first.

Once you have taken care of your consumer debt obligations and completed the other steps listed above, you can now move into the top position. This means that as money comes in you are first on the list to be paid.

Who deserves it more than you after all? 

Take 10% of your earnings and put it toward your financial freedom!

NOTE: If you are further down the path of life you may need to pay yourself more than 10%.

More is Only Better If…

What do folks usually do when they begin to earn more money than they did before?

What usually happens after some lean years have gone by and then there is extra cash in the bank account?

That’s right…a newer car, a bigger house, a finer vacation, more clothes.

What good did earning more money really do?

More money (beyond what it takes to live) is only of substantive benefit if it is first used to bring more freedom to you and your family and then to improve the lives of others.

More, bigger, newer stuff is what most people do as soon as they are able.

I’m not looking for what most people have or do.

Are you?

Personal Finance for Beginners Conclusion

I sincerely hope that you’ve been assessing your own situation as you’ve read through this course.

Now is the time to decide to implement necessary changes to how you’ve structured your financial life, or not.

Please don’t look at all of items I’ve presented as one great whole that is just too big to do.

Take it one piece at a time if you like.

Any movement toward the goal is the right move.

It is far more important that your feet are pointed in the right direction than is how fast you are going.

In the next part in this series, we will move to the topic of long-term investing, which is one of the most fascinating topics you can study in our opinion.


Because the proper study and execution of long-term investing can be a catalyst that changes the lives of you and your family.

It takes work.

It takes patience.

But in time the effects can be extraordinary thanks to compound interest, capital appreciation, and things like dividends.

Continue to Part 4: Long-Term Investing; a Fresh View of an Old Topic