Have you ever heard a financial “rule of thumb”? We hear these phrases often, and they’re usually accepted as the only way to make financial decisions.
However, as a financial planner I can confidently tell you: these “rules of thumb” that everyone abides by? They’re often not the best path available for your unique situation. That’s not to say these personal finance building blocks don’t have merit – they often do! But the problem with these over-generalized rules is that they don’t take into account the many gray areas of your financial life.
Today I want to go over a few common financial rules of thumb that I hear often, why they may not actually work in practice for you and your family, and what you can do instead.
What “Rules of Thumb” Do We Hear Often?
There are several common financial “rules” that a lot of financial experts tout as the end-all-be-all method for building a financial plan. All of these rules are created and promoted with the best of intentions. There’s nothing about these rules that are technically wrong – they’re a good baseline idea to follow. Let’s take a look at a few of the most popular financial rules that seem to recur in conversations with clients:
10% Rule (Car Buying)
Are you car shopping? You may have heard the 10% rule, which states that your total car purchase shouldn’t exceed 10% of your total income (including purchase price, insurance, interest, etc.). While this rule is based in truth (you should never purchase a vehicle that’s above and beyond what you can feasibly afford), it also doesn’t account for cash savings.
Many people, especially as they approach retirement, have saved a good deal of cash that’s specifically earmarked to buy the car of their dreams. If you’re not driving yourself into debt to purchase a vehicle, and have exhibited patience as you save up to purchase it in full, the purchase becomes a question of whether or not the new vehicle will make you feel fulfilled – not whether or not it’s 10% or less of your total income.
Save 15% Toward Retirement
This is a great rule of thumb – as a baseline. In short, it states that you should work to save 15% of your pre-tax income toward retirement each year. However, there are many times that you may be ahead in saving for retirement, or behind. This might mean you need to save less (or more!) than the traditional “15%” rule requires.
Deferring Taxes When Saving for Retirement Is Preferred
Using a 401k, Traditional IRA, or other tax-deferred retirement account can be helpful to reduce your current taxable income and save for retirement. However, if you think that you may be in a higher tax bracket when you retire than you are now, a Roth IRA or a Backdoor Roth IRA may make the most sense. It may also be in your best interest to have a combination of retirement accounts – both tax-deferred and taxable – to give yourself more flexibility to create a retirement income strategy.
These are just three examples of a laundry list of so-called “rules” that people are expected to follow when it comes to their money. A few others are:
- Not buying a home unless you know you’ll live in it for 5+ years
- Following the “4% rule” when creating a retirement spending plan
- Not taking out more than your first year’s salary in student loans
- Not putting another savings goal above retirement saving
Again, there’s nothing inherently wrong with these generalized rules. But in some cases, they may not work for you, or your lifestyle goals either now or in the future. So, what do you do when a “rule” doesn’t feel like it fits your situation?
There Is No “Right” Financial Plan
It would certainly be more cut-and-dry if each of these rules of thumb was the absolutely correct answer for everyone’s personal financial situation. Unfortunately, that’s just not realistic. Every person or family is completely unique. From the type of lifestyle they want when they retire, to the things, people, or organizations they value right now – everyone has a different approach to living life. If we’re all so different, why would we think one blanket-statement rule would be able to guide our financial decisions?
In a recent blog post, I talk about the need for a financial plan that evolves as you do. Essentially, the plan you put together is never going to be 100% right, even if you work with a professional like myself. That’s because your financial needs, values, goals, hopes, and dreams are all going to change with time. Creating a plan that’s guided by the general rules that I listed above isn’t a bad idea, but it’s a better idea to embrace a money strategy that’s crafted based on your life – not someone else’s ideal or hypothetical situation.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.