1. Create a solid foundation
There are three things I consider foundational to successfully build wealth and achieve financial autonomy.
First you need to understand your cash flow. What does it cost you to live, how much do you have coming in, and is there a surplus?
Without surplus cash flow there’s nothing to invest and therefore nothing from which to build wealth. If you need help in this area take a look at chapter two in my book where I provide several different cash flow management strategies and a tool to help you find the best one to suit you.
The next foundational element to building wealth is to have an emergency fund. It’s the lack of an emergency fund that leads people to rack up credit card debt and fall into a rapidly accelerating downward spiral. Your emergency fund could be redraw capacity in your home loan, or money set aside in the offset. The key is it’s money you have access to when the fridge dies, the car needs repairs, or you are between jobs.
And then the final foundation piece is having your debts under control. Typically a mortgage, provided the repayments are affordable, is a good path to achieving wealth and financial security. Debts over cars, and certainly if racked up for things like holidays, are not helpful. If you have these kind of debts, you should initially focus on their clearance before thinking about investing and building wealth.
2. Invest for long term growth
With the foundations ticked off let’s now turn to saving and investing.
Investment assets can be divided between those with growth characteristics and those with more defensive and stable characteristics. Growth assets most typically are shares and property. Defensive assets are cash and bonds.
When developing your investment strategy you need to determine how you will split your savings between growth and defensive assets. The primary determinant will be your investment time frame, but there is also a consideration for your comfort around volatility. An investment strategy that keeps you awake at night won’t work because you won’t be able to stay the course over the long term.
As a guide, for someone with a time frame of seven years plus you could confidently go into an investment consisting of 100% growth assets. For an investment time frame of less than three years, you would want no more than 50% of the balance in growth assets given the volatility that they naturally possess. Between three and seven years apply a sliding scale dependent on your level of comfort. So for instance if your investment time frame was five years then you might go 80% growth assets and 20% defensive assets.
If your investment time frame is less than two years, likely your best bet is just to remain in cash. Perhaps use a term deposit for some better interest. But with this sort of time frame any investment that has some volatility contains too much risk that you will suffer a loss at the point that you need to redeem.
In Step 1 I explained how you needed to have clarity on your cash flow to determine what you had available to save and invest. When it comes to investing for long term growth, you want to be adding to your investment on a regular basis. In the case of a share fund that might be a regular monthly contribution. For a property investment that could be in the form of repayments on a loan.
3. Take advantage of one of Australia’s best tax break
Our tax and financial system has a strong skew towards home ownership. Growth in the value of your primary residence is capital gains tax free. Due to the leveraged nature of a home purchase, and the tendency towards retaining your home for many years, often decades, the growth seen on this investment can be significant. To have this growth be entirely tax free is a major gift, certainly the best tax break we have in Australia.
Layer on top of that the fact that the interest rate on a loan to purchase your home will be the lowest rate you ever get. It’s true that right now mortgage rates are a lot higher than they were 18 months or two years ago. But it’s still the case that the interest rate on your home loan is a lot less than the interest rate on a car loan or credit card. It’s likely lower than any business loan too.
So buying a home exposes you to a tax free growth asset whose gains are magnified through leverage, and where the cost of financing is relatively low. This all being the case, factoring in a home purchase as part of your plan for building wealth is something of a no brainer.
Along similar lines, I’m far from persuaded that the rent-vest strategy that some promote makes sense. Sure the interest cost on the loan becomes tax deductible, but the rental income is fully taxable, largely netting out this benefit, and you will have to pay capital gains tax on the growth in value of the property. The interest rate on the loan will be more expensive as well.
4. Make the most of Australia’s superannuation system
If the capital gains tax free nature of our primary residence is the number one tax break in Australia, then a close second would be our superannuation system. Wealth accumulated in superannuation is taxed at only 15%. And then when you retire, all the income paid out to you is tax free, in addition to there being no tax on the earnings from that point forward. It’s a very generous system.
When it comes to making the most of our superannuation system, the first step is to ensure that you’re not being unnecessarily conservative with the investment options that you use. As I touched on in Step 2, if your time frame is greater than seven years, you could certainly afford to be in 100% growth assets. In the case of super you could probably do this for even shorter time frames given that upon retirement you won’t be accessing all the capital anyhow, only a portion sufficient to cover one year’s worth of living costs.
Keep in mind that risk in an investment sense means volatility. But of course we know that risk and reward are inextricably linked. To ensure your superannuation balance grows to its maximum potential you want to generate the highest prudent returns. Holding allocations in bonds and cash when retirement is still a long way out makes very little sense. Yes, your balance will be less volatile, but who cares. You’re locking in a lower return which means ultimately less retirement income, or an increased risk that your money runs out during your lifetime.
Your employer will automatically make contributions to your super fund, but provided you stay within the contribution caps you do have the ability to top this up. Typically this is done via salary sacrifice, something that is particularly attractive if your income sits within the range of $180,000 and $250,000. In this sweet spot you’re getting the maximum tax saving.
5. Protect yourself
The final step in building wealth and creating financial security is putting in place an appropriate financial safety net. Your emergency fund mentioned in step one is a piece of the puzzle here, but layered on top of that you need insurance.
Income protection insurance should be your starting point. To achieve the level of success that you have in your profession you’ve invested a lot of time and energy. All that investment is now paying off in the form of your annual income, and so it makes sense to insure that income.
If you have children, life insurance is another one that you would want to have in place. The rule of thumb here is to leave your spouse with a debt free home, and enough cash to support the kids through until adulthood.
Typically linked to your life insurance is total and permanent disability cover. This meshes in somewhat with income protection, and so thought needs to be given as to how these will fit together and provide comprehensive financial security.
Need help working out your financial plan? See how we can help here.
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