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What's the single biggest difference between financial success and failure? Is it how much income you have?  You could be making $100K a year but spending $110K and you would be dead broke and in debt.  Or you could be making $30K a year but consistently contributing to your savings.

Money management is difference.  More important than how much you earn is what you do with the money that you do earn. If you make a million dollars a year and squander it all, you are no closer to financial freedom than someone living in poverty.

How to Manage Your Money

The following is a simple money management system I read about in the book Secrets of the Millionaire Mind.  It provides a relatively simple way to divide up your after-tax income.  It requires that you have six different bank accounts in which you allocate a specific percentage for your income:

1. Necessities (50&) - This is the account that you use to pay all of your bills - your mortgage, car payments, other debt payments, phone bill, groceries, entertainment etc. If you have been living paycheck to paycheck in the past, you may have to put some serious effort into reducing your expenses and/or increasing your income.
2. Education (10%) - The best investment you can make with your money is in yourself. By continually increasing your knowledge and working on your personal and professional development, you increase your ability to provide value to others. As you increase the value you provide, your income increases in similar fashion. This money is to be spent on learning resources such as books, seminars, DVD programs, private coaching etc. Anything that helps you grow will also help you earn more.
3. Giving (10%) - By giving your money to causes that are important to you, you'll not only be doing something worthwhile for others, you will also be reinforcing the abundance mindset in yourself. Take your time to research some organizations that you would like to support and regularly contribute 10% of your income to them.
4. Play (10%) - This is the fun part of your money management system. In order to consistently reinforce positive emotions relating to managing your money, you allocate 10% of your income to purchasing things solely for your own pleasure. These are supposed to be extravagant, out of the ordinary purchases for you. This includes things such as front row seats at a concert or sporting event, a super expensive wardrobe item, a day at a spa, a weekend getaway etc. The advantage of this is that the knowledge that you will be spending this money on yourself will prevent impulse spending and the guilt-trip that often accompanies these purchases. It also helps avoid the feeling of depriving yourself if you are not used to managing your money.
5. Saving for Spending (10%) - This account holds the money that you are saving to make large purchases in the future. These purchases include a house down payment, a car, family vacation etc. It is used to accumulate a large amount of funds so that you are able to make large purchases when you choose to.
6. Financial Freedom (10%) - This account accumulates funds that you invest so that you can achieve financial freedom. As mentioned in the previous post, the goal is accumulate a critical mass of funds such that you are able to sustain your lifestyle on the interest that accumulates from this account alone.

Automate It

In order to put this simple money management system into practice, you need to make it as easy as possible for yourself.  The more automatic you make managing your money, the more likely you will actually do it. Now, a lot of banks allow you divide up your paycheck into multiple accounts every time that you are paid.  Call your bank and find out if this is available for you.

The other option is open several savings accounts in a bank like ING.  Keep the money for your necessities in your main bank account. Next, utilize their Automatic Savings Plan of ING (or whatever bank you choose for this) to automatically withdraw the appropriate percentages for the other 5 bank accounts whenever you receive your paycheck.

Finally, if you are an entrepreneur or do not receive a steady paycheck, you are going to have to manage your money manually via online banking.  This scenario is a bit more difficult (this is the one I'm in) but can be managed with a little bit of self-discipline.  At a regular interval, say every Friday for example, log onto your bank account online and divide up your income for that week according to your percentages. 

The Habit is More Important Than the Amount

So you might be thinking, this all sounds great in theory, but I'm barely paying my bills. So, what do you do? You adapt.  Let's say you are in a situation where you think you need 90% of your income to pay for your necessities and there is just no way around that.  What you do is you use that 90% of your income for necessities and divide the remaining 10% among the 5 secondary accounts.  So, in this example, they all get 2%.

Now, over time, as you create additional streams of income, you can change the percentages to adapt to your new income.  You keep your necessities at the same dollar amount, but you increase your contribution to your secondary accounts to reflect your increased income.  Eventually, you will reach the point where your money management system reflects the one outlined in the previous section.

What is important at this point is not that you follow the above system perfectly but rather that you develop the habit of consciously directing your money.  The money management habit is of the most importance.

Once you reach the point of following the percentages outlined earlier, you can use any further income increases to also increase your standard of living or to accelerate your financial freedom.

Accelerate Your Financial Freedom

As discussed in the previous post, you can speed up the rate at which you achieve financial freedom by simply increasing the amount you contribute to your investments.  This is best done by slowly increasing the percentage allocated to your financial freedom account so as to have negligible effects on your standard of living.

In my experience, the best way to do this is to increase your allocation to your financial freedom account by 1% every 3 months and have a corresponding reduction in the money allocated for necessities.   An individual increase of 1% will likely go unnoticed in terms of the reduced money you have for spending because the percentage is so small. However, over a period of several years, you will have created the habit of saving and investing a large percentage of your income.  In 5 years time, you will be saving 30% of your income.

An added benefit of this approach, in my experience, is that you will develop an unconscious tendency to find ways to increase your income.  This tendency results from desiring more money for spending to compensate for the increased amount that you are saving.  At this point in time, I have increased my allocation to my financial freedom account to 20% and decreased my necessities to 40%.  Even at this level, I feel that I am living a more than abundant lifestyle.

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Ultimately, how you manage the money you earn will determine your long term financial success.  Take the time this week to set up your bank accounts and automated savings so that you can ensure that your money is properly managed.

 

This post is part of a series on mastering money & wealth:

1. Intro
2. Raising Your Financial Awareness
3. Commitment and Focus
4. Wealth Mindsets
5. Clean Up Your Limiting Beliefs About Money
6. Generate a Higher Income By Creating More Value
7. 25 Ways to Create More Value
8. Create Multiple Streams of Income
9. The Key to Financial Freedom
10. Money Management
11. Summary and Resources