One of the most important financial concepts we mentioned earlier was the mental modelling or ‘compartmentalizing’ our finances (here). Imagine that all your income is distributed into six buckets or jars as shown below.
All your income should be distributed in one of the jars. (Bear with me, most of the time these are not physical jars, but various banking or investment accounts at financial institutions.) So, here are the ‘rules’ we need to remember.
Living Expenses include everything from shelter, food, transportation and other necessities of life. Most people allocate the highest amount here, but it does not need to be the majority. The important thing here, that you need to live off of this funds. No additional borrowing, from credit cards, banks, or other jars.
Financial Freedom account is arguably the most important jar, it’s purpose is to build up your assets (wealth) long term, in order to get to the point that the accumulated assets generate enough passive income to cover your living expenses. At that point work becomes optional, hence the name Financial Freedom. There are two rules: A) invest the funds for the long-term, and B) never take money out until FF is achieved.
Long Term Savings jar is to collect for big ticket items, such as a car or a vacation. These are typically not mandatory living expenses, but too large to be covered from the PLAY jar. You can make a list what you want to collect for, and as you see your funds steadily growing from every paycheck, you will inevitably get to the point where the item(s) could be purchased one after the other. The rule: only spend on stuff you declared before in order to avoid impulse purchases. (You can even setup multiple saving accounts for multiple purchases. Even better if tax sheltered saving accounts are used.)
Education jar is for anything that helps you grow. Continuous, life long, never-ending education is important, and often costs money. It could be post secondary education, or other formal or informal learning experiences (such as seminars, books, online courses, coaching, or mentoring).
The PLAY jar includes any fun, entertainment, leisure and recreational activities for you and your family. The two rules: you have to have fun, and the jar needs to be emptied (fully spent) every month.
GIVE jar is about getting into the habit of, well, giving away cash to help others less fortunate. Charity is not the privilege of the rich and famous, and there is no reason to hold back your giving until you become wealthy. This is a bit counter-intuitive, as some people tend to think giving away money slows down your financial progress. It’s exactly the opposite. Giving away money confirms to your subconscious that you have ‘more than enough‘, you are wealthy, hence setting your invisible financial thermostat higher. And you start to think and act more like wealthy people do, which naturally result in more wealth. But even if this does not register, nevertheless, just get in the habit of giving: the world will be a better place and you will feel proud that you did your part.
The actual percentage values for allocation are just guidelines, everyone’s personal situation is different. My university student son (who lives at home) allocates very little to Living expenses, and the majority of his income goes for Education (tuition), and of course, the Play jar. Small kids can also start this kind of mental ‘compartmentalization’, which could help them in their entire life. My own kids started to distribute their weekly allowances into 5 jars when they were 6 years old. (No need for Living expenses in their cases.) Nowadays that kind of thinking comes naturally to them.
If you are new to this, start setting up jars/accounts, and assign the desired percentage allocation. I am sure you can figure it out for yourself. Try to live off 70% or less of your income for starter (in other words, allocate less then 70% for Necessities), put at least 10-15% into your FF jar and the rest of the income allocated somehow to the other four jars. If you give only 1% to charity, that is OK, as long as you give something. You can work it up as you go. If your Play jar covers only one movie ticket a month, that’s fine too, assuming you picked the right movie and you had fun. You can always increase later. Just don’t ‘borrow’ from other jars to blow it on something silly.
Remember, only the money you don’t spend will make you wealthy one day. The FF jar is yours to nurture, invest and let snowball into unimaginable riches as compounding interest does it’s thing.
Love,
Mr. SWimmigrant