So here is the rule: pay yourself before anyone else gets the money.
And what does that mean? Well, if you are self-employed, it means putting aside some of what you bring in for taxes and retirement savings, so that you can spend the rest on your living expenses. If you aren’t self-employed but have a regular paycheck, put aside some of it for taxes and retirement savings before anything else, so that you can spend the rest on your living expenses.
If you get paid more than once a month, divide it into thirds or quarters or however many times per month you get paid; pay yourself first out of one of these; then pay everyone else after that. If you get paid once a year, treat this as your monthly payment and put aside enough of it to cover the taxes and retirement savings. That way there will be enough left to live on until next year’s check comes in.
The nominal account is an account where I keep track of what I actually spend.
The idea is to pay yourself before you pay anyone else.
Let’s say my income is $X, and I want to save $X-Y, where Y is 15%. (I could save more than that, but let’s keep it simple.) I allocate $Y to my nominal account, and I transfer $X-Y from my nominal account to my savings account. Now when I get paid, the first thing that happens is that $X goes into my checking account; then 15% goes into my nominal account.
So let’s say my income is $X0. And my nominal account is $Y0. And my savings account is $Z0. On payday, I deposit $X0 in my checking account. Then I transfer $X0-$Y0 from my checking account to my nominal account. Finally, I transfer $Z0 from my nominal account to my savings account.
Now when someone wants to give me money in exchange for something they want me to do, they can either give it directly to me in exchange for the thing I’m doing, or they can give it to me in exchange for the thing I’m saving up for.
If you’re not paying yourself before you pay your taxes, then the government effectively has a claim on your money until it gets around to collecting taxes. That’s why people who get paid every two weeks end up every year owing the IRS an amount equal to what they earned in their first paycheck of the year.
The solution is to set up a separate bank account for tax payments, and pay yourself first. The nominal account should be designated “taxes.” Every time you get paid, transfer the same amount into this account; don’t wait to do it until after payday, or you’ll never do it.
Transferring money into this account does not count as spending. It doesn’t even count as saving, since you’re just transferring money from one bank account to another.
The nice thing about this system is that once you’ve transferred all your paycheck into the nominal account, after-tax income will be exactly equal to your take-home pay — since everything you’ve earned has already been taxed. But because you’ve already paid yourself first, there should be some money left over in your nominal account at the end of each month. You can use this for anything you want: paying off debt, buying something nonessential, or just saving it.
The nominal account is a simple method for making sure you have some money to put into savings. In order to save something, you have to spend less than you earn. But if you try to cut your spending down to exactly what you earn, it will probably fail; there will always be something you can’t resist buying.
The simplest and most effective way of saving is to make your savings last as long as possible by paying yourself first: putting part of each paycheck directly into savings before you ever see the money. If you do this, then you won’t spend it on something else; and once it’s in your savings account, even if you want to, you won’t be able to get at it.
What should that fixed amount be? You shouldn’t save more than 10% of your income, because whatever is left over can be used for paying down debt and building an emergency fund. And whatever amount you do put aside should be proportional to how much you earn: poor people shouldn’t try to save as much as rich people. But beyond that there is no single right answer: it depends on your personal situation and preferences. It might be $100 a month or $5,000 a month; the only wrong answer is “zero.”
A nominal account is any kind of bank account where the money in the account earns interest. The simplest nominal accounts are savings accounts, which are like regular checking accounts with a higher interest rate.
There are also certificates of deposit (CDs), regular bonds, and regular stock. These are all nominal because they pay you for holding them; you can buy them without owning anything physical.
The reason for the name “nominal” is that even though these things earn interest, they don’t earn it in the sense of being backed by something physical. Your CD is just a commitment on the part of the bank to pay you, not an actual pile of gold or silver.
Most people have some nominal accounts, usually a mix of CDs, savings accounts, and stocks. Occasionally people who have been reading this blog will send me an email saying something like “hey I’m putting all my money into this one stock.” I usually tell them that’s not a good idea. If you own one stock you have no insulation against market risk, no diversification. That’s just crazy.
But there is nothing wrong with having purely nominal assets. If your bank offers 5 percent interest on savings accounts and you put your money there instead of under your mattress or in bitcoin.
The nominal account is the simplest kind of financial account. A nominal account is an account that doesn’t carry interest. It’s called a nominal account because it keeps track of the names, or denominations, of assets and liabilities.
The most familiar version of this is the checking account. Checking accounts are nominals because they don’t pay interest. You can use them to hold cash, or money that already has a name, but they are not good for holding assets that you expect to increase in value over time. Interested parties would have to settle up at the end of each month, with either an asset or liability on one side matched by an asset or liability on the other, so there is no way for the bank to know how much money you have.
The bond market works with nominals as well as real accounts. Most bonds are nominals because they don’t pay interest; bonds work by keeping track of who owns what debt. Real-estate investment trusts work on the same principle. Real-estate investment trusts are nominals because they don’t pay dividends or interest; they just keep track of who owns shares in a real-estate portfolio. If you have shares in REITs, you are technically a creditor rather than an owner.
The basic idea of an investment is that you pay money now in exchange for some chance at a greater payoff later. The more money you pay, the higher the chance you’ll get your money back with more on top. Investments are like lotteries; they will almost always make you poorer, but there’s the chance of becoming richer.
The lottery tickets are generally distributed separately from the money people use to buy things they want (which is itself distributed separately from the money used to buy things people need). But even if everyone spent all their discretionary income on lottery tickets it would not change the fact that most investment makes people poorer.
The reason is that the money used to buy lottery tickets doesn’t come out of consumption, and consumption is what makes us rich. It follows that most investment doesn’t increase consumption.
It may seem like consumption is consumption no matter how it’s done, so what does it matter? The difference between spending $1000 on a vacation and investing $1000 for retirement is just a matter of timing. But time is not irrelevant; given enough time, consumption becomes wealth. If you had invested your retirement savings in your 20s, by now it would be worth much more than $1000 in extra vacations would be worth in your 60s.