I’m sure you’ve heard the following financial advice: pay off debts, save an emergency fund, invest in stocks, contribute to a 401(k), contribute to an IRA, etc. But how do you know which to do when you don’t have enough money to do all of those things?
And now that you’re saving at least 10% of your income, where should you be putting that money?
Correct answer: where it works the hardest to make you more money (the largest return on investment).
Wrong answer: let it accumulate in your checking account where it makes 0.1% or less.
I’m going to show you how to use your savings to make 1%, 5%, 10%, 20%, even 100% per year on your initial investment.
Step 1: Create a Monthly Surplus and Do Not Add to Your Existing Credit Card Debt
First things first, before you can start saving and investing you must have a monthly surplus. This means you have to be spending less than you earn. If you haven’t yet completed this step, read my article series which show you how to do this.
From here on, I will be assuming that you are spending less than you earn each month, so that you have money to use toward paying down existing debts or investing. This means you SHOULD NOT still be accumulating more debt. You should be paying your credit card minimum payments in full AND not increasing your credit card debt. If you’ve created a monthly surplus, you should be able to pay everything off that you put on a credit card each month.Let’s say you have $5,000 in existing credit card debt. Obviously, you probably can’t afford to pay off the $5,000 all at once, but at this point you should not be adding to this debt. If you are spending at least 10% less than you earn, you should not have to increase your credit card debt beyond the existing $5,000 ever again. Now, it’s still fine to use your credit card to make purchases (I do this to earn the rewards points), but make sure you pay it off in full each month. If you put $500 on credit cards per month moving forward, that means you should be able to pay the $500 off each month (and be saving an additional 10% of your income in addition to that).
Step 2: Create Emergency Fund Level 1
The first thing you should do, before any investing or debt paydown, is create an emergency fund. This is probably the most boring step, but arguably the most important. This fund is for any unexpected expenses that come up (a flat tire, a job layoff, trip to the emergency room). The purpose of this step is so that you do not have to add to credit card debt when these expenses inevitably come up.
At this point, just save enough for 3 months of living expenses. This amount should be enough to get you by for 3 months if you suddenly lost your job, or a few unexpected expenses. Any time you need to use your emergency fund, your top priority should be rebuilding the fund as soon as possible to get it back to 3 months of expenses.
This emergency fund should be easily accessible, so put it in a high-interest savings account. You can generally earn 1-2% in an online high-interest savings account. I use CapitalOne360 where I have earned 1.3% – 2%. This is better than the 0.1% you’ll earn in a checking account, but still as easily accessible (and can be kept separate from everything else).
For further reading about emergency funds, read my post where I go more in depth.
Step 3: Set 401(k) or HSA Contribution to Receive Full Employer Match
A traditional 401(k) is a retirement account in which your contributions are tax-free. For example, if you decide to invest $5,000 into your 401(k) each year, this $5,000 isn’t taxed. However, it will be taxed when you withdraw it during retirement.
Remember in the introduction when I said you could get a 100% return on your money? This is how. When an employer offers a full match on your 401(k) or HSA contributions, this is essentially free money.
For example, if your employer offers a 100% match on your 401(k) contributions up to 6% of your salary, this means they will match the money dollar for dollar you put into your 401(k), up to the limit. If you make $100,000 and put $6,000 into your 401(k), your employer will also add $6,000 per year into your 401(k). A 100% return on your money! You’ll have a hard time finding a return even remotely close to that anywhere else.
At this point, set your 401(k) contribution to whatever that limit is (6% of your salary in the example above). Employers may also offer similar matching on other accounts, such as a Health Savings Account (HSA). Set your contributions to whatever you need to take full advantage of this matching.
One thing to pay attention to: most companies have a “vesting” period. This means you must stay with the company for a certain amount of years before they will allow you to keep their matched contributions. It may be 3 years before you get any of the company match, or they may allow you to earn a percentage of it each year. For example, they may allow you to keep 25% each year for four years. If you leave the company after two years, you’d only receive 50% of their matched contributions. You’d have to stay four years to receive the full company match. Unless your job is unbearable, try to at least stay for the number of years it takes to vest.
It’s preferable if you do this step at the same time as step 2, so that you don’t miss out on any free money. If you have money left over to save each month after contributing the minimum to receive the full employer match, use that leftover money to build your emergency fund in step 2. It will take longer to build the emergency fund this way, but it’s worth it to receive the free match for as long as possible.
Step 4: Pay off Debt with an Interest Rate Higher than 5%
After you create your 3-month emergency fund, and are receiving your full company 401(k) match, it’s important to start paying down debts with an interest rate higher than 5%. Throw whatever extra money you have per month at this debt. Do this in order of highest interest rate debt to lowest, since your higher interest debts will be accumulating much more interest (but make sure you continue paying your minimum payments on all debt so you don’t adversely affect your credit score).
The reason for this step is two-fold. If you pay off debt with an interest rate of 8%, you’re guaranteed an 8% return on your money. It doesn’t make sense to invest in the stock market (with average returns of 6-8%) when you’re paying 8% on your debt. In the very least, it just cancels out. More likely, you’re paying more interest on your debt than you make back investing in the stock market.
The second reason to pay off debts now is because these minimum payments will still be due if you ever lose your job or run into other financial struggles. The less monthly debt payments you have, the smaller your emergency fund needs to be (since your monthly expenses decrease when you completely get rid of the debt).
I realize some people have $100,000+ in debt with an interest rate higher than 5% (most likely due to student loans). You will be on this step for a while, and that’s okay.
Step 5: Create Emergency Fund Level 2
After you pay off your debt in step 4, it’s time to go back to your emergency fund. This is the same emergency fund as step 2, but now add to it such that it can cover 6-12 months of your expenses. Whether you build this to 6 months, 12 months, or somewhere in between, depends on your comfort level and risk tolerance. Consider your job stability, if you have others who depend on your income, and how much you need to make you sleep easy.
The larger you build this fund, the more flexibility you have to change jobs or even career types. It could even give you greater ability to take risks like starting your own business. The larger this fund, the more options you will have. However, there is an opportunity cost to consider: the larger you build this fund, the less you have to invest in other options (read steps below) that could earn you much higher returns on your money.
Step 6: Max HSA
A Health Savings Account (HSA) is a type of tax-advantaged investment account which may be offered by your employer. You can contribute a certain amount of money annually (tax-free) and then use that for medical expenses (copayments, coinsurance, prescriptions, and deductibles) throughout the year (it’s also tax free when you withdraw it).
One of the biggest benefits is that you can rollover unused contributions with an HSA. This means you could invest the money and allow it to grow over your career and use it for medical costs in retirement (I highly recommend this approach). Personally, I choose to max my HSA and don’t use it for medical expenses now, so that I have it during retirement when my medical expenses will likely be higher.
The 2020 HSA limit is $3,500 for an individual and $7,000 for a family.
FSAs are another tax advantaged account, but not as great as HSAs because the unused amount does not rollover every year. If you choose to contribute to this account, you’d only want to contribute what you know you’re going to spend on the year’s medical expenses, otherwise you lose that money.
Step 7: Max Roth IRA
A Roth IRA is basically the opposite from a traditional 401(k). Contributions to a Roth IRA are taxed, but it’s tax free when you withdraw during retirement. For example, if you again invest $5,000, that $5,000 will be taxed at the time you invest. However, it won’t be taxed when you withdraw it. The 2020 maximum contribution is $6,000.
A Roth IRA is a personal account you can open with an investment company like Vanguard or Charles Schwab. You just open a Roth IRA account and then contribute money from your checking/savings account.
Step 8: Max 401(k)
After completing the steps above, you can max your 401(k) contribution (step 3 only has you contributing enough to receive the full employer match, which is probably significantly less than the maximum contribution). The 2020 maximum contribution is $19,500.
NOTE: Many companies now allow you to choose between a traditional 401(k) and Roth 401(k). The difference, as described in previous steps, is whether the money is taxed going in or coming out.
Step 9: Consider Paying off Low-Interest Debt, Real Estate, Taxable Brokerage Accounts, or Starting/Buying a Business
If you’ve completed steps 1-8, I’m impressed! You rock. Now you can start to consider some other investing options, like real estate investing, starting your own business, or buying an existing business. It really depends on what you’re interested in.
If you would like your investments to remain as simple and passive as possible, you can consider paying off low-interest debt (like your mortgage), or using passive investment platforms such as Fundrise. Or simply continue to invest in the markets in a taxable brokerage account (the same idea as an IRA or 401(k), only without the tax benefits).
Keep in mind that the above plan is a suggestion, not necessarily optimized for everyone’s specific situation. The above order of investing/paying down debt is a suggestion to optimize your finances that will work for anyone.
That said, educate yourself as much as possible and then make the decisions that are right for you. And remember that investing in something means you’re better off than most people.
I followed steps 1-7 in order, but instead of maxing my 401(k) (as in step 8), I chose to move to step 9 because I’m interested in real estate investing. Instead of maxing my 401(k), I save that money in high-interest savings account to use for down payments and reserves for (future) rental properties.
Let me know your thoughts in the comments! Do you follow (or plan to follow) the steps above exactly as outlined?