Where should you put your next investable dollar? This is often the key question I answer for clients, and clarifying this for yourself will do wonders for your financial situation. Here’s where I think most people should put their money in order of priority. Generally you should max out the first item on the list before going down to the others, but your situation could vary, so make your own assessment or get help from a competent advisor.
Assumptions
1) You have some cash to put towards these things. If you don’t, you need to start here so that you can fix and automate your spending, then save some money to free up cash to invest or pay down debt.
2) You are not endangering your health, have proper levels of insurance, and aren’t making yourself miserable by living like a total pauper because you’re following my wealth-building suggestions to the extreme.
3) You’ll tailor this order to your own personal situation. That said, I strongly recommend following items 1 & 2 in that exact order.
Where you should be putting your money
Okay, ready? Numero Uno for where your money should go is….
1) Employer 401k matching
If you’ve read my articles on retirement, you’ve heard me say this before: don’t leave free money on the table! What type of return do you historically get from a risk-free investment? Treasury bonds return about 1-2% as of writing. What is your employer match return? If you get matching of 50 cents on the dollar up to 6% of your salary, your return on that first 6% saved is an instantaneous, huge, risk-free 50%!!! There’s no better investment in the world that I’m aware of. Max this out no matter what!
2) High-interest debt, like a credit card
Some readers might quibble with this as #2. I can hear them now: “What!? Paying off your credit card balance is always the first thing you should do!” There may be emotional benefits to making this #1 that you should consider, but if your employer matching is 50% instantly, and your credit card rate is 25% annually, you’ll do way better to first max out your 401k matching. After that, put the rest of your cash towards that VISA balance.
Other readers might take the opposite tack: “I’ve saved for X instead, why should I ‘lose’ that money paying off my debt?” Paying off high-interest debt is the best investment you can make. Where else can you get a guaranteed return of double-digit interest? You can’t! You should do this immediately even if it means depleting a cash cushion such as an emergency fund, having to build back up a house downpayment (you’re not ready to buy if you have credit card debt!), or postponing some other purchase. You can always put things back on your credit cards if you must.
3) Emergency fund (a couple months’ living expenses + your auto and health insurance deductibles)
You need to have some money socked away for unforeseen expenses or losses of income. A short-term stash of cash to tide you over if you lose a job, get sick, or have to replace something valuable, like a car, is invaluable for financial stability. The general rule for insurance is to insure things which you wouldn’t be able to replace relatively quickly and that would cause you hardship if you had to go without them. This includes your home, life, health, and your car or jewelry, depending on the retail value of these items and your personal savings. (Make sure to avoid useless insurance.)
Expenses you can afford should be ‘self-insured’ by your emergency fund or other savings. Raising insurance deductibles and banking the difference in premiums is a good way to self-insure against small losses ranging from a few hundred to a few thousand dollars. Store emergency money for unexpected car repairs, insurance deductibles (which can be large if you have catastrophic, HSA-eligible health insurance), or high vet bills for your disgustingly-cute Cavalier King Charles spaniel.
Whether you need more or less living expenses saved depends on how steady your income is & how many liquid assets you already have (like non-retirement stocks that you could tap.) The more financially secure you already are, the less of an emergency fund you need: a self-employed person with few liquid assets needs more emergency funds than a union schoolteacher with 20 years seniority and a sizable investment account.
Like all short-term (less than 3-5 year) savings, your emergency fund should be investing in cash or a short-term bond fund. High-interest savings accounts like the kind from Capital One 360 are great for very short-term savings since the principal is guaranteed by the FDIC. Bond funds, which may vary slightly in principle but generally yield a higher return than savings accounts, work better for money that might sit there longer than a year.
For those with incomes low enough to be able to contribute to a Roth IRA, I strongly recommend dumping your emergency fund into a Roth IRA and investing in cash to kill two birds with one stone: simultaneously taking advantage of tax-advantaged retirement savings but also giving yourself the ability to withdraw the contributions (but NOT the earnings) at any time with no penalties or taxes. I describe this tip in more detail here.
4) Tax-advantaged retirement accounts (401ks, Roth or Traditional IRAs)
After you’ve maxed out your employer retirement matching, paid off your high-interest debts, and stored money for emergencies, it’s time to go back to saving for your retirement because of the huge tax advantages offered. In rough numbers, if you’re making less than $100 K as a couple or $50 K as an individual (i.e.: likely in the 12% tax bracket for 2021), max out your Roth IRA and/or Roth 401k at work. If you make more than that/are in the 22% or higher income brackets, I would max our your regular 401k first, then switch to maxing out your Roth IRA next if your income is low enough to qualify (your tax software will tell you this at the end of the year. You can still contribute for last year up until your tax filing date.)
If you make too much to contribute to a Roth IRA, use the backdoor Roth IRA [article coming soon] method IF you either have no Traditional IRAs with pre-tax money in them or can put all your Traditional/Rollover IRA money into your 401k plan to avoid paying taxes on it.
If you don’t have a retirement plan at work, use the appropriate IRA (Roth or Traditional) instead. If you’re self-employed, open an Individual 401k.
Read this to know what investment option to choose.
After maxing out your 401k and Roth IRA/backdoor Roth, if you also have HSA-eligible health insurance, max out your HSA as well. If you make enough to be in the 22% tax bracket or above, put the HSA ahead of your Roth IRA in terms of priority.
Putting money into a tax-free retirement vehicle is critical to building up a nest egg for the future. Assuming you’re in the 24% tax bracket, an investment in a tax-advantaged retirement account made when you’re 25 will be worth about 50% MORE in real dollars when you’re 65 than would an equivalent investment in a taxable account.
To complete step 4, if you’re under 50, in 2021 you’ll be investing $20,500 in 2021 in your 401k if you’re under 50, $6,000 in your Roth IRA, and $3,200 in your HSA if you have single coverage, or $7,200 if your family is covered by your HSA insurance for the entire tax year in question (generally speaking.)
That’s around $30 K in annual savings, which is rarefied territory for more Americans, but very doable for anyone making at least $75 K or more as an individual, or couples making more than $150 K. You just gotta save more.
5) ‘Regular’ taxable investment accounts & short-term savings for big purchases
After you’ve maxed out your retirement options, it’s time to open a plain ol’ taxable investment account for long-term savings. I like to think of these as early retirement accounts; the more you sock away now, the quicker you can exit the rat race.
You should also be saving regularly for big purchases like a house, wedding, vacation or new car. For these shorter-term items, use the banking system I recommend and create a savings account for each major purchase, and label it accordingly.
You might rank a short-term savings goal as higher priority than maxing out your retirement accounts. For example, maybe you want to buy a house and can’t save up the downpayment while maxing out all your tax-advantaged sources. That’s fine, but do NOT neglect your retirement. Investing early, even with just a little bit of money, is the most important factor to building wealth. Saving for retirement will be way easier if you start today with whatever you can.
Now go do it!
Take each step one at a time until you’ve finished it, then move on to the next one. If you’re maxing out steps 1 – 4 and contributing something in step 5, you’re doing very well and on your way to financial independence.
Now that you know where to put your money, find out WHAT to invest it in here.
And Low-interest debt like mortgages? I have trouble deciding between paying the mortgage off faster, or investing in more index funds.
Dave – Short answer: If you’re not yet maxing out tax-advantaged accounts, then I would definitely say invest more in those first. Even if you ARE maxing those out, then I would lean towards funding your taxable stock accounts, assuming your mortgage rate is lower than ~7% or so.
Here’s why (long answer):
Historical market returns are ~10%, and if you buy and hold for a long time, the taxes on those returns become fairly minor (we’ll say ~15% maybe, given taxes on dividends & long-term capital gains.) 15% would reduce your after-tax return to 8.5%, still likely better than your mortgage. Plus, your effective mortgage rate is likely lower based on tax deductions:
If your mortage rate is 6% and you’re in the 25% bracket (and still much more in mortgage interest than your standard deduction), the effective interest is probably around 5%. (The reason it’s not really 25% less (4.5%) is because without itemizing you would still use the standard deduction. The benefit only applies to mortgage interest over the standard deduction.)
Of course, there’s also some psychological satisfaction to owning your home outright, so you should consider that as well (but I would still definitely max out retirement accounts first due to the tax advantages.)
Hope that helps!
I should add that once you take off 3% inflation, the higher effective rates for stock investing (~5.5-6% real return) vs your mortgage (maybe ~3% real return) make it clearer that stocks are probably the better way to go. However, stock investing in the short- to medium- term (<5-10 years) is more volatile than the guaranteed 'return' of paying your mortgage. This is more reason to buy stocks intended to hold them for a long long time.
Ward,
Before you judge what I am about to write please realize this is only me and we all have our opinions. But I freaked out about 2 things and saving money helps one thing but does not help the other, let me explain. The two things that freak me out is.
1. The giant earthquake that is supposed to hit the westcoast within the next 50 years.
2. An attack or some sort of communication by “aliens” or some other form of life.
In talking about number 1 saving money is good because if an earthquake happens then you will have money saved up to replace your stuff so I don’t need to go into this. But what I am trying to say is people have there retirement fund, there emergency funds, I know this goes under emergency but maybe there should be an earthquake fund. I do hope though, that we get more help than Haiti because the Westcoast can contribute to society more than they can.
In talking about number 2 I really think people (or at least I am) should put aside money in case of an alien attack. I am not kidding, I am huge believer of “aliens” and UFO’s. Ward you know this about me and even though the chances are slim, I think that there is the chance that we get attacked by aliens. Not because the aliens want to purposely be mean to us, but because we have resources they may want (metals and such), we might be a food source, their planet’s resources may be gone and they need to infest somewhere else. There could be a lot of reasons. The article or theory by Steven Hawking didn’t help either where he thinks that it’s perfectly rational to think that with how big the universe is that there is more life out there. I for one am a believer, as the X-files says at the end of the shows intro “I want to believe”. I feel the government messed up and there’s too much information out there, there’s an area 52 in Utah now that has an alien spacecraft stored underground. Area 51 has an alien body or bodies and material from the crash from Roswell Mexico. Aliens are real and they might not be nice. I agree with Hawking that we should have some sort of plan or attack and I for one will not be caught off guard. I think you and everyone else should plan accordingly just in case as well. If you save enough money you can use it to build a shelter or to buy supplies or something! You can also use these supplies for the earthquake! If they don’t attack then you have extra money! You just have to spend that money where you tell yourself that you don’t mind dying if they attack.
This employer 401k matching… I’ve never heard of it. Do most employers generally do it? Should I just speak to my boss about it? It seems like an obvious choice to invest in but I’m not sure that mny employers offer this….
@ Stubbings – Re: employer 401k matching: I’m not sure how widespread employer matching is, but most of the folks in know in private sector white collar jobs (like engineering, paralegals) have it.
You can ask your human resources folks to see if it’s available to you or other employees at your firm (it may not be for you, but if it is, definitely max it out.)
Also… wht would you sy the best way to invest $20,000 would be, short or long term? Index funds seem great but I feel like I would want to keep it all together in one lumped, invested, sum….
@ Stubbings: RE: investing $20 K: Your question can’t be answered fully without more context. I find that the best way to think of how to invest is by first deciding what your financial goals are. I recommend deciding what area of your life could use that $20 K investment. Assuming your credit card debt is paid off, you might want to 1) put money aside for retirement (depending on your age, this might mean mostly in a stock index fund for the long-term) or 2) buy a house (likely a bond index fund for the short-term) or 3) some other goal.
In each of these cases, the appropriate investment depends on how far away your goal is. I use the rule of thumb that any money I need in the next 5 years should be in a stable bond index fund (or in cash if 5 yr) goals like retirement or Vanguard’s VBMFX (total US bond fund) for short-term (less than 5 yr) goals like buying a house.
Hope that helps!
good
can u send me some more information about how to invest money.