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.
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.