Optimal Order For Investing Your Money
When it comes to investing our money there is an endless list of choices to make. 401k, IRA, HSA, Student Loans, Mortgage, etc. The list never ends and we are constantly fearful of making the wrong choice. That is why in this post I want to share with you what I personally believe is the most optimal order for investing your money.
Yes, every situation is different, and there is no way we can cover all different scenarios in this post. But I firmly believe that there are some general guidelines most people can follow to make sure they’re putting their hard-earned money to work in the most optimized way possible.
01 - Emergency Fund
Before you put a dime into the stock market or anything else, your first order of business should include building up a reasonable buffer of cash. Store it in a simple checking or savings account. The exact amount will be different for everyone, and much depends on your personal risk tolerance but I recommend at least 3 to 6 months.
I know it's not an exciting activity with your money, but there is a good reason. Imagine an emergency fund like bowling guard rails. These bumpers essentially keep your bowling ball from falling into the gutter. They keep you in the game even though you might have launched the ball improperly or your ball started spinning in the wrong direction. Think of an emergency fund like these bowling bumpers.
Life will alway throw you curveballs and you need to be ready for them at all times. For me, a good chunk of my curve balls are most often related to my car. It might have to do with the fact that both my wife and I drove old clunkers for the first 10 years of our marriage. One time my car wouldn’t start and the mechanic told me it would cost me close to $4,000 to fix the problem, or I would need to purchase a new car.
Now, if I was in a more precarious financial situation and didn’t have cash in my bank account, $4,000 could have easily kicked me off the game. According to a Bankrate survey, only 39 percent of respondents said they would be able to cover an unexpected $1,000 expense from their savings. Most often, people don’t have a choice but to use credit cards to cover the shortfall and it sends them deeper into a financial hole. In our journeys to debt paydown, investing or financial independence, there will always be curveballs. But enough cash in an emergency fund will ensure that we don't get derailed, and help us to stay on track towards our financial goals.
02 - 401K Employer Match
If you work for an employer that offers matching 401k contributions this should be your first and main priority. Before you do anything else, take full advantage of your employer's matching contributions. Why? Because 401K matches provide an instant, guaranteed, 100% return on your investment.
For example, let’s say that your employer matches 100% of your contributions up to 4% of your income. If you make $100,000 a year, when you contribute $4,000 into your 401k, your employer matches you dollar for dollar, another $4,000. You are essentially making 100% return on your investment instantly. There’s not an investment in the world that offers risk free returns like that. The stock market doesn’t. Rental property doesn’t. And even a lucky run in Las Vegas can’t compete.
If you aren’t sure of your company’s 401k employer match policy, ask your human resources department or your benefits manager if they have an employer match and how it works. Then take full advantage of any employer matching contributions.
A quick note. If you don’t plan on staying at your company for too long, make sure to ask about the ‘vesting schedule.’ The “vesting schedule” will tell you how long you have to stay at the company in order to keep the employer’s matching contributions. The most common length of time that workers wait to be 100% vested in company matches is three years. Consider this when you are thinking about moving jobs. You want to be aware of how much money you are leaving on the table by accepting a new position.
03 - High Interest Debt
I would categorize high interest rate debt as anything more than 5%. For most people this would include things like credit card or student loans. In my book, credit cards would be one of the worst of higher interest rate debt given the average credit card carries a 16% interest rate. If you have credit card debt that you’ve been carrying month to month, this is where you want to start with your debt reduction plan.
There is no easy way to knock down high interest debt except to just do it. List out all your high interest debts and create a plan for getting rid of them. You can use the Debt Snowball method or the Avalanche method. Whichever one that can best motivate you. Once high interest debt is knocked out, you’ll be amazed at how much income you’ll have to optimize the rest of your finances.
04 - Roth IRA
In my personal opinion, the Roth IRA is one of the most tax-efficient accounts available to investors. In a nutshell, with a Roth IRA, contributions are made on an after-tax basis, but any growth is tax-free. Of course there are conditions such as needing to leave the money in your Roth IRA account for at least 5 years and you have reached the age of 59 and a half.
However, what is amazing about the money in Roth IRA is that you will never need to pay taxes on it, ever. We don’t know what the tax landscape will look like in the future. A new politician might decide that he or she needs to raise taxes to fund big government projects. When you contribute to a Roth IRA, you reduce the unknown tax related risks in the future.
There are also some eligibility considerations to a Roth IRA. In order to contribute directly to a Roth IRA, you or your spouse must have earned income, but not too much. In 2023, if your Married Filing Jointly combined income exceeds $214,000, you are ineligible to make direct Roth IRA contributions. But if your income is too high to contribute directly to a Roth IRA, consider the 'Backdoor Roth IRA Strategy.’ In 2023, the contribution limit for anybody under the age of 50 is $6,500. If you are age 50 or older, the contribution limit is $7,500.
05 - HSA
Now, this may not be for everyone since in order to contribute to a Health Savings Account, aka HSA, you need to be eligible to do so. You must be covered under a qualified high deductible health plan, HDHP, before you contribute to an HSA. However, if you do qualify, this is a great way to save money for future health related expenses. HSAs offer what’s known as a triple tax benefit:
Your contributions are tax deductible.
Your money grows tax-deferred while in the HSA.
You can withdraw money from your HSA tax-free as long as it’s used to pay for qualified medical expenses.
If your qualified high deductible health plan is for yourself only, you can contribute up to $3,850 in 2023. If your qualified high deductible health plan is a family health insurance plan, you can contribute up to $7,750 in 2023. If you are age 55 or older, you can contribute an additional $1,000.
06 - 529 Education Savings Plan
If you are looking to save money for your children, the 529 Education Savings Plan offers a great tax-efficient way to do it. A 529 Education Savings Plan is basically like a Roth IRA, but for education expenses. Contributions are made on an after-tax basis, but growth is not subject to federal tax, and oftentimes state tax as well, when used for qualified education expenses.
529 plans do not have annual contribution limits. However, contributions to a 529 plan are considered completed gifts for federal tax purposes, and in 2023 up to $17,000 per donor per beneficiary qualifies for the annual gift tax exclusion.
Personally, I don’t want my kids to think I’m going to cover their college tuition 100%, so I invest just a moderate amount. If we are creative, there are tons of different ways to effectively fund college. I personally had my college paid for by the US Army and my wife had her nursing degree paid for by her future employer. So though I like to have the 529 education savings plan as an option, I don’t want my kids to completely depend on it.
07 - Max 401K
Alright, the number seven on our list brings us back to 401k. But this time not just for a match, but to completely max it out. Just because we've taken full advantage of your employer match, doesn't mean we can't contribute more money to our 401k.
This is one of the most effective ways to lower our taxable income and put more money into the market. I have personally saved thousands of dollars per year on my taxes just from maxing out my 401k. In 2023, the contribution limit for anybody under the age of 50 is $22,500. If you are age 50 or older, the contribution limit is $30,000.
08 - Taxable Account
Once you have maxed out all your tax advantaged options when it comes to your investment, you can start investing additional money into a regular taxable investment account. I talk to alot of people who are excited to jump into the market. And oftentimes they are opening up taxable brokerage accounts way before they have maxed out all their tax advantaged accounts. But this should be your last priority since you don’t get any tax advantage when using taxable accounts.
The tax drag from using a taxable account instead of tax-advantaged accounts like a 401k can be significant, especially when compounded over decades. Tax advantages like tax deduction allows more of your money to get to work for you sooner in the market, and therefore greater growth in the long run. Why pay more in taxes than you need to. And make sure you are also following the index fund strategy when it comes to your taxable account. Individual stock and mutual fund picking is a loser’s game and you are a winner.
09 - Lower Interest Debt
I would say lower interest debt are debts with interest rates lower than 5%. Most often this would include lower rate student loans and most car loans, but does not include most mortgages. Even though from a financial perspective, this debt may not be hurting you that much I would still recommend getting rid of it if you have the means to do so.
Debt is quite an interesting concept. It's touted by some as a way to achieve the American dream. Others say, it's the devil and should be avoided at all costs. My personal perception is this. Never let our guard down around debt because it has a way of easily warping our perception about money.
When we accept debt as a normal way of life, it can quickly cascade into a borderline dangerous mindset of justification. We could start to fund an elevated lifestyle with that low interest debt. Buying cars we don’t need. Getting student loans for a degree that won’t advance our career. If at all possible get rid of as much debt from our lives. You are not only taking care of your financial well being, but your mental and emotional well being as well.
10 - Pay Off Mortgage
Number ten on our list is I personally believe optional, but a valid way to deploy your money if you choose to do so. And that is to pay off your mortgage. If you purchased a home in the last few years, you hopefully benefitted from a low interest rate environment. And you have at least a decade before your loan matures. With a 15-30 year timeframe, your chances of the stock market outperforming your 2-4% mortgage is very high. So I would say it makes sense to invest your extra cash into index funds, rather than the mortgage.
However, if you are getting towards the end of your mortgage and would like to be completely debt free, this could be a good option. I mean is there anything better than living in a home mortgage free?
