Setting Financial Priorities

Once you’ve achieved a solid financial foundation and are committed to a lifestyle of living below your means, you’ll have extra money available each month to fund your financial priorities and build long-term wealth. The question becomes where should you be focusing that surplus of cash to maximize your returns? There are a lot of considerations to take into account. The emotional aspects of having enough cash available for emergencies. Understanding the tax advantages or disadvantages of various types of retirement, health care savings and non-retirement accounts. Making the best use of employer retirement account matches and other benefits.

The list below is a guide on where to focus investments across a variety of accounts to maximize returns and improve the tax efficiency of your portfolio. As you fully fund each recommended step, move onto the next step and continue to grow wealth. Everyone’s personal situation is different, so use this as a guide, but modify it to meet your own needs and take advantage of options that may be unique to your situation.

1) Save $1,000 in a Starter Emergency Fund

Why: Everyone needs an emergency fund. This is your basic financial safety net. Keep enough cash on hand to handle moderate emergencies while you tackle more pressing financial needs. $1,000 is enough to provide a little peace of mind, keep you from taking on further debt and ensure that you are not hit with unnecessary fees from bouncing a check or making late payments.

2) Contribute to a 401k up to the Full Employer Match

Why: An employer match on your retirement account is free money and the very best return on your investment. For example, if you make $50,000 per year and your employer offers a 100% match on the first 5% of your 401k contributions, you are investing $2,500 per year and receiving $2,500 per year in free money. You won’t find guaranteed returns like that anywhere else.

Other work-based retirement plans may offer similar benefits. NerdWallet has an excellent article outlining the various types of retirement accounts.

3) Pay off High-Interest Debt

Why: High-interest debt (anything above ~7% interest rate) is toxic to your personal financial situation. You are spending 7% to 20%+ more for products/services when you charge them to a credit card and carry a balance. Plus, you may get hit with late payment fees and other unnecessary fees.

Eliminate the highest interest rate debt first. It’s a guaranteed return on your money. Have a credit card with a 20% interest rate? Eliminate that balance and it’s a guaranteed 20% return on your money with no risk involved. Kick consumer debt to the curb and keep it away.

4) Build a Bigger Emergency Fund (3 – 6 Months of Expenses)

Why: With high-interest debt eliminated, it’s time to build up an emergency fund that will sustain you through an unexpected long-term income loss, such as a significant injury or job loss. Evaluate your monthly budget to see how much is appropriate for your situation.

Be careful not to save *too much* cash in an emergency fund. Cash is an asset that depreciates over time as inflation occurs. You will be better off investing excess cash (money beyond the 3 – 6 emergency fund value) in a non-retirement account and withdrawing at a future date if necessary.

5) Take Advantage of Other “Free Money” Your Employer Offers

Why: It is another guaranteed return on your investment. If you have additional options for matches on retirement accounts or discounted stock at your employer, take advantage. As mentioned in our post about how we saved $1M in our first 10 years working, a subset of our wealth came from optional Pension plans and Employee Stock Purchase Plans (ESPP). Depending on the security of your job, you may want to prioritize this step in conjunction with saving towards a bigger emergency fund.

As a college new hire, I opted to withhold 10% of my paycheck to be set aside to purchase my employer’s stock at a (minimum) 15% discount once every 6 months. Fluctuations in stock price during that period meant the discount had the opportunity to be much greater than the minimum 15%. It was a significant withholding each paycheck, but the long-term financial gains were worth it.

6) Max out a Health Savings Account (HSA) if available

Why: An HSA is an excellent tax shelter, but it is only available in conjunction with a high-deductible health plan. Contributions are tax deductible and withdrawals are tax-free when used for qualified medical expenses. Contributions can be accrued year-to-year and invested to grow the overall balance of the account. There is no income limit for contributions to an HSA.

7) Max out an Individual Retirement Account (Roth IRA or Traditional IRA)

Why: IRAs offer a variety of tax advantages, but there are income limits on who can contribute and how much can be contributed each year. Do a little research to understand which options are best for your situation. Bogleheads has some good information on the differences between traditional and Roth IRAs and how to prioritize based on your current and future tax rates. Another benefit of IRAs is you choose your own broker and have access to a myriad of investment options.

We have always contributed to a Roth IRA. Contributions to a Roth IRA are post-tax and gains can be withdrawn tax-free in retirement. Additionally, principal contributions can be withdrawn without penalty prior to retirement.

8) Max out your 401k (or other Work-based Retirement Plan)

Why: If your employer offers a match, you should already be contributing a certain percentage of your pay towards this retirement account. After fulfilling the prior financial priorities, contribute the maximum to your 401k or other work-sponsored retirement accounts. 401k contributions are pre-tax and lower your yearly taxable income.

Take note that if you receive a raise mid-year and are already contributing a set percentage of your income to reach the maximum yearly limit, you may need to reduce your percentage contribution. If you hit the yearly contribution limit too early, you will miss out on the employer match through the end of the year.

Caveat: Some work-sponsored retirement accounts have very limited investment options. If your only investment options are high-fee funds, you may want to consider skipping this step.

9) Pay Off Debt in the 5% – 7% Interest Rate Range

Why: This is once again a guaranteed return on your investment. Traditionally the stock market will outperform these returns, but if you are taking a more conservative investment approach, it’s a toss up. Use your discretion on whether you would rather invest or pay off debt in the mid-interest range.

10) Start Investing in Taxable Investment Accounts

Why: Once you’ve fully taken advantage of tax-sheltered retirement and health savings accounts, it’s time to start a taxable investment account. Paying taxes on gains is better than no gains at all. And remember, cash depreciates in value over time.

There are so many options on this front. If you’re new to investing, Investopedia has some excellent resources to get you started. We started investing in a taxable account by opening an investment account with Vanguard and choosing a few index-oriented ETFs.

Make it to Step 10 and you’re well on your way to financial independence! Keep building wealth and growing your investment portfolio over time.

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