Happy Friday morning everyone! Today’s newsletter will help you determine how to use every dollar in your budget. Many, many people ask me questions like “should I pay off my student loans before I start investing?” This guide will help answer those questions.
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You probably already know the steps you need to take to reach financial independence; pay off your mortgage, car, and other debt, and save enough money to comfortably retire. Unfortunately, most of us don’t have enough money to do all of that at once, and it can be difficult to know exactly where your next dollar should go. Should you pay off your student loans before contributing to your retirement plan? If you’re already saving an adequate amount for retirement, should you pay off your mortgage early or save even more for retirement? The following guide will help you decide where every dollar should be going, and lead you step by step to financial independence.
I’ll start at square one; square one meaning you make enough money to cover your living expenses, but don’t currently have any savings for retirement or an emergency fund, and you may have debt. So where do you start?
1. Get your employer match (if you have it).
Yes, this should be the first thing you do, assuming you don’t have any payday loans. If your employer offers a retirement plan with matching contributions, you should contribute up to the match. Most employers will match dollar-for-dollar (meaning 100% of your contributions) up to a certain percentage of your income. For example, if you make $50,000 per year and your employer matches your contributions up to 3% of your income, that means if you contribute $1,500 to your employer-sponsored retirement plan, your employer will also contribute $1,500.
Even if your employer only matches 50%, that’s still higher than even the highest credit card interest rates.
2. Pay off high-interest debt.
After you’ve got your employer match, you should focus on paying off any high-interest debt. This may only include credit cards; student loans are usually not high-interest, but private student loans may be. Any debt with an interest rate greater than 8% can be considered high-interest debt.
You may want to consider transferring some high-interest debt to a balance transfer card or taking out a debt consolidation loan if it will take you more than a few months to pay off your high-interest debt. This could end up saving you hundreds or even thousands of dollars on interest, but make sure you run the numbers and know exactly how much you’ll save before you make a decision.
3. Build an adequate emergency fund.
Why does building an emergency fund come after paying off credit card debt and getting your employer match? When you pay off your credit cards, you’re essentially getting a guaranteed return of whatever the interest rate on your card is, and when you get your employer match, you’re getting a guaranteed return of 50% or 100% or whatever your employer match is. An emergency fund could keep you from having to use your credit card in emergencies, but there is no guaranteed return (other than the interest paid on your savings account).
If you don’t have access to credit cards, though, building an emergency fund should be the first thing you do. You need a financial safety net to prepare for the unplanned and unexpected.
The size of an emergency fund looks different for everyone. 3-6 months of expenses is the general rule of thumb, but it isn’t one size fits all. It depends on your job security, career field, and your spouse or significant other’s job. If you have a specialized job, it may take you longer to find a similar job if you become unemployed, so you’ll want to have a larger emergency fund.
Job security is also an important factor; how long have you been at the company, how well is your company doing financially, and what is the risk of losing your job? If your spouse or significant other works at the same company or in the same industry, you’ll also want to have a larger emergency fund. If you’re both real estate agents, for example, you may be vulnerable to a downturn in the economy and could both be out of work at the same time. It’s best to plan for the worst-case scenario when determining how large of an emergency fund you need.
4. Save for retirement.
Now is the time to go all-in on saving for retirement. Most of you will probably want to contribute to a Roth IRA before you make contributions to your employer-sponsored retirement plan. This is because a Roth IRA offers flexibility that an employer-sponsored plan does not; you can choose your custodian and investments (low or no-cost index funds, anyone?), and the choices in your employer plan may not be as attractive.
The after-tax contributions of a Roth IRA are also a huge benefit. Your employer plan may let you make Roth contributions, but most don’t. If your combined marginal tax bracket (state + federal + local) is around 30% or higher, though, you may want to consider contributing to a traditional IRA instead of a Roth IRA.
After you’ve maxed out your Roth IRA, you may want to look into contributing to an HSA. Only those who are enrolled in a high-deductible health plan (for 2019, the IRS defines an HDHP as any plan with a deductible of at least $1,350 for an individual or $2,700 for a family) qualify for an HSA, but they are a viable retirement savings vehicle. They offer a triple tax advantage; contributions go in pre-tax (meaning you don’t pay tax on money you put in), interest and investment earnings grow tax-free, and payments for qualified medical expenses are tax-free. Once you’ve reached age 65, you can take penalty-free distributions from your HSA for any reason, but they will be subject to ordinary income tax. When you reach that age, though, you may have more medical expenses to use your HSA for, and payments for medical expenses always come out tax-free.
Once you max out your HSA, your employer-sponsored retirement plan, such as a 401(k), is next up. Employer plans are usually hit or miss with investment choices, so that’s why many savers prioritize Roth IRAs and HSAs first. If you do get an employer match, though, you should have gotten that a long time ago (that was step one, c’mon guys).
If you max out your IRA, HSA, and employer plan, you’ll need to open a taxable investment account. There aren’t any favorable tax breaks when contributing to the account, but earnings are taxed at capital gains rates instead of normal income tax rates (assuming they are long-term capital gains).
5. Save for college (if you have kids who might go to college).
Some parents may prioritize paying for their child’s college education over their own retirement, and more power to them, but there are many good reasons to put your own retirement first. Your kids can take out loans for school, but you can’t take out loans for retirement. They also have an entire lifetime of earnings ahead of them, while your career may be winding down.
Paying for your child’s college education is certainly a noble and worthwhile financial goal. Millions of graduates are unable to buy a house, car, or start a family due to crippling student loan debt, so lifting that burden from their shoulders will give them a great financial head start compared to their peers. Before you save for your kid’s college, though, you need to make sure your own retirement needs will be met.
6. Pay off your debt early.
If you’ve accomplished steps one through five and are wondering “What do I do now?”, it’s probably safe to pay off your debt early. The only debt you should have at this point is lower interest student loans, auto loans, or mortgages. After your retirement goals and college savings goals are being met, it’s now time to pay off your low-interest debt.
Auto debt is a weird type of debt, and doesn’t belong at any one step (that being said, I chose to put it on step six). Cars are quickly depreciating assets, so you’ll want to make sure you don’t carry auto debt for more than five years after you purchase your car, or three years for a used (but in good condition) vehicle. If your car breaks down or needs repairs, you could easily end up owing more on your car than it’s worth, which is a situation you want to avoid at all costs.
As you get older, into your 50s or 60s, you will probably want to have all your student loan debt paid off, and it may be best to pay your house(s) off before retirement.
7. Give your money away.
Now that you spent a lifetime building wealth, the next step is to give it all away. Not really, but once you have your retirement and kid’s college funded, and all your debt paid off, you can afford to be a lot more generous with your money. This doesn’t mean you have to wait until you reach financial independence to donate to charity, but in your younger years you’ll probably be able to give your time more easily than your money.
Once you’ve reached financial independence, your money will benefit others much more than it will benefit yourself. Again, I’m not telling you to give it all away; you should still enjoy the fruits of your labor, but you may be able to fund some charitable endeavors that you didn’t have the money for in the past.
I hope this guide has provided some clarity on where your money should go. If you have any questions, please respond to this email and I’ll get back to you. Substack also offers a forum post feature, where I can post a topic and interact with everyone. This could be used for answering general financial questions or for everyone to tell me what they want me to write about. If this is something you would like me to do in the future, please respond to this email and let me know. I want this newsletter to help and reach as many people as possible, but need your guidance on how I can go about doing that.
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