In grade school math class we were taught PEMDAS (or Please Excuse My Dear Aunt Sally) as the order of operations on how to attack a math problem. By handling the parenthesis’ and exponents first, you could then tackle multiplication/division and then do any adding and subtracting. Voila! Right answer. By following a process you achieved the desired result.
There’s the same “order of operations” of where to put your money to maximize your retirement savings.
Maybe you have these questions:
- Should I put more money in my 401(k)?
- When should I pay off my student loan or car loan? Should I do a payment plan while still saving?
- What if I get a bonus? Where should that money go?
- What if I sold some property or inherited some money, how should I put that to work?
- I want to make sure all my money is going in the right place. Where is that?
If you’ve ever wondered these questions, this post will put your mind at ease. I’ll give you a specific order to follow so you won’t ever have to spend time beating your head against the wall wondering where the next dollar should go.
Keep in mind this is if you’re wanting to save for retirement and lower taxes. If you’re wanting to save for a mini-sabbatical or a house, then this process won’t be the one to follow.
With that said, let’s begin!
1) Pay off Consumer Debt
What is consumer debt? I define it as anything except a mortgage: student loans, car loans, and credit card debt.
Tackling these debts is your first step toward saving for retirement. Why? Because every dollar of debt is multiple dollars of your future money that you can’t spend. Debt is borrowing money from your future self to pay for something you can’t afford today. Every dollar you borrow today is just more money you don’t control in the future.
For retirement we’re trying to build as many income streams coming in as we can. Debt is an outflow and won’t stop being an outflow until it’s repaid. The longer you take to repay, the greater the amount of interest that is paid (read: less money in the future).
You can wander into debt (a large purchase on a credit card or signing that student loan application for college without really understanding it), but you can’t wander out.
Many people think that consumer debt is just a part of life (How can you buy a car without a loan?). That’s the biggest lie we’ve all fallen for. It doesn’t have to be and you’ll be so much richer (and happier) without it.
Plus, by paying off debt you are guaranteeing yourself a high investment return. Let’s say your credit card rate is 18%. If you pay off your credit card balance, you just earned yourself an 18% return by not sending that money to a credit card company.
Ok, rant over. Here’s what you do.
First, pull together 1 month of living expenses and put it in your savings account. This savings amount should be enough to cover housing, groceries, utilities, and necessary clothes, but not dining out or entertainment.
Next, decide which strategy you’ll use to pay off your debt. There’s two main strategies:
The snowball method involves listing all your debts from smallest balance to largest balance (don’t worry about the interest rates). You then pay minimum payments on all the debts except for the smallest balance. With the smallest balance, you throw as much money as you can scrape together at it.
Here’s an example. Let’s say you have an extra $300/mo. You pay minimum payment on credit card 2 and the student loan and then put everything else toward credit card 1
|Balance||Minimum Payment||Extra Payment|
|Credit card 1||$500||$50||$300|
|Credit card 2||$3,000||$50|
Once credit card 1 is paid off, you take that minimum payment ($50) and add it to the $300 and then start paying off credit card 2.
|Balance||Minimum Payment||Extra Payment|
|Credit card 1|
|Credit card 2||$3,000||$50||$350|
Once credit card 2 is paid off, you now have $100 extra since you’re no longer paying payments on credit card 1 & 2. You use that extra $100 with the $300 and apply it all towards the student loan.
|Balance||Minimum Payment||Extra Payment|
|Credit card 1|
|Credit card 2|
The reason why this works well is because you get an emotional boost by paying off a debt category. It sure feels good to only have 2 outstanding debts instead of 3. This helps motivate you to get after it.
The other option is the avalanche method. With this method you list your debts from largest to smallest based on interest rates. And you start paying on the one with the highest interest rate first. Once that’s paid off, you move to the next highest interest rate debt. You can use the same process as the snowball method with paying minimum payments on everything but the highest interest rated balance.
Mathematically, the avalanche strategy is the “best” way to pay off debt because you’ll be paying the highest interest rate balance first. So you’ll pay less back over time.
Either strategy is great. You have two options. Choose one and get after it.
2) Complete Emergency Fund
Once your consumer debt is gone (and after you’ve celebrated that achievement), you then need to complete your emergency fund.
The rule of thumb is to set aside 3-6 months of living expenses. I find this rule of thumb unhelpful because you then wonder if you should do 3 months or 6 months, which is it?! I think that all emergency funds should be 6 months of living expenses. Did that help clear things up?
Remember living expenses are only those that you absolutely need to survive if you were to lose your job. Pay your rent/mortgage, utilities and have some money for gas and groceries. If you’re between $18,000 and $40,000 for your emergency fund, you’re probably on the right track.
But don’t just stick it in your bank and earn nothing on that money. Open up an online savings bank (like Ally Bank), and stick that emergency fund money there. You’ll earn much higher rates and the fund will be held at a separate location making you think twice before you dip into them.
I know most people are anxious to start investing, but please don’t skip this step. Investing works wonders when it’s allowed to compound undisturbed. Emergencies will happen and you don’t want to pull from your investments to compensate for a job loss or a large medical bill.
3) Employer match
With your consumer debt paid off and emergency fund fully funded, you’re now finally ready to start investing.
If you’re lucky enough to work for an employer who offers a “match” on their 401(k), let me tell you what that actually means: FREE MONEY!
Who doesn’t want that? Your employer is incentivizing you to save into a 401(k) by offering to contribute some money as well. Yes, please.
When you’re given your HR benefit packet at work, they’ll usually say how much the match is. For example, the match could be 50% up to 6% of your salary. This means that if you make $100,000 and contribute $6,000 to your $401(k). Then your employer will “match” $3,000 and put that into your 401(k). So in total you now have $9,000. Awesome!
Since you don’t want to pass up this free money, at the very minimum contribute up to the match, then move to the next step. We’ll be back to the 401(k), don’t worry!
4) Max HSA
A Health Savings Account is part of your health insurance benefit package at work. It’s attached to a High Deductible Health Plan and you can only contribute to a HSA if you’re enrolled in your employer’s High Deductible Health Plan (HDHP).
Wait. Health insurance? I thought we were talking about investing. Hang with me for a second.
Here’s why a HSA is so powerful for retirement and lowering taxes:
- Contributions are tax-deductible (above the line). Who doesn’t love a tax deduction that you don’t have to itemize for?! Furthermore, they reduce your income for taxes and won’t impact your AGI (Adjusted Gross Income), which is what a lot of income phaseouts are based on.
- The contributions can be invested and grow tax-deferred
- Distributions are tax-free if they are used for qualified medical expenses
Triple-tax free! No other investment account offers this benefit.
If you’re enrolled in a HDHP, I highly recommend you max out your HSA. Usually, your employer will contribute an amount on your behalf (just like a 401(k) match). This is because HDHP’s are much less expensive from an employer cost standpoint. Again, free money. Don’t pass it up.
Some advise you to pay for medical expenses out of pocket and keep the receipts. Once you reach retirement age, you can then reimburse yourself for those medical expenses that you incurred decades ago. I find this highly impractical. My suggestion would be to use the HSA account as medical expenses come up. You’re already getting a tax deduction and you’re saving on health insurance premiums by being enrolled in a HDHP. Use those premium savings and invest a higher percentage of your salary into your 401(k).
5) Employer Stock Purchase Plan (ESPP)
If you work for a publicly-traded company, chances are your employer allows you to purchase company stock through a payroll deduction or directly in your 401(k).
The company stock can usually be purchased at a 15% discount. Purchase the stock and then immediately sell it.
Companies lose market value all the time (Amazon has lost 90% of its market value multiple times). So even if you work for a large company you are not immune to market swings of the company stock. You’re just one bad announcement away from your company stock getting slammed. 40% of all publicly traded companies are duds.
Better to diversify and never chance the risk of losing all your money.
6) Contribute the max to workplace retirement plan
Now we’re back to our 401(k). Your next step is to work towards maximizing out this account.
If you’re under 50, you can contribute up to $20,500 (2022). If you’re over 50, you can contribute an additional $6,500 or $27,000 total.
But be careful. Some workplace retirement plan investment funds are expensive and have high costs. Find the column that lists the expense ratios. If any funds are over 0.50%, skip them. Those are too expensive and will hurt your long-term returns. The cheapest funds (but not any worse) are most likely index funds. Your best bet is to build an allocation based on those index funds. You’ll get broad diversification and low-cost.
If all the investment fund options are over 0.50%, then skip maxing out your workplace plan and start contributing to a Roth IRA.
Bonus: If your employer offers a Roth 401(k) option, opt to contribute to that. You won’t get a tax deduction in the year you contribute but those funds will never be taxed again. Imagine not paying taxes when you’re 65 and buying a new car or boat with your investment funds.
7) Max Roth IRA
Open a Roth IRA account at any brokerage firm (Vanguard, Charles Schwab, TD Ameritrade, Fidelity, etc).
And contribute the maximum for this account. If you’re under 50, the maximum you can contribute is $6,500 (2023). If you’re over 50, you can contribute an additional $1,000.
Don’t forget about a spousal contribution, too. Even if your spouse isn’t working, they can still contribute for themself as long as one spouse is earning a paycheck. If you’re under 50, this is another $13,000 going to retirement each year.
If you make too much money for a Roth IRA contribution (married filing jointly & income over $214,000 for 2022) then consider a Backdoor Roth contribution: make a non-deductible contribution to a Traditional IRA and then convert the funds to a Roth IRA. Be sure to file Form 8606 with your taxes, so you don’t pay taxes twice!
8) After-tax contributions to 401k & Roth Conversion
There are two conditions that are needed to perform this strategy. (1) Your workplace retirement plan has to allow for after-tax contributions and (2) the plan has to allow for in-service withdrawals (which is retirement plan language for “rollover while you’re still working for the employer”). If either of these conditions are not met, then you’re out of luck.
Most people think their 401(k) contributions are capped at $22,500 (plus $,7500 catch-up if you’re over 50). That is the cap for the elective deferral eligible for a tax deduction. You can make additional contributions up to a limit. The total contribution limit for both employee and employer contributions to 401(k) defined contribution plans is $66,000 ($73,500 if age 50 or older).
In other words, if you’re under 50 and maxed out your 401(k) with $22,500 plus your employer put in $6,000 through a match, then you can still contribute $37,500 of additional after-tax money ($66,000 – $22,500 – $6,000). Don’t forget to count your employer’s contribution against the total!
If you contributed the additional after-tax money, you would then request an in-service withdrawal to a Roth IRA.
I don’t recommend keeping after-tax money in a 401(k) without rolling it out. Yes, you get tax deferral but it’s very easy to lose track of your basis and you have to pay ordinary income taxes when you eventually do withdraw it.
9) Taxable investment account
If you’ve made it this far, congratulations! You’ve used up all the tax-advantaged strategies and accounts there are for retirement savings.
The last option is to contribute money to a taxable brokerage account (Individual, Joint, or Trust). You will pay taxes on dividends, interest earned, and capital gains in the account each year. However, if you invest in low-cost index funds there will be very low turnover and little capital gains realized each year.
As long as you don’t trade, this is a great way to grow savings tax-deferred and the last place to park savings for retirement.