Should you pay off all of your debts before you begin investing? Should you fully fund your retirement account before you begin investing in taxable accounts? Should you save an emergency fund or pay off credit card debt? The list goes on.
Here’s an email from Mike asking a variant of this question:
Great podcast! I just discovered it this past week and have already listened to about 10 of them. You do a great job of simplifying these concepts for folks.
A lot of what you have been discussing/preaching I already knew and am practicing but it was great to get some confirmation that I’m mostly on the right path.
That said, I’m curious what your thoughts are on the order in which we should save/invest (i.e., which accounts to put money in first and then the order in which to allocate the rest of our income in other savings accounts).
We already have an emergency fund with 6 months of living expenses, which we broke out evenly into 5 high yield CDs that we are laddering through Ally Bank since the penalty to close the CD is not extreme.
Given that premise, this is how my wife and I (both in our late 30s) currently allocate our income (in this order):
(1) We max out our 401(k) accounts on a yearly basis as this is a great investment vehicle and we get the pre-tax benefits. We each have low-cost Vanguard (or similar options) and go mostly 55% domestic stocks, 25% international stocks and 20% U.S. bonds.
(2) We pay fixed installment debt (i.e., mortgage, car payments, and student loans). I know that a listener had previously asked you whether it was better to pay down debt or use that money to invest. Our interest rates on our debt is low (4.2% for mortgage, under 3% for car and under 5% for student loans) so we chose to use any extra after-tax income and invest it as the return is higher than the interest rate on the debt.
(3) We invest in a 529 Plan that we just opened for our infant daughter. After we have invested and/or paid the expenses listed above, the issue gets trickier. Most financial advisers recommend investing IRA accounts and maxing those out after maxing out one’s 401(k) account. My issue with that is a liquidity issue as well as a benefit issue. My wife and I make too much combined to benefit from a Roth IRA so our option is a traditional IRA. From our perspective, we have chosen liquidity over what we see as limited benefits of traditional IRAs in our circumstances. Yes, we do not get the tax benefit but our taxable brokerage accounts are liquid if there is ever a need to tap into that money (e.g., property investment opportunity or expenses beyond what is in our emergency fund and general savings). If we kept our money in an IRA, then we’d get hit with the penalty plus having to pay tax on the gains vs. just paying tax/capital gains in a taxable account. That’s just us — personal preference.
So, we split our after-tax income (after 401(k), 529 and debt payments) between a taxable account and money market account through Ally at roughly 75% into a taxable brokerage account and 25% into a money market account yielding .08% for general savings.
This works for us but I was curious to get your thoughts on this — taxable brokerage accounts vs. IRAs after maxing out 401(k) accounts and what would be some other options/plans for investing such after-tax accounts.
This is great email with very practical points and questions. In Mike’s case, they’ve planned and executed well. Now, they’re working toward setting financial goals.
Listen to the Podcast of this Article
Try a “backdoor” Roth IRA
Addressing Mike’s situation more specifically, they may want to consider a “backdoor” Roth IRA. Their income is too high to take a deduction for a traditional IRA, since they’re covered by employer plans. But they can contribute to a non-deductible IRA, then roll the money over into a Roth IRA. Since there will be no tax deduction on the traditional IRA contribution, there will be no tax consequences for the Roth IRA conversion. The money will then be able to accumulate investment income on a tax deferred basis.
There’s a 5 year rule — two of them actually — with Roth IRA withdrawals. He can always take the contributions without taxes or penalties, since the contribution had no tax benefit. But the earnings will be taxable and subject to penalties if he makes the withdrawals prior to age 59 ½. You can get more information on the five year rule from Podcast 105, since it‘s a complex topic.
If he has other IRAs, the backdoor Roth gets tricky. You can’t pick and choose the IRA you’re going to convert to a Roth IRA. The IRS lumps them all together and uses ratios based on all of your IRAs, which will result in tax consequences. You can check out Podcast 40 for more information on the backdoor IRA.
Getting Back to those Financial Goals
Dave Ramsey was my inspiration to set financial goals, with his 7 Baby Steps. I didn’t follow his baby steps. As personal finance advice goes, they really aren’t that great. But I did find inspiration in listening to those who called into his show to scream that they were debt-free.
Learn More: Here’s the Real Deal on Dave Ramsey and Debt
In the spirit of his Baby Steps, however, I’m going to cover six factors to consider as you set your own financial priorities. Then, we will apply these factors to some key financial goals that most of us have.
1. This is NOT one size fits all
It’s difficult to come up with a generic list of financial goals, because everybody’s financial situation is different. A college graduate with $200,000 in school loans, but no other debt, will have different financial priorities than somebody in their 50s with little saved for retirement and $25,000 in credit card debt. Given the fact that variations in financial situations from one person to another are so great, there’s no such thing as one size fits all.
This is my biggest concern when it comes to financial gurus who are dogmatic about their approach to personal finance. They leave no room for different financial situations, different personalities, and different life goals.
As an example, Dave Ramsey is well known for his debt snowball. According to Dave, everybody should pay off their smallest debt first, regardless of interest rates. His theory is that getting rid of a debt provides motivation to stay on the path to getting out of debt. Yet what about those individuals who don’t need that type of motivation and have larger debts with very high interest rates? Blindly following Dave’s approach would be very costly.
A Different Approach: The Debt Snowball vs the Debt Avalanche
2. Think in terms of goals
You can’t just think in terms of steps. Instead, focus on your financial goals. Having $1 million in the bank is not a goal — it’s a number. What are you going to do the day you become a millionaire? Probably the same thing you did the day before. That’s what most people who become millionaires do.
As an example, one goal is to be financially able to handle an emergency. This goal often translates into saving three to six months worth of expenses in a savings account. While that’s one way to meet this goal, it’s not the only way. We relied on a home equity line of credit as our emergency fund while we were paying down debt. Today, we rely as much on our taxable investments for emergencies as we do an FDIC-insured savings account.
The key is to separate the goals from how you’ll achieve the goals. Doing so enables you to think outside the box for creative solutions.
3. Multi-tasking is the Key
Throw out the idea of working on just one goal at a time. There’s no set of required sequential steps. You should be pursuing multiple goals at the same time. For example, one can — and should — build an emergency fund at the same time they’re saving for retirement. The notion that you should pursue financial goals one at a time, a concept usually marketed by popular financial personalities as “steps,” often leads to sub-optimal results.
4. Track Your Net Worth
If you see your net worth — what you own, less what you owe — you’ll see your progress. Net worth is more important than income in determining your financial resilience. It’s your financial “scorecard”.
You can make decisions about how certain actions and strategies will affect your net worth. For example, we can evaluate whether to pay off a debt quickly or invest the extra cash in light of how the two options will affect our net worth. But first you have to know what your net worth is, and be able to track it.
It’s very easy to do — here’s how to track your net worth.
5. Liquidity is important
Liquidity is your ability to access cash quickly. It’s often overlooked when it comes to getting out of debt. For example, paying off installment loans (e.g., car or student loans) reduces your liquidity. Once you pay extra on these loans, you can’t get the money back. In contrast, paying off a revolving loan (e.g., credit cards or home equity line of credit) increases your credit.
Of course the goal is to get out of debt completely. But one could use a revolving line of credit in an emergency. You can’t use a car loan to deal with an emergency. We considered this when getting out of debt. We paid off our home equity line of credit first, and then tackled our school loans.
6. Money you don’t spend can have a significant impact on your life
You don’t need to spend money to get the benefits of having money. The money you save can have a profound effect on your life. Let me explain.
We require our children to save 50% of their income while living at home. This rule prompted my son, who questions everything, to ask this question: What am I saving for? I think he wanted to have a goal in mind, like buying a car. That’s certainly a good approach, but I was hoping to teach him something more.
Having a solid financial foundation enables us to make life choices we wouldn’t otherwise make. With money in the bank, you may be more likely to pursue your dreams, which may involve a different lower paying job, starting a business, or something else. You may not need to spend the money you’ve saved to accomplish these goals, but the money in the bank can give you the confidence to take the risk.
My List of Financial Priorities
I have my own list of financial priorities, and it may not look like Dave Ramsey’s or anyone else’s. And that‘s the point – you have to come up with a list of priorities that work for you, based on your own circumstances, goals, and personality.
That being said, here is a list of common financial goals:
- Emergency Fund
- Non-Mortgage Debt
- Child’s Education
- Buying a Home
- Pay off Mortgage
So how should one prioritize these goals? Here’s one approach. Note that I’ve listed these sequentially to show what are, in my opinion, the priorities of each goal. As noted above, however, these can and often should be accomplished together. Goal #1 is the only one I’d prioritize above the rest.
Goal #1: Short term security
This is about not living month-to-month. For me it’s having at least one month’s living expenses saved. That will enable you to survive for a month if you lost your job. It should also cover most emergency expenses such as a car repair.
This is your emergency fund. It should be invested in an FDIC-insured account. That’s the traditional way to accomplish this goal, but not the only way. We relied on a home equity line of credit for our security while paying off debt. There are risks to using a home equity line of credit. The bank could cancel the line in a bad economy, or the interest rate could rise. The point is that there is more than one way to accomplish this goal.
As far as accumulating the money for your emergency fund, don’t contribute to retirement, and don’t try to pay off your debt. Put the money into your emergency savings instead. This is one area where I don’t think folks should multi-task with their goals.
That being said, expenses should be managed so that this goal is accomplished very quickly. Save 20% a month, and you’ll reach this goal is just four months. If that math seems wrong to you, check out this article on how long it takes to save a month’s worth of expenses.
Goal #2: Contribute to your 401k to get the employer match
Contribute at least enough to max out the employer match. This is where I disagree with those who recommend getting out of debt before investing for retirement. Failing to take advantage of an employer match is like negotiating for a lower salary. Further, time is the secret ingredient of compound interest.
Goal #3: Tackle high interest debt
High interest debt is any loan with a rate of 7% or more. Your definition might be different. The point is that high interest debt needs to be dealt with as quickly as possible.
There’s more than one way to address high interest debt. Obviously, paying it off is one way. You can also refinance the debt to a lower rate. Car and student loans can be refinanced, and credit card debt can be transferred to 0% cards. This is a perfect example of distinguishing the goal (getting rid of high interest debt) with the tactics (paying it off vs. refinancing).
Another approach is to sell something. With secured debts, for example, you should seriously consider selling the stuff that you bought with the debt. This certainly comes to mind with car loans. If you are struggling to make the monthly payment, sell the car, and buy whatever you can afford to buy with cash.
Goal #4: Max Out 401k/Fund IRA
The tax advantages on tax-sheltered retirement plans are too rich to pass up. This gets back to Mike’s question. At what point does Mike get comfortable enough to do this? Once his concerns for liquidity have been satisfied, he can begin funding an IRA. Understand too that you don’t have to max out the IRA.
Goal #5: Build a “Freedom Fund”
Financial freedom is NOT having so much money that you can choose to do nothing. It’s having enough money so that you can choose to do anything. This is the ultimate financial goal. It’s what drives my financial decisions.
For example, in the list above of financial goals I included saving for a child’s education, saving for a down payment on a home, and getting out of debt. Of these, so far we’ve only dealt with high interest debt. What about the rest?
I view these and other priorities through the lens of financial freedom. For example, we could pay off our home. In fact, if we were following Dave Ramsey’s Baby Steps, that’s exactly what we’d do. But retiring our mortgage won’t bring us additional financial freedom. Instead, it would zap a lot of our liquidity all to pay off a debt that, after taxes, is at less than 3% interest. While the day may come when we do pay it off early, we are in no hurry. The same would be true with other low interest debt.
Goal #6: Give Back
Giving back should be a priority no matter where you are in your financial journey. You don’t have to limit this to money. You can volunteer your time, too. It’s important to realize that none of this is ours – we’re just renting it. That helps to put all financial decisions into a better perspective.
What are your financial goals, and what is your strategy to reach them?