Given the name of my blog, you might guess that this answer would be pretty obvious, but it’s a little more complex than that. When I finally got serious about my finances, I was faced with an important decision:
- Should I start by paying down my massive credit card and student loan debt?
- Or should I start investing for retirement?
- Or should I start putting money into savings?
All are certainly important goals, and yet each would require some cash flow. Here is the logic that I used to decide what to do first with my disposable income every month:
Step 1: INVEST. Say yes to free money by taking advantage of company match for 401(K)
This sounds simple enough, but I’m sure there are lots of people out there who don’t take full advantage of an employer match for retirement contributions to a 401(K). A 401(K) is an employer-based retirement account to which both you and your employer can contribute. Some companies offer to match your contributions up to a set amount — usually 5% or so.
I know that I’ve briefly considered lowering my retirement contributions below the 6% my company when I think about how much I hate my debt, but the logic I use to talk myself down is this: not taking advantage is like trading the instant 100% nominal return of a 401(K) company match for the 7.9% annualized interest rate of my student loans. As such, there are a lot of things I would give up before giving up this company match. If you meet the income requirements for any form of federal tax credit for retirement savings — such as the Saver’s Tax Credit (IRS link) — you should treat contributions to retirement savings in the same way.
Step 2: INVEST. Contribute to a Roth IRA
A Roth IRA is a tax-advantaged retirement account, into you which you put after-tax money whose growth is tax-free, under the condition that this growth is not removed until after retirement (or in a few other special cases). The original contributions to a Roth IRA, however, can be withdrawn at any time without penalty. In this sense, it can be considered fairly liquid.
Step 3: PAY OFF DEBT. Pay the monthly minimums on each account
Wait, I waited to pay off debt until here?
Yes. This makes sense because I got a 100% instant nominal return on the money I sent toward my 401(K) to get the company match. If I need more money to make my minimum payments, I could withdraw money from my 401(K), get hit with the 10% penalty for doing so, and still be up 90%.
And then alternatively, if I run out of cash before paying off all my minimums, I could withdraw from my Roth IRA contributions without penalty.
Some questions you might have are: (1) Why not pay more than the monthly minimums? I’ll get to that. (2) Why not pay less than the monthly minimums? That’s ignores what the word “minimum” means.
Step 4: SAVE. Build a one-month cash buffer (emergency fund)
I make sure that I have enough cash in a liquid account to pay every expense I have coming in the next 30 days and the 30 days after that. This is sometimes called a two-month buffer. It can also be referred to as an emergency fund.
There are a few reasons to maintain an accessible emergency fund. Some are intangible — such as the peace of mind most people will cite when asked why they keep such a fund — and others very tangible, such as the high cost of getting your hands on money in an emergency.
Other people like to keep a bigger cash emergency fund and I wouldn’t argue with them — especially if their situation is very different from mine. I explained how I decided on my preferred size in this post: “Why I don’t keep a lot of cash around in an emergency fund.”
Step 5: PAY OFF DEBT. Make additional payments to debts with after-tax interest rates above 4%, starting with the highest interest rate
Next, I use remaining disposable income to pay off my higher interest rate debt. It makes sense to me to start with the highest interest rate because those loans are the ones that are costing me the most in interest every month.
Why would I stop this step once I hit 4%? Personal preference mostly. It also has to do with expected long-term returns on equity mutual funds.
Step 6: INVEST. Make additional contributions to 401(K) or traditional IRA
Oh, you still have disposable income left? How lucky. Then I’d use these remaining funds to make additional contributions to either of these pre-tax retirement accounts — the one you pick should depend on which gives you better investment options, based on expense ratios and your preferred allocation. I don’t use it, but if it makes sense for you, this could even include online foreign exchange trading.
You know how you can tell I’m the worst blogger alive? Because I needed to have a heading titled, “Conclusion.” Also, because I answer so many of my own questions.
Here are some things I didn’t include that maybe I’ll add someday:
- Long-term savings goals, such as to buy a house
- Health savings account, while switching to a high-deductible plan
- 529 and other vehicles to save for higher education of me or some kid
I would probably put these between 5 and 6, depending on how soon I wanted to reach that long-term savings goal.
How do you decide where to send money first?