Introduction
Many of us want to save and invest more, but with so many options available to us, such as our 401(k)s at work, IRAs, ESPPs, 457(b) plans, etc., it can sometimes be hard to figure out the order of where to save money first. If you can relate to this, then this blog is for you.
Where Should I Stash My Cash?
Below, I’ve outlined what I believe to be a good order of priority regarding where you should put your excess money that you want to save or invest.
Please note that while this is a good starting place for most people, you may need to tweak it a bit based on your personal financial situation. Also note that you most likely won’t have every single option available to you or you might have already taken care of an item already. If that’s the case, just skip down to the next item in the list.
Ready to get into it? Let’s go!
1.) Build Up an Emergency Fund
If you don’t have adequate cash reserves saved up inside an emergency fund, take care of this before anything else. Investing and paying down debt are great things, but if you don’t have ample cash in savings, then you will end up liquidating your investments at an inopportune time or putting more money on the credit card that you’ve worked so hard to pay down.
Unforeseen expenses are going to happen to you at some point. Whether it’s your home’s AC unit going out unexpectedly, being laid off, or medical bills from a prolonged stay at the hospital, unexpected expenses will happen and it’s important to be prepared.
So how much cash do you need to keep in an emergency fund? It’s generally recommended to have 3-6 months’ worth of mandatory living expenses (no luxury expenses, just items that you’re going to have to pay to stay afloat: mortgage payments, groceries, insurance, etc.) sitting in cash. If you work in a fairly steady industry where layoffs are uncommon, then being closer to the 3 months’ worth of savings is probably acceptable. If you work in a highly volatile industry where layoffs are the norm, then I’d probably stick to closer to 6 months’ worth of cash.
It’s important that your emergency fund be liquid, so keep it in cash. With that said, you want it to grow at least a little bit while it’s sitting there, so I’d recommend opening up a high-yield savings account at a reputable online bank (make sure it’s FDIC insured) instead of at a local brick-and-mortar bank or credit union. If you don’t know where to start, I’d suggest looking at Ally Bank or https://www.maxmyinterest.com/.
2.) Pay off High-Interest Consumer Debt
So why should paying off consumer debt be your next priority? Well, because it improves your personal balance sheet over time and has the highest guaranteed return on your dollars. If you have large credit card balances, you’re most likely paying 15-25% a year in interest. By paying down the debt, you’re essentially getting a guaranteed return of 15-25% return on your money.
Two of the more well-known strategies to pay off debt are the Debt Snowball and the Debt Avalanche. Either method can work, but both require you to stick with it.
Debt Snowball
The debt snowball is the method made popular by Dave Ramsey. To use this method, order all of your consumer debt from smallest to largest and begin paying all excess money to the smallest amount first, while paying the minimum on all of the other debt. When the smallest debt has been repaid, use all of the money that you were paying on the smallest debt to the next one on the list. Repeat this over and over until the debt has been eliminated.
Debt Avalanche
The debt avalanche method works similarly except that you order the debt from highest interest rate to lowest interest rate. Any additional cash that you want to pay towards your debt, in excess of minimum payments, should be paid towards the debt with the highest interest rate. When the highest interest rate debt has been taken care of, move on to the debt with the second highest interest rate and devote all excess cash to this debt. Repeat until all of the debt has been retired.
3.) Max out Employer Match
In order to create some incentive for employees to save money for retirement, many employers offer to “match” money that the employee puts into their workplace retirement account. If you have a 401(k), 403(b), 457(b), or a Simple IRA plan at work, then there’s a good chance that your employer might be willing to match some of the money that you are contributing towards retirement.
For example, an employer might offer a 100% match for every dollar contributed by the employee up to 4% of the employee’s income. If an employee makes $100,000 a year and contributes $4,000 annually, then his employer will contribute an additional $4,000!
Obviously, you don’t want to miss out on free money, so this is the first place to put your extra cash towards once the emergency fund and high-interest debt issues have been addressed. You really should try to max out the employer match every year, if at all possible.
4.) Max out HSA
I’ve devoted an entire blog post to how amazing I think Health Savings Accounts (HSAs) are, but I think there’s still fairly low consumer understanding of just how awesome they are. Simply put, HSAs are the most tax-efficient account there is. It gets what’s known as “the tax-trifecta.” You receive a deduction when contributing to the account, it grows tax-deferred, and if you withdraw money for a qualified medical expense, the distribution is tax-free!
As of 2020, individuals may contribute up to $3,550 per year, while families can contribute up to $7,100 per year. Note that unlike most other retirement accounts (which have individual contribution limits), the HSA has a family contribution limit of $7100.
One important thing to note is that you must be enrolled in a High Deductible Healthcare Plan (HDHP) in order to contribute to an HSA. If you currently are not enrolled in a HDHP, you will probably need to wait for your company’s next enrollment period before you can start contributing to an HSA.
5.) Employee Stock Purchase Plan (ESPP)
Employee Stock Purchase Plans (ESPP) allow you to purchase company stock through your employer at a discounted price. Seems like a pretty good deal, right? I love being able to buy things on discount and if you’re fortunate enough to have this option at work, I’d take advantage of it.
Once you purchase the stock, you have the option to hold onto it in the hopes that it will continue to appreciate in value, or sell it on the open market for a profit. Even if you love your company and think that the future is very bright there, I’d highly encourage you to keep no more than 5-10% of your portfolio invested in your employer’s stock and sell the rest.
So why should you keep a relatively low amount of your portfolio invested in your employer’s stock? The answer is because you don’t want your paycheck and your savings to be dependent on the success of the same company. When Enron imploded in the early 2000s, many employees not only lost their jobs, but also lost the vast majority of their nest eggs (which was held in Enron stock).
You’re not betraying your company by protecting your financial future. If you want to have 5-10% of your portfolio in company stock, that’s fine, but any additional stock that is purchased through the ESPP should be sold and reinvested in broadly diversified mutual funds or ETFs.
6.) Max Out Pre-Tax or Roth Contributions to Workplace Retirement Accounts
If you’ve done all of the above and are still looking for a place to save/invest your money, the next step is maxing out your contributions to your workplace retirement accounts.
The maximum annual contribution limits differ depending on the type of plan that you’re enrolled in. For 2020, individuals under the age of 50 can contribute up to $19,500 to 403(b), 401(k), or 457(b) plans. Individuals 50 or older are allowed to contribute an additional $6,500 per year to these plans. If you have a 401(k) or 403(b) plan AND a 457(b) plan, the IRS allows you to max out BOTH accounts if you so desire. This means that if you are under 50, you can save up to $39,000 annually inside these two tax-advantaged accounts!
If you contribute to a SIMPLE IRA through work, as of 2020, you may contribute up to $13,500 annually, with individuals 50 or older being allowed to contribute an additional $3,000 per year.
Some Exceptions:
There are two notable exceptions that may change the order of maxing out your retirement accounts.
First, if you only have access to expensive investment options inside your company’s retirement plan (i.e. funds with expense ratios that are higher than .5%), you may want to skip ahead to step 7 and come back to this step later. While this can be an issue inside a 401(k), it is more commonly an issue in 403(b) plans, as they sometime use annuity investment options inside their plans with high expense ratios.
Secondly, if you want to invest in a Roth 401(k) but don’t have that option through your employer. You may want to skip down to step 7 and max out the Roth IRA before coming back to max out your workplace retirement accounts.
Also, if you currently are investing in a Roth 401(k) through work and don’t have any Roth IRAs set up outside of work, it might make sense to open up a Roth IRA account and fund it with a few hundred bucks. This will give you more flexibility and options with your Roth 401(k) money should you leave your employer or decide to retire. For more information on this, check out my blog from earlier this year on Roth 401(k)s.
7.) Max Out Roth IRAs
Once your pre-tax or Roth workplace retirement plan contributions have been maxed out, it’s time to start contributing to a Roth IRA!
Even though you don’t get an upfront tax deduction, Roth IRAs are incredibly flexible accounts that have valuable tax-preferential treatment on the backend. If you are above the Roth income contribution limits, don’t worry! There is still a way for you to make contributions to a Roth IRA via backdoor Roth conversions.
The Roth contribution limits for 2020 are $6,000 per year ($7,000 for individuals over 50). Note that this is an individual contribution limit, so if you are married, both you and your spouse may max out your respective Roth accounts.
8.) After-Tax Contributions to Your 401(k) or 403(b)
Before even discussing this, know that not all 401(k) or 403(b) plans allow for non-Roth, after-tax contributions. You need to check with your HR rep at your employer to see if their particular plan allows for such contributions. With that said, if your employer does allow for this type of contribution, it can lead to some interesting planning opportunities.
Unbeknownst to most people, while the pre-tax or Roth contribution limit is set at $19,500 per year, the total annual deferred compensation contribution limit is much higher. For those under the age of 50, you may have a maximum of $57,000 in total contributions for 2020. This includes employer matches. If you are 50 or older, the total contribution limit is $63,500.
For example, let’s say that you maxed out your pre-tax contributions of $19,500 for the year and also received $7,500 in matches from your employer, for a total of $27,000 in contributions. Because the limit is $57,000, you would be allowed to make $30,000 in additional after-tax contributions to your retirement plan!
After-tax contributions grow tax deferred and, if left in the 401(k)/403(b) until retirement, the contributions will be available to be withdrawn tax-free, while the investment earnings in the account will be part of your taxable income. That’s not a bad deal, but what makes after-tax contributions really valuable is, depending on your particular retirement plan at work, you may be allowed to move all after-tax contributions immediately over to a Roth IRA in a move called a “Mega-Backdoor Roth IRA.”
To carry on the example from earlier, if you contributed the additional $30,000 to reach the contribution limits, and then had the ability to immediately convert the after-tax dollars to a Roth IRA, you would be able to contribute $36,000 ($6,000 in maxed out Roth IRA + Mega Backdoor Roth conversion) in one year! All of that money plus the growth in the account will be available to you in retirement tax-free!
9.) 457(f) plans
So why are 457(f) plans so far down this list? It’s because 457(f) plans don’t enjoy the same creditor protections that most other employer retirement plans, such as 401(k)s or 403(b)s, do. If your employer goes bankrupt, the company’s creditors cannot claim assets in your 401(k) as payment for money owed to them by your employer. Executive 457(f) plans, on the other hand, do not have these same protections and can be lost should the company become insolvent. Therefore, this is one of the last places we’d invest money for tax-deferral purposes.
10.) Taxable Accounts
Now that you’ve maxed all of the above out, congratulations, you’ve pretty much maxed out all tax-advantaged accounts that are probably worth you maxing out (more on this below)! The final step is to invest all remaining savings inside a non-qualified investment account. I would suggest investing in broad-based, low-cost index mutual funds or ETFs.
A Couple of Accounts I’d be Hesitant to Put Money In
Annuities and permanent life insurance products are often promoted in the financial services industry as good places to use for savings due to the tax advantaged treatment that they receive from the IRS. While there are some situations that these products might be a good fit for a particular person, I would, as a general rule, encourage you to be very hesitant in putting money into these type of accounts, as they tend to be very expensive products where the product’s internal costs outweigh the tax savings.
If someone is pressuring you into putting large sums of money into these products, I would encourage you to ask yourself the question, “Is this in my best interest or is this in the best interest of the one selling me this product?” Chances are the answer is the latter and not the former.
Conclusion
So there it is! Hopefully this gives you a good foundation to figure out where you want your savings/investment dollars to go. Like I said earlier, this may need to be tweaked a bit based on your personal financial situation. If you’re wanting to discuss your situation in more detail with a professional or feel like you need more hands on help, schedule a free initial consultation with me.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
