Where should you put your money? There are a ton choices including credit card debt, retirement accounts, mortgage payments, that new Le Creuset stockpot that you’ve always wanted, a trip to Tahiti, etc. Below is a list of where I think most people should put their money in order of priority. That means that I recommend maxing out the first item on the list before going down to the others.
This list assumes a couple of things:
1) You have some cash to put towards these things. If you don’t, you need to read Rule #1 of personal finance, cut costs where you can, optimize your spending, and automate your savings.
2) You are not endangering your health, have proper levels of insurance, and aren’t making yourself miserable by living like a total pauper because you’re following my savings suggestions to the extreme.
3) You’ll tailor this order to your own personal situation. (But even so, I strongly recommend following items 1 & 2 in that exact order.)
Okay, ready? Numero Uno for where your money should go is….
1) Employer 401k matching
If you’ve read my articles on retirement, you’ve heard me say this before: don’t leave free money on the table! What type of return do you historically get from a risk-free investment? Treasury bonds have returned about 4-5% annually. What is your employer match return? If you get matching of 50 cents on the dollar up to 6% of your salary, your return on that first 6% saved is an instantaneous, huge, risk-free 50%!!! There’s no better investment in the world that I’m aware of. Max this out no matter what!
2) High-interest debt, like a credit card
– Some readers might quibble with this as #2, I can hear them now: “What!? Paying off your credit card balance is always the first thing you should do!” There may be emotional benefits to making this #1 that you should consider, but if your employer matching is 50% instantly, and your credit card rate is 25% annually, you’ll do way better to first max out your 401k matching. After that, put the rest of your cash towards that VISA balance.
(Of course, if you have a rate as outrageous as this one, you may want to switch to paying this off first…)
3) Emergency fund (3 – 6 months worth of living expenses)
You need to have some money socked away for unforeseen expenses or losses of income. While you should at least have long-term disability insurance to protect yourself against injury, you also need a shorter-term stash of cash to tide you over if you lose a job, get sick, or have to replace something valuable, like a car. The general rule for insurance is to insure things which you wouldn’t be able to replace relatively quickly and that would cause you hardship if you had to go without them. This includes your home, life, health, and possibly your car or jewelry, depending on the retail value of these items and your personal savings. (Make sure to avoid useless insurance.)
Expenses you can afford should be ‘self-insured’ by your emergency fund or other savings. Raising insurance deductibles and banking (NOT spending) the difference in premiums is a good way to self-insure against small losses ranging from a few hundred to a few thousand dollars. Store emergency money for unexpected car repairs, insurance deductibles (which can be large if you have catastrophic health insurance like I do), or high vet bills for your disgustingly-cute Cavalier King Charles spaniel.
Whether you need more or less living expenses saved depends on how steady your income is & how many liquid assets you already have (like non-retirement stocks that you could tap.) The more financially secure you already are, the less of an emergency fund you need: a self-employed person with few liquid assets needs more emergency funds than a union schoolteacher with 20 years seniority and a sizable investment account.
Like all short-term (less than 3-5 year) savings, your emergency fund should be investing in something that is not only stable and liquid (easily accessible), but that will also give you a decent return on your investment. High-interest savings accounts like the kind from INGDirect* fit the bill for very short-term savings since the principal is guaranteed by the FDIC. Bond funds, which may vary slightly in principle but generally yield a higher return than savings accounts or CDs, work better for money that might sit there awhile. I use a low-fee, highly-diversified bond index fund for my emergency fund due to the higher returns compared to high-interest savings accounts.
(Read this for an advanced way to juice your emergency fund interest rate while keeping your principal safe & accessible.)
4) Tax-advantaged retirement accounts (401ks, Roth or Traditional IRAs)
After you’ve maxed out your employer retirement matching, paid off your debts (except perhaps your lower-interest mortgage or student loan), and stored money for emergencies, it’s time to go back to saving for your retirement. Read up on the Roth IRA, and then read this to see if it would be better for you to put your retirement savings in a pre-tax account like a 401k or an after-tax account like a Roth IRA or Roth 401k. For people in high-ish tax brackets (25% and above as a rule of thumb) and who don’t already have a large pre-tax dollar nest egg saved up, I recommend putting the bulk of your retirement savings into a 401k plan (or a Traditional IRA if your employer doesn’t offer a 401k.)
If retirement is still 5-10+ years off, invest in broad, low-fee stock-market index funds like those that track the S&P 500 or the total stock market. Index funds outperform mutual funds about 70-80% of the time and require no maintenance on your part since they passively track the entire market for you! Any good 401k plan should offer at least one of these indexes. If you’re investing in a Roth or Traditional IRA, select a mutual fund company that offers a good selection of low-fee index funds like Vanguard or Fidelity.
Putting money into a tax-free retirement vehicle is critical to building up a nest egg for the future. Assuming you’re in the 25% tax bracket (and some other things**), an investment in a tax-advantaged retirement account made when you’re 25 will be worth about 55% MORE in real dollars when you’re 65 than would an equivalent investment in a taxable account. (Obviously, if your tax bracket is higher, it’s even more advantageous to avoid taxes.)
5) ‘Regular’ taxable investment accounts & short-term savings for big purchases
After you’ve either maxed out your retirement options (you’re a beast!) or decided you’re contributing enough to retire how you want to at a given age, it’s time to look at plain ol’ taxable investment accounts for long-term savings. (Index fund recommendations still apply.) I like to think of these as early retirement accounts; the more you sock away now, the quicker you can exit the rat race (or do something for lower pay that you like more.)
Also, you should be saving regularly for big purchases like a house, wedding, vacation or new car. For these short-term items, I use the high-interest savings sub-account technique that I learned from Ramit Sethi (you could also use the Roth IRA ‘hack’ I mentioned in priority 3 above.)
Simply open an ING high-interest savings account*, then create multiple savings accounts, labeled according to each item you’re saving for (‘Wedding’, ‘San Francisco trip’, etc.) Then, set up an automatic monthly contribution to each account based on the amount of time you have to save and the amount of money you’ll need. For example, if you need $30,000 to put down on a house in 2 years, that’s $1250 per month that you need to be saving ($30,000/24 months = $1250 per month.)
Note that you might sometimes rank some short-term savings goals as higher priority than maxing out your retirement accounts (#4.) That’s fine, but do NOT neglect your retirement. Investing early, even with just a little bit of money, is the most important factor to building wealth. Saving for retirement will be way easier if you start today with whatever you can.
So there you have it, the rank-ordered top 5 places to put your money: 1) Max out employer matching contributions before anything else, 2) pay off high-interest debt like credit cards, 3) create an emergency fund of 3-6 months worth of expenses, 4) put as much as you can into tax-advantaged retirement accounts, and 5) bankroll anything left into short- & long-term (taxable) savings/investment accounts.
Take each step one at a time until you’ve successfully mastered it, then move on to the next one (don’t try to do it all at once!) Once you’re eventually able to do all of these things, consider yourself pwning your money!
Now that you know where to put your money, find out WHAT to invest it in here.
[And just for good measure, here’s a link from the Motley Fool’s insurance page, which should contain some complimentary info to this post.]
* If you want to set up an ING Direct high-interest savings account, the first 24 people that email me can get a referral link that will get them a $25 bonus if they deposit at least $250 when setting up the account (I’ll get a $10. referral bonus.)
** This assumes dividends & capital gains remain at the historically low rate of 15% for those in the 25% and up brackets. It also assumes an effective tax rate at retirement of 16%, which corresponds to an income in today’s dollars of about $90K for a married couple. If dividend or capital gains rates go up, tax-advantaged accounts perform even better against taxable accounts. On the other hand, if your tax rate goes up relative to the capital gains rate after you’ve retired, tax-advantaged accounts lose some of their edge (but they’re always better.)