When you get dressed to go for a run, there is a generally accepted order to things that works best. For example, you put on your socks before your shoes, and you put on your shirt before your jacket. Any other way just wouldn’t make sense.
Similarly, in personal finance there is a generally accepted order for your financial milestones. It would make no sense to contribute to a taxable account before a Roth IRA, and it would be quite foolish to start investing for retirement if you were sitting on thousands of dollars of credit card debt at 18% interest.
Although the process of reaching your financial milestones may not be completely linear, and although the order of some of these steps is debatable, you really can’t go wrong it you follow the rough outline I present below. Remember, you should be saving 50% of whatever you make, so take that money and start moving through the milestones.
Milestone #1: Get motivated
You didn’t think I would forget step 1, did you? Remember, you won’t accomplish anything in life if you aren’t motivated. If you’re feeling apathetic, go back and read “What does it mean to be Free?”
Milestone #2: Save up a small emergency fund
When attempting to pay off your debt, the last thing you want to do is to go into more debt. Therefore, it will generally make sense to save up a small emergency fund before you actually start paying off your debt. The exact amount to save is debatable, but a reasonable benchmark would be one month of expenses or around $3000. Some have argued that if you have high interest debt, you should put all money towards the high interest debt before putting anything in a bank account. I think that argument could go around in circles forever, so feel free to swap milestone #3 and #2 if it makes more sense to you.
Milestone #3: Pay off high-interest debt (>8%)
If you have debt, you are losing money by the minute and you have an emergency! You need to get rid of your debt as soon as possible, but the highest interest debt takes highest priority. I will define high-interest debt as an interest rate greater than what you could reliably expect to make from your investments. This would include credit card debt, payday loans, or high-interest private student loans. The expected rate of return from investments is debatable, but a reasonable expectation would be between 5 and 7% after inflation. Remember, as you pay off debt, you are essentially getting a GUARANTEED return equal to the interest rate of that debt. Therefore, any debt with an interest rate higher than 7% should be paid off before investing.
Milestone #4: Contribute to your 401k up to the match
If your employer offers you a 401k match, this is free money and you should not pass it up. Let’s look at an example to see how this works. If you make $5000 per month and your employer offers you a 4% match, then you would contribute 4% of your paycheck to your 401k and your employer would match that 4% contribution. 4% of $5000 is $200, so you would contribute $200 per month and your employer would contribute $200 for an instant 100% return! The astute reader may notice that since a 100% return is higher than even the highest interest credit card debt, it might make sense to switch milestone 3 and 4. You could make this argument, but I’m still going to recommend that you stop your debt hemorrhage before you start doing any investing for retirement.
Milestone #5: Pay off moderate interest debt (4-7%)
Moderate interest debt may include mortgage debt or student loan debt. This rate is very similar to the rate of return that you could expect to get from your investments. Therefore, it is mainly a philosophical discussion as to whether to pay off debt or invest. Personally I hate debt almost as much as Dave Ramsey, so I annihilated my loans before investing. You may feel differently and that’s perfectly fine.
Milestone #6: Save up a full emergency fund
After you have paid off all your high and moderate interest debt, I think it makes sense to save up a sizeable emergency fund, perhaps 3-6 months of expenses, in the case of a job loss, unexpected medical bills, or other catastrophe. Your emergency fund should be completely safe and liquid, so the best you’re going to do is a high-yield savings account with 1% interest. Yes, you are losing money on this account since inflation averages 3%. Some have argued that with a stable job, an emergency fund is not necessary and reduces your investment returns. I can see this perspective but would counter that the purpose of an emergency fund is not to be an investment; it is to create peace-of-mind and security and to prevent any further debt accumulation.
Milestone #7: Max out your Roth IRA
In Use it or Lose It, I explained why the Roth IRA is the best retirement account for MOST people. If you have a very high income (and thus are in a very high tax bracket), it may make more sense for you to max out your Traditional 401k first, since any contribution to a 401k reduces your taxable income. For example, if you are in the 33% marginal tax bracket and you contribute the maximum to your 401k ($18,000), then you will reduce your taxes owed by 0.33 x $18,000, or $6,000. However, if you’re really making that much income, you should have no problem filling up a Roth AND a Traditional 401k each year, so it’s really not an either-or proposition.
Milestone #8: Max out your 401k
If you are able to max out your Roth IRA, then you should put all the rest of your retirement savings into your 401k. If you have a high income (>100K), then I would recommend contributing to a Traditional 401k. This contribution gives you an up-front tax break (as explained above) and will grow tax-deferred until you take distributions in retirement, when you will likely be in a lower tax bracket. If you have a mid-range income (<100K) and your employer gives you the option, you may wish to contribute to a Roth 401k (post-tax contributions, grows tax free, distributions are tax-free). Either way, you’re getting a nice tax break from the government, so don’t neglect it.
Milestone #9: Pay off very low interest debt (<3%)
If you have very low interest debt at a rate less than inflation (think refinanced student loans or excellent mortgage rate), then you may choose to let it sit around since you will be able to earn more from your investments than paying down the debt. This makes mathematical sense, or course. However, if you have a variable rate loan, or if you detest the psychological burden of debt, you may choose to pay this off in milestone #5. I had around 400K in student loans at around 2% variable. Since I was concerned about the potential for rate increases and since I wanted the loans killed, I decided to pay down my debt aggressively rather than saving additional funds in a taxable account. It worked for me, but you may choose to do it differently and that’s probably just fine.
Milestone #10: Contribute to a taxable brokerage account
If you still have money left over to save for retirement after paying off your loans and maxing out your Roth IRA and 401k (lucky you!), then open up a taxable retirement account through a low-cost provider such as Vanguard and Fidelity. Even though the earnings are taxed each year, there are ways to reduce the effect of taxes. Check out this post about the taxable retirement account. Spoiler alert: the fear of taxes is not a reason to avoid a taxable retirement account.
Milestone #11: Earn your Freedom!
This is what it’s all about. If you missed it, check out How to Earn your Freedom.
Caveat #1: I presented this timeline in a linear fashion. However, it does not need to be completely linear. For example, I paid off my student loans and contributed to a Roth IRA and 401k simultaneously.
Caveat #2: Depending upon your situation, you may want to switch some of these steps. For example, if you are in an unstable job situation, you may wish to save up a full emergency fund before paying off moderate interest debt.
The Bottom Line
Order matters when it comes to reaching your personal finance goals. I presented a rough outline that you may modify to fit your particular situation or values. The most important thing is to get motivated, save 50% of your income, check off these milestones, and go grab your freedom.
What do you think? Which milestone have you reached? Would you add, eliminate, or change the order of any of the milestones?