Prioritizing your money

Investors are faced with many choices on where to put our money. 

For example here are some common questions:

• “Should I pay off debt or invest?”

• “Should I invest in a taxable account or a 401(k)?”

• “Should I invest in a HSA or Roth IRA?”

Now, the ultimate goal of these decisions is maximizing your return (making you the most amount possible) and decreasing overall risk.

Here is a general rule of thumb for prioritizing your money allocation:

1. Emergency fund 
2. Maximum employer match from an employer retirement plan (e.g. 401k or 403b)
3. Pay off high interest debt (8-30%+)
4. HSA (if applies)
5. Max out Roth IRA (Backdoor Roth for high income earners)
6. Fully max out 401k or 403b
7. Mega backdoor Roth
8. Pay off medium rate debt (4-8%)
9. Taxable brokerage account

More details:

1. Emergency fund

The size of your emergency fund depends on your risk tolerance and life circumstances. As a rule of thumb, you should have 3-6 months’ worth of expenses saved in a stable situation (e.g.  good job, reliable car, renting) and 6-12 months’ worth in a more risky situation (e.g. self-employed, old house, old car). Make sure that the emergency fund is earnings at least 4% APR.

However, if you have high-interest debt (such as credit cards), you might prioritize saving only 1 month’s worth of expenses and allocate every extra dollar toward paying off your debt.

2. Employer match

Contribute enough to get an employer match. For example, I get a 100% match up to 5% of my salary; so, for every dollar I contribute, I receive another dollar. Essentially, I get a 100% immediate return on every dollar I put in. Nothing can beat this return.

One thing you have to keep in mind is the vesting rules related to your employer plan. These rules determine when you will be able to keep the money your employer matched. For me, I’m 100% vested at all times, regardless of years of service. Your plan might be different. One popular vesting rule is 50% year 1, and 100% vested year.

3. Pay off high interest debt (7-30%+)

Paying off high interest debt (like credit cards) should be prioritized before investing in a Roth IRA or a taxable brokerage account. On average, investments generate 7-12% on a nominal basis. Paying off 24-29% credit cards is guaranteed, tax free returns. 

4. HSA

A Health Savings Account (HSA) is a tax savings account designed only for people with high-deductible health plans. A HDHP is a health insurance plan with a deductible of at least $1,600 for an individual plan, or $3,200 for a family plan.

Contributions to an HSA are made with pre-tax dollars (similar to 401k/403b). Any interest or investment earnings within the HSA are also tax-free. Withdrawals from the HSA are tax-free if used for qualified medical expenses. So it provides a triple tax advantage (tax deduction, tax-free growth, tax free withdrawal).

For many people, HSA is not applicable due to having a non HDHP; skip this step then.

5. Max out Roth IRA

Maxing out a Roth IRA is the next priority. It’s preferred over maxing out a 401k/403b (step #6) due to:

– More investment choices (more control)

– No fees.

– Easy access to funds

I wrote an article on how to open a Roth IRA and all the benefits associated with that account. High income earners will need to use the Backdoor Roth strategy to contribute.

6. Max out 401k 

After Roth IRA, you can max out the 401k. The limit on employee deferrals is $23,000 in 2024. At this stage, you may also need to decide whether to allocate more funds towards a Roth 401(k) instead of a Traditional 401(k). I discussed this subject in depth 2 weeks ago. 

7. Mega Backdoor Roth

Mega Backdoor allows you to contribute after-tax dollars beyond the annual $23,000 limit if your employer allows it. I discussed this topic in Issue #11

8. Pay off your medium interest debt (4-7%)

Investment returns are not guaranteed. After maxing out retirement accounts, you should prioritize paying off your medium-interest debt if you are seeking peace of mind, simplicity, and increased liquidity

Depending on your risk appetite and investment timeframe, you may consider swapping with step #9 instead:

9. Invest in your taxable brokerage.

After paying off high-interest debt and maximizing all retirement accounts, investing in your taxable brokerage is the final step. If you are curious exactly what I invest in, I shared details in Issue #9

Now, many of these decisions depend on your income, tax rate, future goals, and comfort level with risk. However, this general outline will help you think strategically about where to allocate your money.

Additionally, it’s not a “set and forget” type of arrangement. Your income can change, your goals might shift, and your reliable job might become unstable. 

That’s all for today. Thanks for reading The Crunch. 

Do reply. I’m not a robot, I talk back!

MC, CPA