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What To Do With Your Money…Today and Tomorrow

We all want more money. We all want to be better with the money we have, too. But what exactly to do with your money is not so straightforward. Should you just be keeping money in a checking or savings account? What about a money market account that gets a higher interest rate? Should you be investing your savings? Should you be transferring your credit card balances to an account with a lower interest rate or try to get one of those 0% balance transfer cards? Which debt should you pay off first? These questions are just examples of reasons why personal finance can seem so confusing. This article should help provide some guidance and direction on what to do with your money today and tomorrow.

 

For The Love of Lists

If you follow the steps below you will be improving and well on your way to optimizing your money. In return you should expect your overall returns to increase as well so you can earn even more. First off, I am a big fan of lists. My office desk is filled with countless Post-It notes with lists scribbled on them.

I feel everything is so much easier when there is a documented list with directions of what needs to be done except for maybe IKEA furniture assembly instructions.

 

ikea

 

Money Order of Operations

This list is meant to be worked in order. So don’t move on to the next item until the previous one is completed. Kind of like the old order of operations from math class. I was taught to remember the acronym, PEMDAS for Please Excuse My Dear Aunt Sally. Anyway, the acronym stands for Parentheses, Exponents, Multiply, Divide, Add, and Subtract. So when you ran across a math problem you would work the problem out and run the calculations in order of PEMDAS. Well it’s time to put your new middle school algebra skills to the test!

mathprob

What answer did you come up with? 6, 1, 7, 4?

The correct answer is below the Amazon links at the bottom of this post.

I think that it is essential to have a set plan for executing tasks, especially long term tasks like saving for retirement.  But what’s the best way to go about funding retirement?  What is the proper order to save? Well, I have come up with an order of operations list for what to do with your money. No matter what your current financial situation, this list will help you on your way to retirement and financial independence. Whether you are just out of high school or college, just a few years away from retirement, or anywhere in between you can follow the list below in order and be confident you are making smart decisions with your money.

  1. Save in a 401(k) up to Employer Match

  2. Pay Off High Interest Debt

  3. Max Out a Roth IRA

  4. Max Out a 401(k)

  5. Invest in a Brokerage Account

  6. Prepay Debt

Now let’s dive deeper into each of these:

 

#1 – Save in Your 401(k) up To Employer Match

Why did I list saving in your 401(k) up to your employer match even BEFORE paying off high interest debt? Because if you are offered a 401(k) match by your employer your rate of return by taking advantage of your match is higher than the interest rate you are paying on your debt. Many companies offer some type of 401(k) match. If your company matches your contribution, and you don’t contribute, you’re leaving free money on the table. Think of it as giving up a percentage of your paycheck!

I will use the match offer from my employer as an example. My company matches 75% of what I contribute to my 401(k) up to 6% of my annual salary, or up to 4.5% of my total salary (0.06 x 0.75 = 0.045 or 4.5%). So that means I am getting 75% return on my money for free! A consistent 75% return on your money year after year in unheard of in the investment world. Here is what that annuals savings amount will look like based on a few different salaries:

 

Annual 401(k) Contribution with Company Match

       

Salary

6% Paycheck Deduction

4% Employer Contribution

Total Annual Contribution

$50,000

$3,000

$2,000

$5,000

$75,000

$4,500

$3,000

$7,500

$100,000

$6,000

$4,000

$10,000

 

Also, as my salary increases the amount of money my company puts in my 401(k) for me goes up as well. For the sake of making these calculations easier, let’s assume you never get a raise but you do contribute money to your 401(k) just enough to take full advantage of the company match.  Your savings after 20 or 30 years is significant.

 

401(k) Savings with Annual Contributions

         

Account Value from Total Annual Contributions

Initial Value

5 Years

10 Years

20 Years

30 Years

$5,000

$25,000

$50,000

$100,000

$150,000

$7,500

$37,500

$75,000

$150,000

$225,000

$10,000

$50,000

$100,000

$200,000

$300,000

 

This table doesn’t even include interest from investments! If you invest your 401(k) in mutual funds then you should include the amazingly powerful effect of compound interest in your calculations. Those figures are ridiculously higher. Check it out!

 

Compound 401(k) Earnings with Annual Contributions
 
  Account Value with Compounding Interest
Initial Value 5 Years 10 Years 20 Years 30 Years
$5,000 $37,779 $83,755 $238,674 $543,426
$7,500 $56,669 $125,631 $358,011 $815,140
$10,000 $75,558 $167,508 $477,349 $1,086,853
*Assumed average annual return of 7%
*Assumed your salary stayed the same and you never got a raise
*These interest calculations were performed with this calculator

 

 

 

If you make $50,000 a year and NEVER get a raise, but you invest the 401(k) money you save, the effect of compound interest will earn you over half of a MILLION dollars in less than 30 years!

I can’t speak highly enough of getting this free money if your employer offers it and even recommend prioritizing and saving in your 401(k) even before high interest debt because the rate of return is so high! However, if your employer doesn’t offer a 401(k) match, start with number two.

 

#2 – High Interest Debt

Now it is time to tackle your high interest debt. Let’s consider debt to be high interest if the rate is over 6%. You should know, or at least be able to quickly figure out from your statements, the interest rate you are paying on the debt you have. Some examples of debt that I would expect to have an interest rate greater than 6% are credit cards, maybe some personal loans, potentially some student loans.

As I have said before, borrowing money and incurring debt ultimately impacts your time and future. This is because you likely need to spend more time working in order to earn money so you can pay off your debt. Therefore, when you take on debt you are really committing your future time to working, rather than being able to spend that time with your family and friends having fun. Make a plan to get rid of your debt so you can work towards your future rather than paying off your past.

The only way I would recommend paying high interest debt over taking the 401(k) company match is if you don’t have enough money coming in each month to meet the minimum amount due on all of your debt every month. In this scenario, you have no extra money to contribute to savings as it is all going towards debt. Although, there is a high possibility you could cut down in other areas like food costs, cell phone plans, and cable.

 

#3 – Max Out a Roth IRA

Individual retirement accounts (IRA’s) and 401(k)’s have many similarities. Both are tax-advantaged retirement accounts. The primary difference in an employer sponsored 401(k) plan is they typically only have around a dozen or so mutual funds to choose from. But in an IRA you can choose just about any type of investment. In an IRA you can pick individual stocks like Google (GOOG) or Apple (AAPL), mutual funds, ETF’s, etc. Rather than trying to guess the next hottest individual stock, I personally use and recommend index funds which are a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund typically provides broad market exposure, low operating expenses and low portfolio turnover.

There are two primary types of IRAs - traditional and Roth. The reason I recommend a Roth over the traditional is that starting at the age of 59 ½ you can withdraw your money completely tax-free from a Roth account! This can be a really powerful wealth building tool. Note that you do pay taxes on the money going into the Roth IRA. With a traditional IRA, the tax is deferred until you withdraw the money.

The 2016 annual maximum limit for a Roth IRA contribution is $5,500. For those of you over the age of 50, you are allowed to put in an extra thousand dollars of “catch-up contributions” for a total contribution limit of $6,500. You can open an IRA through Vanguard here.

 

Screen-shot-2012-03-27-at-Mar-27-2012-10.51.47-PM-

 

#4 – Max Out 401(k)

Let’s head back to your 401(k). Your next goal is maxing this account out. The 2016 annual maximum you are allowed to contribute to a 401(k) is $18,000. Most employers typically cap paycheck deductions for 401(k) contributions at a max of 25% of your salary. Depending on how much money you earn you can potentially meet the annual 401(k) maximum before the year is over. Or you may never reach the $18,000 maximum if you get paid a little less and your contributions are still capped at 25% of your pay.

The same applies if, instead of a 401(k), your employer offers a 403(b) or 457 plan.

 

#5 - Invest in a Brokerage Account

If you have made it to number five then you have already maxed out the typical tax-advantaged retirement accounts available to most people. If you still want to save and invest more you can do so through a brokerage account. Invest options in a brokerage account are similar to an IRA where you have very few restrictions on the type of investment you want your money in. There are no direct tax advantages or tax deferment options with brokerage accounts. But this money will be available to be accessed and used, unlike retirement accounts where you have to wait until the age of 59 ½ to withdraw to avoid any penalties.

I recommend setting up a brokerage account through Vanguard because Vanguard charges lower fees than most other firms. Although there are a ton of options for brokerage accounts that you are probably familiar with: E*TRADE, Fidelity, Schwab, and most of the large banks as well. Your focus should be on low fees.

 

#6 - Prepay Debt 

Prepaying debt is about paying off the remainder of your debt to become completely debt free. In number two you tackled your high interest debt so all that is left is low interest debt at or below 6%, such as a mortgage on a home.

You may choose to tackle mortgage debt gradually. If you make just one extra mortgage payment per year, you could substantially reduce the total cost of your loan. For example, if you borrowed $100,000 on a 30-year loan at 4 percent, your monthly payment would be $477. If you make biweekly payments of $238 instead of $477 once a month you wind up making 13 payments over the course of a year instead of the standard 12. Over the life of the loan you would save over $10,000 in interest and pay off your mortgage four years early. And if you are able to double the amount you pay towards your mortgage, you could pay off that same 30-year loan in only 11 years! (Most mortgage companies and lenders offer the bi-weekly payment schedule. You just need to call them or go online to set it up).

 

But You Still Have Options

Investing in a brokerage account (#5) and prepaying debt (#6) could easily be swapped. It all comes down to personal values. For example, I personally wouldn’t refinance my home just to invest the equity to pursue higher returns in the stock market. And conversely, right now I am not going to sell a bunch of stock investments to pay off our mortgage. For me it just wouldn’t make sense either way. You could make a case for both situations.

While historical stock market returns you earn you more money if you’re investing, being completely debt free has got to be an amazing feeling. If you find yourself having to make this decision of investing versus being debt free then you should just smile. You are doing very well against any standard. The best approach may be a mix of both. Paying a bit of extra principal toward your mortgage to get it paid off faster and while also adding to and accelerating your investment accounts.

 

Even More Investment Options

This list can be your go to resource for what to do with your money. However, there are several scenarios when this order of “To Do’s” may change. For example, if you are already retired you won’t have an employer, so how could you get a match? Or if you are a high income earner, you may not qualify for a Roth IRA and should consider a traditional IRA instead. Everyone’s situation is different but if you choose to do anything at all I recommend that you completely understand the pros and cons of every decision you make with your money. Investing your money into accounts and funds that you don’t understand can do more harm than good, leaving you with less money than you started with.

And this list is just the basics. If you are able to save enough that you are maxing out retirement accounts then you may consider maxing out a Health Savings Account (HSA) if you have a high deductible health insurance plan. And if you have young children and pay for daycare then you should consider a Dependent Care Flexible Spending Account for some tax savings. If you are a high income earner according to the IRS (greater $117K as an individual or $184K married filing jointly) then you may want to look into a back door Roth IRA to try and take advantage for the Roth tax savings.

We could all make better decisions with our money. Follow the money order operations above and you will know what to do with your money today and tomorrow.

The answer to the math problem above is 7. Based on the order of operations, you multiple and divide first, then it becomes 6-0+1 = 7.

What do you think?