From time to time, all of us probably still have our parents’ “advice” ringing loudly in our ears. Theses reverberations are most likely because the advice was yelled to us repeatedly (and justifiably) when we were kids.
One such piece of sage advice was to “get your priorities straight” – which for today’s kids might mean spending less time on social media and more time reading a good book. For us “grown-ups” it might mean dedicating more time at the gym and less time binge-watching Netflix.
Rest assured, we’re not writing to preach on those personal priority choices. But we are hoping to emphasize “getting your priorities straight” as it relates to saving, paying down debt and investing.
In short, prioritizing the best use of incoming cash flow can maximize savings, lower taxes and lower interest expense. This can be optimized by wisely directing income in an order that we view as the most impactful.
So what’s our preferred order?
- Emergency Fund: Most people are more interested in “getting in the market” with stocks, bonds or ETFs when in reality, they should first focus on building up an emergency fund to be able to handle true emergencies such as a job loss or uncovered health care expenses. A good rule-of-thumb is to set aside at least three months of living expenses if your income is generally stable, six months if your income is volatile or uncertain and between eight to twelve months if self-employed. If it takes a while to save up this amount, a good “band aid” for homeowners with equity is opening a home equity line of credit while this fund is being built up. The idea here is to avoid the need to sell assets or pull money from retirement accounts for emergencies, which could incur income taxes and penalties.
- Maximize “the Match” on employer retirement plans: While we often preach “there’s no such thing as a free lunch” employers’ matching contributions are as close to free money as most of us will ever see. At a minimum, you should contribute at least the amount needed to take full advantage of this benefit. Think of it as an instant 100% return on your money.
- Payoff High-Interest / “Unproductive” Debt: Of course the most common boogeyman here is credit card debt which is usually high interest and almost always “unproductive”. By “unproductive” we mean the debt usually financed a consumable item that’s well past its prime (those trendy shoes or that trip to Vegas) and the interest expense is not tax deductible. If your credit card interest rate is 13% for example, paying off the balance is an instant 13% “return” on your money in the form of avoided interest expense.
- Contribute to an HSA Account: If you have a high-deductible health care plan, very often these are accompanied by a Healthcare Savings Account. These are fantastic tax deductible contributions (with no income phase-outs) and the funds can be used for qualifying medical expenses without taxes or penalties. There are contribution limits ($6,750 per family in 2016) and other restrictions to note but we detailed our affinity for these accounts in another post which can be accessed here.
- Roth IRA: As most know, Roth IRA contributions are after-tax and grow tax free without RMDs (required minimum distributions). There are some limitations however. These include the phase out of eligibility at $184,000 AGI (Married Filing Jointly) and contributions must be “earned income”. But we love these savings vehicles as a good way to lower your tax base moving toward retirement.
- Company 401(k) to Maximum: The next priority should be to maximize your 401(k) contribution ($18,000 or $12,500 if you have a SIMPLE 401(k) to take full advantage of the tax deduction associated with these contributions. One reason this isn’t higher on our priority list is we’ve seen many, many 401(k) plans with limited fund choices and very expensive fees.
- After-Tax Investment Accounts: After all these savings have been fully funded, excess cash flow can certainly be contributed to an after-tax investment account to allocate in accordance with the broader investment strategy.
Now others might have different priorities and the priorities might change based on tax brackets, self-employment (with different retirement account types) and of course the need for college savings for the kids.
But we believe implementing this type of strategy (along with proper asset allocation, tax planning and other integrated financial planning) will go a long way toward your financial success.
So even if you’ve skipped your evening work-out (again) and you’re on your 4th episode in a row of Game of Thrones, we give you full permission to mentally ignore your parents’ advice to “get your priorities straight” because you can rest easy on your couch knowing at least financially- your priorities are in order.