When I finally made the decision to put an emphasis on saving my money instead of spending it, I realized I had no real idea how to get started. I know I was getting the full 3.5% company match (on 6% contribution) in my 401k thanks to auto-enrollment. My dad started a Roth IRA for me some 12 years earlier, but I hadn’t contributed to it in over 5 years. I wasn’t sure where to start, so I started reading blogs and books to find a smart way to get started.
Eventually I was able to find some articles on emergency funds. Some people recommended 12 months of expenses, other recommended 0 months expenses; just utilize credit as an emergency fund and pay off what you need to. If you lose your job, sell some investments to pay your bills until you are back on your feet. Pretty large range on what you are “supposed” to do. Eventually my wife and I felt comfortable working towards a three-month emergency savings account.
So, after the emergency fund filled up, what were we supposed to do next? This was a question that took a long time for me to answer. Everything else I was “supposed” to do after building the emergency fund I pieced together from various blogs, articles and books. I thought it would be nice if there was a simple guide to show what you should do with your money after you hit each step in your savings. So, I created the Savings Hierarchy (based on the Retirement Wrapper from Reddit user, BrainSturgeon on r/personalfinance):
It helps keep focus and perspective on how you could be saving your money. After you complete one step, you move up to the next until you are a money saving machine. Because personal finance is so personal, anyone can take this guide and adjust as they see fit. If their employer doesn’t offer a company match on contributions, they can skip that step. If they are comfortable with 0 or 2 or 12 months emergency savings, they can do it.
The reason I have this first is because the match is free money. If you don’t give yourself the match, you are giving up (potentially) hundreds of thousands of dollars in retirement dollars. If you are making $40,000 and have a 3.5% company match, over 30 years that company match is worth more than $204,000 (investor.gov calculator).
3-6 months seems to be the standard. That’s 3-6 months of your monthly expenses, not your monthly income. When I was first starting out, that wasn’t so clear to me, and it made saving up an emergency fund seem nearly impossible. Currently, our monthly expenses to live (after cutting out the things we don’t need to live) are about $3,850. Thus, our fully funded 3 month emergency fund is $11,550. As you can tell from our most recent net worth update, we aren’t quite there since my wife took the fall off to be home with our newborn. But we have been purposely spending a bit more in order to pay down our Home Equity Loan, knowing that my wife would start working again in January (we’re almost there!!).
Pay off Debt
Once a comfortable runway of emergency savings has been built, the next most important place to put your money is into debt. Specifically, debt with a higher rate than 6%. The reason I specified 6% is because it is essentially, a guarantee of 6% (or greater) return on your money by paying that debt off. Start with the highest interest rate debt and pay that off first. Use Dave Ramsey’s Debt Snowball to pay off the rest of your debt.
Since 1950, the stock market has returned 7% annually. But, over shorter periods of time, the stock market has much more volatility and can easily return less than 6%. For example, in the 5 year period ending in May 1932, the market “returns” were -19.4%. More recently, from 1999 to 2008, the market LOST 1.3% per year. Thus, for short term debt above 6%, pay it off quickly before moving on to the next step.
There isn’t another step here to pay off lower interest debt. I believe the money is better spent earning 7% over the long term. However, if you would be more comfortable paying off all debt, do that in addition to moving on to the next steps.
When we first bought our house, we overpaid our mortgage to eliminate mortgage insurance ASAP. We are currently overpaying our Home Equity Loan to pay down that debt quickly too.
Another important point to remember is that during this time of paying off debt, you will want to limit yourself to taking on additional debt. Keeping your spending down will help expedite the debt pay down.
Max Roth/Traditional IRA
The maximum annual contribution limits in 2019 are increasing to $6,000 ($7,000 if you are over 50 years old). If you aren’t at the income limit for Roth contributions, you should put your money there ($122,000 single income; $193,000 married filing joint income). If you are over the income limit, you can contribute to a traditional IRA, or you can use the “backdoor” Roth IRA strategy. Here is an article from Kiplinger on how to do a backdoor Roth, as well as some of the pitfalls. As far as what funds to invest your money into, stick with low cost index funds. Recently, Fidelity launched four 0-fee funds which should be strongly considered for where to invest outside of company sponsored funds.
Max Company 401k
Once the $6,000 limit is reached in the Roth/Traditional IRAs, extra income should go into your company sponsored retirement plan. For 401k’s/403b’s/457’s, the maximum in 2019 is $19,000, with an extra $6,000 catch-up contribution if you are over the age of 50. Completing this step will take some time for most. This is a smart place to put annual raises because it shelters your income from taxes (for now) and helps fight against lifestyle inflation. Many plans offer annual increases to your retirement plan. Ours automatically enrolls employees in a 1% annual increase and can be adjusted or removed entirely. It’s a great tool to help automate a growing savings plan.
Save and Invest
Once the emergency savings is built, major debt is paid off, and the retirement accounts are fully funded, extra money can be devoted to other saving (or giving) goals. If you want to keep the money fairly liquid (easily accessible with minimal risk) consider an investment grade bond fund. For longer term savings goals, consider one of the Fidelity 0-fee index funds. At this point, your retirement should be taken care of. With 30 years of maximizing your IRA and 401k/403b/457 you will have $2,750,000 to enjoy your retirement.
By prioritizing my savings using these steps, I know I will hit my $1,000,000 retirement account goal in 4,218 days. If you’re ready to start saving, follow the steps above to reach a comfortable retirement. If you have a friend/family member that needs some help on where to put their money, send them to this blog, or send them the picture of the hierarchy.