Today, I am going to share my philosophy on how to prioritize competing savings goals. In other words, what do I save for first? What types of accounts should I use? And should I pay off debt instead of investing for the future? Unfortunately, life can get complicated, so many financial dilemmas will require you to make tradeoffs.
I recently read the book Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts. The book’s premise is that life is not like the game of chess where there’s always a right and wrong move that can be seen in advance. Life is like poker, where you have to make lots of decisions with incomplete information (e.g., you don’t know what cards your opponent has, or how other players are going to bet). Poker is all about probabilities. Good poker players are constantly weighing the upside vs. the downside of each decision and thinking both offense and defense at the same time.
This is a long way of saying that financial planning is like poker. You never have all the information about what may happen in the future. The goal is to make the best decisions you can, based on available information, and be prepared to change gears as life unfolds. My savings priority ladder is a great starting point, but it is best to understand why you should save in this order, so you can adapt to your situation.
Savings Priority Ladder
1) Emergency Fund – This comes first. Cash is king for solving all the problems life throws at you. You never want to find yourself making bad financial decisions because you have no other options. Therefore, you need some safe money that you can get your hands on quickly. Your emergency fund should have 3-6 months of living expenses. If that seems like a lot, begin with at least 1-2 months before starting on other saving goals; then continue to add to your emergency fund until it is fully funded. I usually recommend keeping an emergency fund in an online savings account, despite the relatively low rates compared to riskier or less liquid alternatives.
2) 401k Plan (up to employer match) – The 401k is the first place to save for retirement. However, as the second step in my savings priority ladder, you should save up to the company match. If your employer matches the first 6% in contributions, you contribute at least 6%. The company match is free money. OMG! Don’t walk away from free money.
3) Debt – Pay off high interest rate debt first (e.g., credit cards). Paying off debt is like getting a guaranteed return equal to the interest rate you were paying on the loan. Just imagine how motivated you would be to invest in something that guaranteed you a 15% return.. Paying off a credit card balance charging you 15% is the same thing. In general, I am very anti-debt. My philosophy is: Only borrow money for things that appreciate (e.g., a home).
4) Short-Term Savings Goals – These may include money saved to buy a car, a down payment on a house, home improvement projects, or a college savings plan for your kids. I think this is a good time to remind you that picking the wrong investment for your time horizon is the most common investor mistake. Do not put short-term money (upcoming car purchase) in the stock market or in real estate.
5) 401k (after the employer match) or ROTH IRA – Fund your 401k up to the maximum, which is $18,500 if you’re under 50 or $24,500 if over 50 (as of 2018). You may not be getting matching dollars from your employer on these additional contributions, but you’re still getting a tax-deduction and tax-deferred growth. Alternatively, if you are in a low tax bracket, you may prefer to fund a ROTH IRA. (Learn about ROTH IRAs in this post: ROTH IRA vs. Traditional IRA: Which Is Better?)
Wait. You may be asking: Can I contribute to an IRA if I am also contributing to my company 401k? That depends on your income. See the income limitations, HERE.
6) After-Tax Savings and Investments – These accounts are typically titled as: Individual, Joint Tenant, or Trust accounts. It is nice to have some money in this category because you can access it prior to age 59½ without penalty.
There’s More to Life Than Savings Goals:
Final thought: With all this focus on how to save, save, save…remember to treat yourself occasionally. Money is for making memories and having fun (now and in the future). Vacations, concerts, sporting events, and generosity are all important to living a fulfilling life.
As my friend Ed Jacobson, says, “Everything in moderation…including moderation!”
Have a great week.
P.S. Remember that my “Savings Ladder” is just a guideline. If you have questions about a specific situation, email me: email@example.com.