When people start their journey to Financial Independence they manage to get a little money saved and often do not know what to do with it. Many people don’t know where to put the money they have saved and just leave their money in a checking or savings account earning little to no return. The journey to Financial Independence (FI) is not quick or easy but with the right strategy, it can be quicker and easier than most people think. This article assumes that you are at the point that you have extra money to save every month and are wondering where to put it. Here is what I believe is the best accounts to put the money you have saved and in what order you should fill those accounts.
Ok, let us start. You managed to save a little bit of money. What do you do? I will go into more detail but here is a simple list of where your saved money should go. None of the items on this list requires much effort or financial knowledge except the last item.
- One month’s savings in a checking or savings account for emergencies
- Pay off any high interest (above 10%) debt
- 401k up to employer match – if available
- Pay off any medium interest debt (above 5%)
- Five more month’s savings in I-Bonds
- Increase 401k to legal maximum/short term goals
- ROTH IRA
- HSA if available
- Investment Brokerage Account
Let us go into the details of each account and why you should put your money into the account.
The first step and most important thing to have on your journey to FI is an emergency fund. Studies have found that most Americans cannot afford to pay for a sudden $400 emergency. If you are one of those people, stop reading this article and focus on learning how to either make more money or spending less. However, let us assume that you are at least minimally financially stable and make enough money to be able to save some each month.
The first thing you need to do is to put the equivalent of one month’s after tax earnings into a savings account at your local bank. This is your minimum basic emergency money in case of unexpected expenses such as a car problem or loss of employment. Emergencies are by definition, sudden and unexpected so you need some money you can access quickly. You want to be able to go to your bank or ATM and access that money right away if needed. A few hundred dollars in cash hidden in your house could also be useful. Once you have at least a month’s pay in an emergency fund you will be able to weather the most common small emergency expenses without having to resort to things like payday loans, which just dig you deeper into debt. You will also be able to sleep better at night knowing that you will be able to handle minor emergencies without too much trouble.
High Interest Debt
After you get your emergency fund established it is now time to start getting out of debt. 7 in 10 Americans carry debt excluding their mortgage. Use the stream of money you used to fill up the emergency fund and redirect it to any high interest debt you may have. For example, let us say you had $300 a month going towards filling up your emergency fund and was making minimum payments on your credit cards. Once you have one month saved up you should direct that $300 a month towards paying off your credit cards or other high interest debt. There will be many differences of opinion on what is “high interest” but for our purposes let us consider anything above 10% interest as high interest. This category includes most credit card debt.
I recommend the Debt Avalanche method of paying off your debts where you work on paying off the debts with the highest interest rate and work your way down. There are many other methods such as the Snowball method where you pay off and close the account with the smallest balance and work your way up to the debt with the largest balance. However, in my opinion the Debt Avalanche would be the fastest and most efficient method.
Like a real avalanche or snowball, things will start slowly. It may feel like it is taking forever to pay off your loans. However, once you pay off the first debt and you can redirect the money you were paying that debt to other debts things will go faster and faster. As time passes and you are able to put the money you were paying in interest to paying off even more debt, you may be surprised how fast you can do it.
401K up to employer match
Once you get rid of the ball and chain of high interest debt we can really get going. Start contributing to your workplace 401k plan or equivalent up to the employer match. That employer match is basically a free pay raise and all you have to do is go get it. All decent 401k plans should have a low cost Index fun option. You best bet would be to put the money in your 401k into a large cap S&P500 fund or you can go with a Total Stock Market fund. If your employer does not have a 401K or match then skip to next step.
Contributing to your company’s 401k plan is one of the best things you can do to ensure a secure financial future. Contributing has many less obvious side benefits besides just money in an account.
First, it is the easiest and most painless way to save money. It comes out of your paycheck like taxes before you even see it so you never even miss it. You can think of it as a required tax to pay for your financial security that you cannot reduce or avoid any more than you can your income tax.
Second, it helps avoid standard of living inflation. The higher your standard of living the more money you need to save before you can retire. If you are used to spending $40,000 a year then you can retire with $1 million. However, if you are used to living on $30,000 a year then you only need $750,000.
Third, it reduces your current tax bill so you pay less tax now.
Fourth, it may be possible that you will be able to avoid paying taxes on that money later on as well. This means you may be able to completely avoid paying taxes for the money you earned and put into your 401k. For more information about this read this article: https://orgotravel.com/2022/04/26/how-to-legally-pay-no-taxes-in-retirement/
Pay off any medium interest debt (5% or more)
Most 401k employer matches are usually pretty modest, around 3% so after you contribute to your 401k up to your employer match it is time to turn your attention to your medium interest debt. This is debt with interest rates higher than 5%. At this point, you should focus on paying off all credit card debt. You can use the Avalanche method as you did on the high interest debt. The only exception to this would be a house mortgage. The reason is that a house is an appreciating asset and the house mortgage is tax deductible.
If you have debt that cost less than 5% interest then you should consider keeping it instead of paying it off. Debt that is less than 5% is usually long-term real estate debt. The long-term return of stocks is around 8%. Instead of paying off your long term 5% or under debt, if you invest the money in stocks you will earn at least 3% on that money. 3% provides a minimum cushion of security to account for volatility. So once you pay off all debt above 5% interest move to the next step.
Five more month’s savings in I-Bonds
Congratulations if you have gotten to this step. 43% of Americans have credit card debt that they carry over from month to month. If you have paid off all your credit card debt and all debt over 5% except for your home mortgage you are ready to really secure your current finances.
In order to protect yourself from financial problems such as a loss of job you need to have about six months of pay saved. If you have been following this plan you should already have one month’s pay saved in a savings account. Unfortunately, savings accounts don’t really pay much interest. That is OK for some money but we need to do better for more money.
The solution is I-Bonds. These are risk free, government insured, inflation protected, tax deferred bonds. As of this writing in 2022 they are paying an annualized interest rate of 9.62% compared to a less than 1% savings interest rate. There are a number of limitations to I-Bonds that make them unsuitable as a primary emergency fund including not being allowed to sell the bond in the first year and a three month interest penalty if the bond is sold before five years. However as secondary emergency fund built up over years there is no better option for money you don’t want to lose.
The way to use I-Bonds as an emergency fund is to put money in slowly and after your initial year lockup is done you can consider the freed up money as part of your emergency fund. In case of emergency you use the money in your savings account first and charge the rest to your credit cards. You can then sell the bond and use the money to pay off the credit cards.
You can only buy $10,000 of I-Bonds a year so if you are a higher income earner it may take you several years to build up six month’s savings in I-Bonds. Just keep the money in a regular savings account until you have a chance to move it over to the I-Bond. There are other rules and restrictions to I-Bonds including several ways around the $10,000 purchase limitation so you will want to research them more and make sure you fully understand how they work.
Increase 401k to legal maximum/short term goals
Now that we have a secure financial base of low or no debt and six months of emergency funds. It is finally time to get ahead and secure your retirement. We turn our attention back to your company 401k. You are going to want to contribute the full legal maximum for the same reasons as above. You may alternatively divert some of the money to a savings account to save for a big purchase such as a car or down payment for a house.
You do not have to maximize your 401K contribution right away, especially if you have other goals such as saving to buy a house. You can start at the employer match amount and increase your contribution percentage by half of your pay raises. For example if you get a 4% pay raise, you increase your 401k contribution from 3% to 5%. This way you get a little extra money in your paycheck and you save a little bit more painlessly. Since half that raise goes automatically into your 401k you never even see or miss it.
If you can get to this step and are able to max out your 401k and keep doing this 20 or 30 years, you will have already secured your retirement at normal retirement age. Just keep working and adding to your 401k, roll it over to an IRA every time you change jobs. Keep it invested in a low cost S&P 500 fund and a few decades later you will be set to retire, barring extreme bad luck.
Once you have maxed out your 401K each year then you should look at maxing out your ROTH IRA next. Although it does not reduce your current taxes it has many useful features in retirement such as tax free withdrawals and no Required Minimum Distributions.
HSA if available
If your company offers a Health Savings Account then that is the next place you will direct any extra income you have after the above options. If you have enough money in a HSA, you will be able to invest that money in the HSA and have it grow tax-free. While not a traditional vehicle to save for retirement it can function as a tax advantaged account because everyone is going to have medical expenses eventually. As you get older, you will most likely incur more health related expenses.
Investment Brokerage Account
If you have completed the above steps, you will almost certainly have a wonderful and secure retirement. However, we can kick it up a notch and retire early. This last step is where we achieve this.
If you have built up six months savings, paid off all your high and medium interest debt, maxed out your 401k, Roth and put some money in your HSA we are ready to take your finances to the next level.
Extra monthly income after you fill the above buckets should now go to a brokerage account. You can open one at any brokerage such as Fidelity, Vanguard or Charles Schwab. Unfortunately, now is where things get complicated. There are many, many options to invest your money to make it grow. You can invest in traditional asset such as stocks, bonds or real estate. You can invest your money in a practically unlimited number of ways. Entire libraries are filled with books about the many ways you can invest your money so it is way beyond the scope of this short article to be able to tell you what investment options are best for you.
However, you will need to do something in order to advance from a regular retirement to an early retirement and the first step is to save money in a brokerage account. How you choose to invest from there is entirely up to you. Perhaps the easiest way is to follow Warren Buffet’s advice and just put it all in a low cost S&P 500 fund. In the end though, you will need to find what is best for you and your particular situation and personality.
I hope you enjoyed this article and if you have any comments please post them!