“As new funds come in to my bank account, in what order should I prioritize them to my different monetary needs?”
This is a question I get asked fairly frequently, and indeed, it makes sense to pose the question because it is not totally straight-forward and involves much complexity.
However, the following two priority orders are what I have learned in reading several financial related books and from studying finance in college. In my experience, I’ve found that two orders are needed – one for people that are either debt-free or mostly debt-free and another separate one for people are heavily in debt.
Debt-Free Account Hierarchy
Hierarchy of what order to contribute money to which accounts if you do not have significant amounts of consumer debt (can be paid off within 2-5 years – does not include mortgage debt).
1. Buy or make sure you have adequate health insurance coverage.
This is absolutely the most important and highest ranking thing on the list due to the fact that you will have no income if you get hurt and can’t work. Additionally, medical procedures can cost hundred’s of thousands of Dollars these days. Can you afford that with the cash out of your savings account? I sure can’t.
Most of the time, this coverage will be provided through your employers plan to defray some of the cost. Independent plans are available at a higher monthly premium cost, but is still worth having in the long run.
2. Invest enough cash in a high yield taxable money market savings account to cover 6-9 months of living expenses
The purpose of this account is to have enough a safety cushion to cover your expenses in the event that you lose your job or cannot work due to an injury for an extended period. While it is possible to obtain a personal loan to obtain some extra liquidity, it is best to make sure that you have some reserves of your own.
You can open up a high yield savings account online at Dollarsavingsdirect that I discuss in this previous post with the link below. Whatever account you choose in the end will need to be taxable so you have easy access to it, and can withdraw money at any time without penalty.
3. Pay off/get rid of your high-interest credit card debt
After you have ensured that you will not be in “financial ruin” if you lose your job or get injured and have to pay for medical expenses, the next highest priority of where to put your money will be to pay off your high interest credit card debt. In essence, this is the best idea to do because you will get a guaranteed 18% return by getting rid of your debt. No one else can promise you that high of a return/money savings!
4. Pay your monthly mortgage payment (only the minimum amount required)
After you have secured health insurance, a sufficient emergency fund, and paid off the majority of high interest credit card debt, you can then think about buying a house/condo/townhouse. If you have not done steps 1-3, I would not recommend buying property.
Since you receive significant tax savings from the interest your pay on your home loan and the property tax paid on your property, you should pay off your required monthly or biweekly mortgage payments. However, you should not pay off any additional principal loan balance at this time, as there are no tax benefits to doing so.
5. Invest in your employer’s 401k only up to the company match level
In general, the investment selections for mutual funds in company 401k programs are not the best. Usually, the management fee levels and management style are not as good as with the indexed mutual funds that Vanguard offers.
For this reason, it is best I believe to invest only enough initially in your 401k to the level which your employer matches. For example, my company matches 75 cents per dollar for what I contribute up to 6% of my annual income. So, I make sure to invest a base level of 6% in my 401k so I can get this free money!
6. Max our your IRA (individual retirement account – either Roth IRA or Traditional IRA)
The next place to contribute your money to is to max out your individual retirement account (I use Vanguard for my Roth IRA). The current contribution amounts for 2009 and 2010 are $5000 per year, and you can still contribute to your 2009 levels until March 31 of 2010. The only thing you have to make sure of is that you can only contribute money in your IRA up to the level of income you make in a year, with $5000 being the maximum. For example, when I was 18 years old and wanted to contribute to my IRA, I could only contribute $2500 because that was the level of income I had that year.
Once the money is parked in your self-directed IRA, you can invest as you want to (see link below for index mutual fund recommendations that I invest in)
My Current Investment Selections and Asset Allocation
7. Finish fully funding your company 401k account
This is the next highest priority account to place your money after maxing out your IRA because you will be able to take advantage of tax-free growth/protection until retirement when you withdraw funds.
With most employers, there is a limit of how much you can contribute to your your 401k. Usually, this level is 25% of your base salary, up to $15-16K per year.
8. Prepay additional amounts to reduce the principal on your home mortage loan
Assuming that you did your homework and obtained a loan that doesn’t involve penalties for pre-paying a home loan (paying off more of the loan than is required by the mortgage amortization schedule), you should now focus committing funds to paying off additional principal of the loan. This will benefit you greatly, as it will reduce the amount of interest you pay going forward.
9. Open up an individual, taxable mutual fund account with Vanguard.com to invest any remaining money
This one is pretty much self-explanatory! Once you have pretty much exhausted all of your tax-sheltered account options and still have money to invest, open up an individual account and invest in tax-efficient mutual funds.
Since this account is not tax-sheltered, be careful about the tax-liability of short-term selling of shares. In the book, Random Walk Down Wall Street by Burton Malkiel, he has a good section summarizing what type of index mutual funds to invest in with taxable accounts.
He suggests using something called Tax-Managed Funds. Essentially, what these funds are are index funds that minimize taxes by deferring capital gains realization. However, the main pitfall I ran in to with these funds is that they require $10,000 of principal to buy into, an amount of money that I do not keep handy. Instead, I do the next best thing which is to invest in large cap domestic index funds in my taxable accounts, since these generally experience less buying/selling than small cap funds.
10. Open up a tax deferred higher education savings account for your children and fund it
As I mentioned in my post at the link below, the government has set up a special type of account that can give you tax deferred growth that you can use to save money for your child’s college education. Take advantage of this with whatever money you have leftover!
However, be sure to place the account in your name (but in support of your child) so that they still qualify for financial aid.
So, I’ve found that the priority order listed above works great for people with low amounts of debt. However, if you have LARGE amounts of car, student, and credit card debt that you will have to pay off for MANY years to come, this order won’t work.
For complete details about exactly why it won’t work, visit the following post – Account Hierarchy Paradox – Should Paying Off Debt, Saving for Retirement, Having an Emergency Fund, or Securing Health Insurance Be Your Highest Priority?. Because of this, I’ve recently created a second account hierarchy for people with large amounts of debt (see below).
Debt-Payoff-And-Retire Account Hierarchy
Hierarchy of what order to contribute money to which accounts if you DO have significant amounts of consumer debt (that CANNOT be paid off within 2-5 years – does not include mortgage debt).
Note: Before we get started with this list, for the sake of simplicity, I’m going to make the assumption that it is known that prior to embarking on prioritizing funds according to the list below, that you have already met your very basic requirements for survival each month.
These include paying the rent or minimum required mortgage payment, water/electricity/sewer/gas/trash bills (other bills also), and buying food from the grocery store for your family. However, these basic survival needs do not include cable TV, internet, going out to eat every night of the week, or other frivolous spending. With this in mind, let’s get on with the list!
Part A – The Minimum Requirements
1. Pay only the minimum required payment on your credit card and other loans (student, car, etc). DO NOT PAY MORE (yet)!
In the Debt Free Account Hierarchy, you probably noticed that debt payments weren’t addressed until Priority #3. However, if money is very tight and you have large amounts of debt to payoff, the reality of the situation is that you cannot skip out on paying back the minimum required balance on your debts. Well, I suppose you could, but no up-standing citizen wants to have debt collectors calling them up, right?!
Because of this, paying only the minimum required balance on your debt accounts is first on the list. Prioritizing the minimum loan payments ahead of health insurance (see below) was one of the paradoxes I ran in to with this exercise. I wanted to place it first, but ultimately decided against it in the end.
In addition, I would advise you to negotiate a lower APR rate with your credit card company and also discuss your “low-money” situation with your student loan provider (student loans like to see ex-students succeed and may be lenient in pushing back the terms of loan repayment).
2. Buy or make sure you have adequate health insurance coverage.
The next highest priority on the hierarchy is getting adequate health insurance. I cannot stress enough how important health insurance is. If you get in a car wreck or get injured otherwise, medical bills can rack up to be in the $100,000 range or higher, something that could result in financial ruin for the rest of your life. Because of this, you simply cannot afford to go without health insurance.
The trouble? Health insurance is VERY expensive if it is not provided through your employer, especially if you have multiple part time jobs as a lot of people do these days. Typically, if you have to pay for your own health insurance, you should expect to pay between $150-$400 per month. When you are shopping for health insurance, make sure that you find a policy that features a low enough deductible that you can actually pay it with your emergency fund money (see below for details). I personally like to see my deductible be between $500-$750.
Also, remember – with the new health care regulations, you can still be covered under your parents’ health insurance until you are age 26. This may be a viable option for some of the younger people out there.
3. Invest enough cash in a high-yield taxable money market savings account to cover 6-9 months of living expenses (Emergency Fund)
After first paying the minimum payments on your loans so that you don’t have debt collectors knocking down your door and securing health insurance, it is now time to focus as much money you have remaining on accumulating a secure, liquid, readily-available source of cash that you can tap in to in the event of an emergency. Often, this fund is used to pay the deductible on your health insurance (or other forms of insurance) mentioned above. It is very important to state also that the purpose of this account is NOT TO MAKE TONS OF MONEY. It is to provide you with peace of mind and security.
In today’s low-interest landscape, it’s important to be very selective in choosing where to park your emergency fund. I prefer to use a high-yield online savings money market account. These accounts offer much higher interest rates/returns than savings accounts at brick-and-mortar banks and are still FDIC insured! A no-lose situation if you ask me!
So, this all sounds well-and-good. However, you might be asking yourself the following question at this point. – “But Jacob, funds are really tight for me right now. If I’m doing this math correctly, at the current $1000 monthly expenses level at which I am operating, this would sum to $6000-$9000 total. I currently have $0 saved up. This might take me 9 years to accumulate! How do I proceed?”
This is actually a great question! It’s quite tempting to recommend that people only really need a minimum level of an emergency fund (maybe only $500), and after they accumulate this amount, they can move on to higher-earning investments and credit card debt payoff. This is even more tempting given the plethora of options available to people for personal loans in the event of an emergency. For example, you can compare loans online and very quickly narrow down your choices to a loan with suitable terms.
However, at the end of the day (and although there might be some disagreement on this), I believe that the peace of mind and safety that comes from having a sufficient emergency funds outweighs the benefits of being “debt free.” So, my answer to this would be that if it does take you 9 years to accumulate an emergency fund, then so be it. Your debt balances may accumulate significantly, but at least you won’t experience financial ruin if an emergency occurs and you cannot work.
Part B: Beyond the Minimum Requirements
Having fulfilled the absolutely essential requirements listed in Priorities 1-3 above, you can now shift your focus to actually becoming debt free and saving for retirement.
Enter our next paradox: traditional financial wisdom states that if you had to choose between investing in mutual funds for retirement (which at best can earn you 10-11%) and paying off credit card debt balances which carry a 20% or higher interest rate, the clear choice would be to pay off the credit card interest rate first because it represents an AUTOMATIC and GUARANTEED savings.
Indeed, this is the wisdom that applies for myself and many others who are lucky enough to be consumer debt-free. However, if you have large amounts of consumer debt that you cannot possibly pay off in less than 5 years, the choice becomes much harder. On one hand, we need to pay off our credit card debts to capture the automatic savings on the extraordinarily higher interest. However, if you are 24 years old and will be paying off your huge debt balances for 20 years to come, you cannot put off saving for retirement until that time. That would be both very unfulfilling and unwise due to the power of compound interest over long periods of time.
Because of these facts, in the Debt-Payoff-and-Retire Account Hierarchy, I recommend the following hybrid approach:
4. With the money leftover from Priorities 1-3 above, split the balance in to two (2) sub-accounts – one forpaying off debt and one for saving for retirement.
4.1 Use the debt-payoff sub-account to pay off your various debt accounts beyond the minimum balance
In this exercise, funds should be prioritized to pay off your highest interest debt balances (probably credit cards) first and then moving down the chain from there.
4.2 Using the funds in your “saving for retirement” sub-account, invest in your employer’s 401k only up to the company match level
Matching employer contributions represent free money, and we should all take advantage of this! After that, continue working your way through the priorities listed below. This order pretty much remains the same from the original Account Hierarchy.
4.3 Max our your IRA (individual retirement account – either Roth IRA or Traditional IRA).
4.4 Finish fully funding your company 401k account.
4.5 Prepay additional amounts to reduce the principal on your home mortage loan (if you have one).
4.6 Open up an individual, taxable mutual fund account with Vanguard.com to invest any remaining money.
4.7 Open up a tax deferred higher education savings account for your children and fund it.