Ideal Order Of Investing For High Income Earners
From a young age, we're taught to follow a specific life path:
- excel in school
- land a great job
- climb the corporate ladder
But what comes next?
What should you do with the money you've earned?
It seems that after achieving career milestones, the guidance on financial matters disappears.
When payday rolls around, you're swarmed with conflicting advice on how to allocate your hard-earned money.
- Should you pay off debt first?
- Or focus on savings?
- Or maybe dive straight into investing?
It's natural to be scared of making the wrong choices, especially if you earn a high income.
So, what's the optimal approach to go about it?
Now before we start, this is Ivan here from the Vanilla Investor, a former investment analyst and with over $100k invested in the markets.
My goal is to bring you simple finance at your fingertips.
Today, we will talk about what I think is the best order for high income earners to allocate their paychecks.
We will be starting off with 1: having a safety net, followed by:
2: Employer match
3: Employee stock purchase plan
4: High-interest debt
5: 401k
6: HSA
7: Backdoor Roth
8: 529 plan
9: Taxable brokerage
10: Real estate
11: Low-interest debt
So hopefully by the end of this, you will have learned something new so that you can apply it in your own paycheck routine.
So without further ado, let’s get started.
#1: Safety Net / Emergency Fund
As a high-income earner, the top priority for investing your money is having cash readily available, often referred to as an emergency fund or safety net.
Regardless of what you call it, I strongly believe that maintaining a significant amount of liquid cash is crucial.
Unexpected events happen all the time—your child gets injured during a weekend soccer game, your car needs a new tire after hitting a curb, or your laptop suddenly breaks down.
Having enough cash on hand turns these incidents from major disruptions into minor inconveniences.
Personally, I prioritize liquidity above all else.
I want to be able to access my funds easily and quickly without any hassle.
While high-interest CDs might seem appealing, they often come with penalties for early withdrawals, so a great alternative for me is a high-yield savings account.
This gives me decent interest, and they also have no penalty fees for the first 6 withdrawals in any given month.
The amount of cash you should hold depends on your risk tolerance and recurring expenses.
Personally, I aim to have enough to cover up to 6 months of expenses, but some may opt for more like 12 months or less like 3 months if they have a stable career and higher risk tolerance.
The key is to build up a healthy cash reserve before considering investing your money elsewhere.
#2: Employer Match
The second priority for investing your money as a high-income earner is to contribute to your 401k up to the employer match.
The employer match is like getting free money.
Here's how it works:
Let's say you earn an annual salary of $100,000, and your company matches your 401k contributions up to 4%.
This means that if you contribute $4,000 into your 401k, your company will match you dollar for dollar, adding another $4,000 into your 401k.
Essentially, your $4,000 contribution instantly doubles to $8,000 without you having to do anything—it's a 100% return right away.
Additionally, contributing to your 401k up to the employer match allows you to lower your taxable income by $4,000, reducing the taxes you owe to the government.
Taking advantage of the 401k employer match is a no-brainer.
If you're not already contributing to your 401k up to the match, pause whatever you are doing, and take action now before moving on to the next point.
#3: Employee Stock Purchase Plan (ESPP)
The third priority for investing your money as a high-income earner is to participate in your company's Employee Stock Purchase Plan, also known as ESPP.
An ESPP is a program run by the company where employees can buy company stock directly at a discounted price, typically around 15%.
Employees contribute to the plan through payroll deductions, which accumulate between the offering date and the purchase date.
On the purchase date, the company uses the accumulated funds to buy stock on behalf of participating employees.
Similar to the 401k match, a 15% discount is essentially like getting free money.
Imagine getting an automatic 15% discount on anything—where else can you find such a deal?
If there's no restriction on when you can sell your ESPP stock, then there's minimal risk.
By selling your shares immediately, you essentially pocket the 15% discount.
A good strategy with ESPP is to sell your company stocks, which you bought at a 15% discount, and immediately reinvest the proceeds into a broad market index fund.
This strategy offers several benefits:
- firstly, you take advantage of the 15% discount;
- secondly, you remain invested in the market rather than spending the extra money elsewhere;
- and thirdly, your investment isn't tied to the performance of a single company.
It's important to note that not all companies offer ESPP, so if your company does, be sure to take advantage of this opportunity.
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#4: High-Interest Debt (above 5%)
The fourth priority for investing your money as a high-income earner is to focus on paying down high-interest debt, such as auto loans, student loans, and credit card debt.
Carrying high-interest debt from one month to the next doesn't benefit you—it only makes someone else richer, not you.
Therefore, before considering other investments, it's advisable to tackle these debts as fast as possible.
I prefer a straightforward approach to debt repayment: list out all your debts and start tackling them one by one.
You can choose between the debt snowball method or the debt avalanche method—both are effective, so it ultimately comes down to personal preference.
The key is to prioritize paying off high-interest debts to alleviate financial burdens and move closer to financial freedom.
#5: 401K
The fifth priority for investing your money as a high-income earner is to maximize your contributions to your 401k retirement account.
If you're in a higher income bracket, putting money into a tax-deferred retirement plan like the 401k during your peak earning years offers significant tax benefits.
You receive an upfront tax deduction,
You enjoy tax-protected growth on the duration of your investment,
You often benefit from a tax rate arbitrage between when you contribute and when you plan to withdraw.
This tax deduction is one of the most substantial you can qualify for, surpassing many other deductions like those for charitable donations or mortgage interest.
The contribution limit for 2024 is $23,000 for individuals under 50 years old, while those aged 50 and older can contribute up to $30,500, including a $7,500 catch-up contribution.
#6: Health Savings Account (HSA)
The sixth priority for investing your money as a high-income earner is to maximize your contributions to your HSA, or health savings account.
If you and your family are generally healthy, it's worth considering opting for a high-deductible healthcare plan, also known as an HDHP, for your health insurance coverage.
With an HDHP, you'll have a higher deductible compared to traditional insurance plans, but you'll also benefit from lower premiums.
Additionally, you'll have the opportunity to open a health savings account, or HSA.
In the realm of financial independence, many people view the HSA as a secret weapon for early retirement.
Here's why: While HSAs are commonly seen as tax-advantaged accounts where you can save for medical expenses, they offer a triple tax benefit that's often overlooked.
First, your contributions to an HSA are tax deductible, providing a tax benefit upfront.
Second, the funds in your HSA can grow tax-free over time.
Finally, if you use the money for qualified medical expenses, your withdrawals are also tax-free.
This triple tax benefit makes HSAs extremely valuable for reducing taxes and increasing your overall net worth.
One of the key advantages of HSAs is that there's no time limit for using the money inside.
This means you can save your medical receipts from years ago and withdraw money from your HSA tax-free whenever you need it, whether it's today or years down the line.
For 2024, the contribution limit is $4,150 for self-only coverage and $8,300 for family plans.
#7: Backdoor Roth IRA
The seventh priority for investing your money as a high-income earner is to take advantage of the backdoor Roth IRA.
Roth IRAs offer significant benefits: you pay taxes on your contributions upfront, but your investment growth and withdrawals are tax-free.
However, if your income is high, you may not be eligible to contribute directly to a Roth IRA.
For instance, in 2024, if your combined income with your spouse exceeds $230,000, you're disqualified from making direct Roth IRA contributions.
But don't worry, there's still a workaround known as the backdoor Roth strategy.
Here's how it works:
First, you make a non-deductible contribution to a traditional IRA, up to the maximum allowable amount for 2024, which is $7,000 if you're under 50 and $8,000 if you're 50 or older.
Next, you convert your traditional IRA into a Roth IRA.
This conversion is typically a taxable event, meaning you'll owe ordinary income tax on the amount you convert.
However, all the earnings and growth in the Roth IRA after the conversion will be tax-free, provided the funds remain in the account for at least five years.
#8: 529 Education Savings Plan
The eighth priority for investing your money as a high-income earner is to consider a 529 education savings plan.
If you have children, nieces, or nephews whom you'd like to support with their education expenses, a 529 plan functions similarly to a Roth IRA but is specifically designed for educational costs.
Contributions to a 529 plan are made after taxes, but the growth on those contributions is not subject to federal tax, and often not to state tax either, when used for qualified educational expenses.
Unlike some other investment accounts, 529 plans don't have annual contribution limits.
However, it's important to note that contributions to a 529 plan are considered completed gifts for federal tax purposes.
In 2024, up to $18,000 per donor per beneficiary qualifies for the annual gift tax exclusion.
#9: Taxable Brokerage Account
The ninth priority for investing your money as a high-income earner is a taxable brokerage account.
Once you've maximized all your tax-advantaged options that we've covered so far, you can begin investing additional funds into a regular taxable investment account.
Of course, all investments should be made with a simple broad market index fund.
My personal favorite is the Vanguard 500 Index Fund, also known as VFIAX.
Or you can buy the ETF version of this: Vanguard S&P 500 ETF, also known as VOO.
I've seen many people who are just getting started with the stock market and are eager to dive in.
However, one of the most common mistakes they make is opening taxable brokerage accounts before maximizing their tax-advantaged accounts.
In my opinion, this should be the last priority because you don't receive any tax advantages with a taxable account.
The tax consequences of using a taxable account instead of a tax-advantaged account, such as a 401k, can be significant, especially when compounded over decades.
Tax advantages, like tax deductions, allow more of your money to start working for you sooner in the market, leading to greater growth in the long run.
Why pay more in taxes than necessary?
However, once you've maximized all your tax-advantaged accounts that we've discussed so far, your taxable account can play an important role in bridging the gap between regular retirement and early retirement.
Just be careful not to rush into funding it before prioritizing the other accounts we've discussed earlier.
#10: Real Estate / Real Estate Investment Trust (REIT)
The tenth priority to invest your money as a high-income earner is in real estate.
In the book “Taking Stock”, Dr. Jordan Grumet talks about the importance of adding more legs to our financial plan, similar to a dining room table.
In this analogy, each leg represents a source of income or an investment.
Relying solely on one source of income, such as a W-2 job or your day job, is akin to standing on one leg like a flamingo.
The risk here is that a single blow could easily topple over your financial stability.
Adding more legs to your financial plan, such as investing in your 401k, Roth IRA, and brokerage investment accounts alongside your W-2 job, is a step in the right direction.
However, to make it even sturdier, consider adding real estate to the mix.
There are a few ways to approach real estate investment.
You can buy and own individual rental properties, renting them out for additional cash flow.
This not only brings in extra income but also diversifies your money within a different asset class.
Or if you prefer not to deal with the hands-on work of owning rental properties, you can invest in Real Estate Investment Trusts (REITs).
A REIT is a company that owns, operates, and finances income-generating real estate.
They function similarly to mutual funds, allowing investors to tap into real estate investments without the hassle of managing properties themselves.
For a specific fund recommendation, consider the Vanguard Real Estate Index Fund (VGSLX) or its ETF version, Vanguard Real Estate ETF (VNQ).
Regardless of your approach—whether it's direct real estate investing or investing in REITs—adding diversity to your investment portfolio will enhance the stability of your financial plan, much like adding more legs to a dining room table.
#11: Low-Interest Debt (3% ~ 5%)
The eleventh priority to invest your money as a high-income earner is in paying down low-interest debt.
This could include a home mortgage or any other debt with an interest rate of less than 3% to 5%.
While some may argue that it's not the most financially optimal move, suggesting that investing the money in the stock market could yield greater returns, it's important to consider what's best for you.
Ultimately, there's no one-size-fits-all answer when it comes to financial decisions.
If being debt-free brings you peace of mind, then don't let others stop you.
Paying off all your low-interest debt can pave the way for a debt-free life, which may align better with your personal financial goals and values.
If you liked this article, then a good continuation from here will be this article on how you can manage your money like the top 1%.
Thank you for reading, cheers!
- Ivan