Optimal Order To Investing For Maximum Returns
What order should you invest your money in?
Should you max out your 401k first?
Or should you wait until after you paid off your student debt?
That is what we will talk about in this article with ten things ranking from most urgent to least urgent!
Number #1
The first thing on our list is establishing an emergency fund.
Before you start investing, it is crucial to prioritize building a reasonable cash reserve.
This fund should be stored in a basic checking or savings account.
The specific amount you require varies for each individual and depends largely on personal risk tolerance.
However, I recommend aiming for at least three to six months' worth of expenses.
While it may not be the most exciting way to allocate your money, there is a valid reason for creating an emergency fund.
Think of it as bowling guardrails that prevent your bowling ball from landing in the gutters. These guardrails keep you in the game, even if you make a faulty throw or the ball starts spinning in the wrong direction.
Similarly, an emergency fund acts as a buffer for the unexpected events life throws at us.
According to a Bankrate survey, only 39% of respondents said they would be able to cover an unexpected $1,000 expense using their savings.
In such situations, many people resort to credit cards, which often leads to deeper financial struggles.
Throughout our journey towards paying off debt, investing, or achieving financial independence, unforeseen challenges will arise.
However, having a sufficient amount of cash in our emergency fund ensures that we don't lose momentum and helps us stay on track toward our financial goals.
Number #2
The second thing on this list is taking advantage of a 401k employer match.
If your employer offers matching contributions to your 401k, this should be your primary focus before considering other investment options.
It is crucial to maximize the benefits of your employer's matching contributions.
Why is it so important?
Well, a 401k match provides an immediate and guaranteed 100% return on your investment.
Let's illustrate this with an example: Imagine your employer matches 100% of your contributions up to 4% of your income.
If you earn $100,000 per year and contribute $4,000 to your 401k, your employer will match that with an additional $4,000.
Essentially, you are instantly earning a 100% return on your investment. There are very few investments in the world that offer such risk-free returns.
Neither the stock market, rental property, nor even a lucky streak in Las Vegas can compete with this level of guaranteed return.
If you're unsure about your company's 401k employer match policy, I recommend reaching out to your HR department or benefits manager.
Inquire about the employer match and how it works. Make sure you understand the details and then take full advantage of the employer's matching contributions.
A quick note: If you don't plan on staying with your current company for an extended period, it's essential to inquire about the vesting schedule.
The vesting schedule specifies how long you must remain with the company to retain the employer's matching contributions.
The most common vesting period for employees to be fully invested in the company match is around three years.
Consider this when contemplating job changes, as it helps you to be aware of the amount of money you may be leaving on the table by accepting a new position.
Number #3
The third item on our list is to eliminate high-interest debt.
I would consider any debt with an interest rate higher than 5% as high-interest. This typically includes credit card debt and student loans for most people.
Credit card debt, in particular, can be one of the most problematic forms of high-interest debt, as the average credit card carries a 16% interest rate.
If you have been carrying credit card debt from month to month, it's crucial to prioritize tackling this debt as part of your debt reduction plan.
There's no way to eliminate high-interest debt except to face it head-on.
Begin by listing out all your high-interest debts and create a plan for paying them off.
You can choose between different methods like the debt snowball method or the avalanche method, depending on what motivates you best.
Once you start knocking out your high-interest debt, you'll be surprised at how much income you free up to optimize the rest of your financial situation.
By eliminating this burden, you'll have more financial flexibility to allocate towards other goals and investments.
Number #4
Okay, once you have paid down your high-interest debts, the next step on our list is to maximize your contributions to a Roth IRA.
In my personal opinion, the Roth IRA is one of the most tax-efficient accounts available to investors.
Here's how it works:
contributions to a Roth IRA are made with after-tax money, but any growth or earnings on those contributions are tax-free.
There are, of course, certain conditions to meet, such as leaving the money in your Roth IRA account for at least five years and reaching the age of 59 and a half.
The remarkable thing about a Roth IRA is that you will never have to pay taxes on the money in the account, regardless of future changes in the tax landscape.
It's possible that future politicians may decide to raise taxes to fund government projects, but by contributing to a Roth IRA, you reduce the risk of unknown tax implications in the future.
However, there are some eligibility considerations for a Roth IRA. In order to contribute directly to a Roth IRA, you or your spouse must have earned income.
Additionally, there are income limits for making direct Roth IRA contributions.
For example, in 2023, if you're married filing jointly and your combined income exceeds $228,000, you are ineligible to make direct Roth IRA contributions.
But if your income is too high to contribute directly, you can consider utilizing the backdoor Roth IRA strategy.
In 2023, the contribution limit for individuals under the age of 50 is $6,500, while for individuals age 50 or older, the contribution limit is $7,500.
Number #5
Okay, the fifth item on our list is taking advantage of a Health Savings Account (HSA).
Now, this option may not be suitable for everyone because eligibility for an HSA requires being covered under a qualified High Deductible Health Plan (HDHP).
However, if you do meet the eligibility criteria, an HSA can be a great way to save money for future healthcare expenses.
HSAs offer what is known as a Triple Tax Benefit.
Firstly, your contributions to an HSA are tax-deductible, meaning you can reduce your taxable income.
Secondly, the money in your HSA grows tax-deferred, allowing it to accumulate earnings without being subject to taxes.
And thirdly, you can withdraw funds from your HSA tax-free as long as the money is used to pay for qualified medical expenses.
Next, the contribution limits for an HSA in 2023 depend on whether you have a qualified High Deductible Health Plan for yourself or for your family.
If you have an individual plan, you can contribute up to $3,850.
However, if you have a family health insurance plan, the contribution limit increases to $7,750.
Additionally, if you are 55 years or older, you can make an additional catch-up contribution of $1,000.
Number #6
Alright, number six on our list is the 529 education savings plan.
If you have children and you're looking to save money for their future college expenses, a 529 plan can provide a tax-efficient solution.
Think of it as similar to a Roth IRA, but specifically designed for educational expenses.
Contributions to a 529 plan are made with after-tax dollars, meaning you don't receive a tax deduction for the contributions.
However, the growth within the plan is not subjected to federal tax, and in many cases, it's also exempt from state taxes when used for qualified education expenses.
Unlike some other savings plans, 529 plans do not have annual contribution limits, allowing you to save as much as you want.
It's important to note that contributions to a 529 plan are considered completed gifts for federal tax purposes.
In 2023, up to $17,000 per donor per beneficiary qualifies for the annual gift tax exclusion. This means that you can contribute up to $17,000 per year without triggering any gift tax implications.
Personally, I believe in not completely relying on the 529 plan to cover my children's college tuition.
Instead, I prefer to invest a moderate amount in the plan.
Besides, there are numerous creative ways to effectively fund college education, such as scholarships, grants, employer-sponsored programs, or even military service.
Number #7
Alright, the seventh item brings us back to the 401k, but this time our focus is on maximizing our contributions beyond just the employer match we talked about in point number two.
This strategy is highly effective in reducing your taxable income and allowing you to invest more in the market.
Personally, by maxing out my 401k, I have been able to save thousands of dollars per year on my taxes.
In 2023, the contribution limit for individuals under the age of 50 is $22,500, while those who are 50 years or older have a higher contribution limit of $30,000.
Number #8
Moving on to number eight on our list, we have the taxable account.
Once you have maximized all your tax-advantaged investment options, you can consider investing additional funds into a regular taxable investment account.
I often come across people who are eager to enter the market and open taxable brokerage accounts before fully utilizing their tax-advantaged accounts.
However, it's important to prioritize tax-advantaged options and keep taxable accounts as the last resort.
The main drawback of taxable accounts is that they do not offer any tax advantages.
The tax implications of using taxable accounts instead of tax-advantaged accounts, such as a 401k, can be substantial, especially when compounded over many years.
Tax advantages, such as deductions, allow a greater portion of your money to work for you sooner in the market, resulting in potentially higher long-term growth.
It doesn't make sense to pay more taxes than necessary, right?
Number #9
At number nine on our list, this is where we address debt with lower interest rates.
Specifically, this refers to debts, such as low-rate student loans and most car loans, that carry an interest rate below five percent.
It's important to note that this does not include most mortgages.
Although this type of debt may not have a significant negative impact on your financial situation, I still recommend eliminating it if you have the means to do so.
Debt is a fascinating concept, with some considering it a pathway to achieving the American dream, while others view it as a destructive force to be avoided at all costs.
Personally, I believe we should always remain cautious about debt, as it has a tendency to distort our perception of money.
When we start accepting debt as a normal part of life, it can quickly lead to a dangerous mindset of rationalization.
We may begin using low-interest debt to finance an extravagant lifestyle, buying unnecessary cars or pursuing degrees with student loans.
If possible, it is advisable to reduce as much debt from our lives as we can.
This not only takes care of our financial well-being but also contributes to our mental and emotional well-being.
Number #10
Now, number ten on the list is actually optional, it is still a valid way to allocate your money though, which is paying off your mortgage.
If you recently purchased a home during the low interest rate period, you would still have several years, possibly a decade or more, before your loan reaches maturity.
Considering the 15 to 30-year timeframe of most mortgages, it is highly likely that the stock market will outperform the interest rate on your mortgage, which typically ranges from two to four percent.
Therefore, it may be more sensible to invest any extra funds you have into index funds rather than paying off your mortgage.
However, if you are nearing the end of your mortgage and you would like to be entirely debt-free, paying it off is a fantastic option.
After all, some of us really like that peace of mind from being free of debt.
So that’s it.
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Thanks for reading!
- Ivan