Yesterday we talked about 2 different ways to create a spending plan. Today we are going to dive into what you do with your savings money from yesterday. Quick Disclaimer: I am not a finance expert and don’t have any licenses. This should not be considered legal or financial advice.
Do you remember PEMDAS from high school math class? Its the order you do a math equation – parenthesis, the E means something, multiplication, division, addition, subtracting. Nailed it. Now that we have your spending plan done, we know your expense money is paying for your living costs and your spending money is yours to live life with. This means we have some savings money to figure out where to put it. Instead of PEMDAS I have created a new one to help you remember the order, its 4DR4M. It’s not quite as catchy but give it time.
4 – The first thing to put your money into is your 401K if your employer does a 401K match. This means that your company will match the money you put into your 401K up to a % of your salary. I tend to be allergic to anything that ties my money up until I am an old man but this is your company literally giving you free money so you shouldn’t pass it up. Try to take the total number for the year they will match and divide it by 12 months. Then put that money into your 401K monthly. If your company doesn’t offer a 401K, then skip this step (and know that the Roth IRA will be your friend).
D – The D is for debt. I initially was going to spend this post talking about good and bad debt and all that but you honestly already know this. I would consider debt for this case as anything outside of your mortgage so your car loan and credit card payments would be the big one for most people. After you max out your 401K match, you should put any money left over towards your debt. The goal is to become debt free so you can free up more money to put into this list. Plus you can take the interest savings and spend them on yourself if you want! There are 2 strategies for paying down debt. The 1st is to take all of your debt and compare the rate they charge you. Then you pay down the highest rate first until it is gone and then move on to the next highest rate. This rate is all about paying off the most “expensive” debt first to be cost efficient. Dave Ramsey has popularized the 2nd strategy called the debt snowball plan where you pay your smallest (in amount owed) debt off first. This allows you to completely erase a debt and feel like you are making progress which makes you excited to tackle the next smallest debt until you are left with only the last large one but have already crushed a handful of debts. The first strategy may save you some money but don’t underestimate the psychological power of the 2nd option.
R – The R is for Roth IRA. A Roth IRA is an account you open (we’ll tell you where to open it tomorrow) and put in your money after it has already been taxed. You can put in up to $6K a year into your account and only if you make under a certain salary range. You then invest in the market and get to take the money out completely tax free after you are 59 (this is a huge benefit and allows you to skip the capital gains tax and income tax when you pay it out). Remember how I said I am allergic to things that tie my money up until I am old man? Well, after your Roth IRA has been open for 5 years, you can take out your contributions (the money you put in) at any time, penalty free. You just can’t touch the gains until you are 59. This clock starts when you open your account (not when you first invest) so if you are on the fence about opening a Roth IRA, I would suggest opening it now even if you don’t use it to start that 5 year timer. One note: you probably should never take the money from your Roth IRA, but you do have the option without penalty after 5 years unlike the 401K.
4 – If you have managed to get your employee match on the 401K, pay off your debt, and max out your Roth, then your next step would be to go back to the 401K and put the max into your 401K. The limit you can invest is 18K, so that should use up the rest of your money, but . . .
M – If you have more money left over you basically have 2 options. The first is to invest in a non-retirement account which is basically an investment account that doesn’t have any tax benefits. The second option is to put money towards your mortgage payment. Now it is important to know that the average return on investing in the market is 8% after inflation and most peoples mortgages are in the 3-5% nowadays. The technically correct answer is probably to invest in the market. However, I would suggest putting the money towards the mortgage payment. If you make it to this point and have money left over, things are clearly going great for you right now. By paying down your mortgage you create 2 great options for yourself. First, if things stay great and you pay off your mortgage then you will have more money left over each month in the future. Second, if things go sideways and you can pay down your mortgage then you have been able to pay down the biggest expense most of us have which will take a ton of pressure off of you during that tough time.
4DR4M. Just keep saying it, it will catch on soon. I hope these basic steps help you understand what options you have to put your investment money towards.
One other thing. I do suggest putting about $20-50 a month into an emergency fund before even worrying about the steps above. This way you can build some funds for those unexpected expenses that tend to put us on our ass right when things start to look good.
I hope this has been helpful! Tomorrow we will talk about what bank accounts you need, where to open a Roth IRA, and how to fund and invest it.