Optimizing your finances
A step-by-step guide for how to maximize your savings
Too often I see friends and family hoard their money in a savings account because no one ever told them about the great wealth-building vehicles available to them, and how to prioritize them. While there’s no one-size-fits-all in how to manage finances, here are 8 steps, in sequential order, to start building wealth. It’s ok if you can’t get through all 8 at this point in life — it’s something to work toward as you progress.
Step 1: Get your employer’s retirement match
If your employer matches contributions to a retirement account, take full advantage of it. If your company does a dollar for dollar match on your contributions, that’s literally an instant 100% return on your investment. If it matches $.50 for every dollar you contribute, that’s a 50% rate of return. You won’t find those kinds of guaranteed returns anywhere else
Even if you have to withdraw the very next day and pay an early withdrawal penalty on your 401k, you’ll still make a killer return
Step 2: Pay off high interest debt (6%+)
Compounding interest should work for you through investment returns, and not against you. Too many people are saddled with high credit card debt or other types of high interest debt, and that debt compounds. These types of debt need to be eliminated ASAP
My personal definition of ‘high interest’ is 6%+ right now, but it might be different for you. The questions to ask are “can I make a higher return by investing the money that I would otherwise use to pay my debt” and “how confident am I in being able to make that return”? If I have student loans that have a 6% interest rate, but I have an investment opportunity that will yield 10% with absolute certainty, there’s no reason to pay off the student loans. Now if I have a credit card that has a 20% rate, I should definitely pay that off first
Why is my threshold 6%? On the lower bound of where I can deploy my cash, I can easily make 5% essentially risk-free in a high yield savings account, so the threshold should be above that. On the upper bound, the S&P 500 has historically yielded 10% returns on average over the last several decades, which could be an argument to bump the threshold beyond 6%. However, the market doesn’t grow in a straight line, so there’s always a possibility that the market tanks in the near-term. I’d rather be more conservative and pay off the debt given the uncertainty in generating high returns in the near-term
Step 3: Save for an emergency fund
Now that you’ve secured your bag from your employer (i.e. got your employer match) and staved off the loan sharks (i.e. paid off high interest debt), it’s time to start building some security. You never know when you might lose your job or get hit with a large emergency bill, so it’s best to give yourself some cushion as you prepare for the worst
How much should you keep in an emergency fund? Generally, I think people should save 3-6 month’s worth of expenses. If you work in a field where it’s super easy to find another job (e.g. nurse, doctor, etc), I think the lower end of that range is fine. If you work in a more niche field where you aren’t sure you can find work very easily, you might want to be toward the higher end of that range. Generally, I think people should keep enough so that they don’t feel the financial pressure to jump on opportunities that would be a step back in their career
Where should you keep your emergency fund? Emergency funds should be kept somewhere safe, liquid, and productive. Safe meaning you don’t have risk of losing it (e.g. not the stock market), liquid meaning you can access it easily (e.g. not in a rental property), and productive meaning you’re earning some returns on it (e.g. not under your mattress). Generally, you should keep it in something like a high-yield savings account, money market account, or cash account. I keep mine in a Wealthfront cash account, similar to a high-yield savings account. It yields 5.0% right now (as of 11/2/23) and you can get a 3-month boost to 5.5% if you sign up with a referral (you can use mine here – full disclosure, I also get a 3-month rate boost if you sign up). However, there are a lot of other good options out there
Step 4: Contribute to an HSA
An HSA is a Health Savings Account, which is a type of account that lets you set aside money for qualified medical expenses. You can invest funds that you contribute to an HSA. You can only contribute to this if you’re part of a HDHP (High Deductible Health Plan), but if you have access, this is a POWERFUL tool
Now you might be thinking, why is contributing to something that I can only spend on medical expenses so high up in priority? The reason is that it’s triple tax advantaged. First, HSA contributions are tax-deductible, meaning that they reduce your income (similar to a 401k). Second, both your contributions and earnings grow tax-free. Third, withdrawals for qualified out-of-pocket medical expenses are also tax free. One tax advantage is awesome, but three advantages is… three times as awesome.
You might be thinking, well I’m healthy so this is isn’t really relevant to me. Well the reality is that most of us will have much higher healthcare expenses when we get older. And if you don’t end up needing all of the HSA money when you get older, you can withdraw it once you’re 65 and you’ll owe taxes but not pay a penalty
You can read more about HSAs and their advantages here
Step 5: Max out your Roth IRA
A Roth IRA is an Individual Retirement Account (i.e. not through your employer, meaning that you can open one up on your own) where your investments grow tax-free and your withdrawals are tax-free. This account has 2 of the 3 tax advantages that the HSA has
Note that there are income limits to whether you can contribute to a Roth IRA, meaning that if you earn over the income threshold, you can’t contribute directly. However, if you make more than the income limit, you can take advantage of a Backdoor Roth IRA, which is a completely legal way for you to contribute to a Roth IRA, with a couple extra steps. Roth IRAs are more important to max out than other retirement vehicles because (i) you can withdraw what you contribute without penalty as long as you keep it in the account for over 5 years, and (ii) you have more investment options than accounts like 401(k)s
You can read more about Roth IRAs here and Backdoor Roth IRAs here
Step 6: Max out other retirement vehicles
Now you can take advantage of other retirement vehicles (e.g. 401(k) or 403(b), whether that’s a traditional account or Roth account (the difference between the two is that for the former, you don’t pay taxes up front for your contributions but pay taxes when you withdraw, and vice versa for the latter)
You might see a pattern emerging here, that steps 4-6 are all taking advantage of tax-advantaged accounts. The name of the game is trying to put your money in accounts that will protect it from Uncle Sam, whether that’s in the form of reducing your tax bill today or down the road
Step 7: Contribute to a brokerage account
If you’ve exhausted all your tax-advantaged contributions and have money left over, it’s time to contribute to a good old-fashioned brokerage account. You won’t get any tax breaks from these contributions, but the S&P 500 has returned ~10% on average over the last 30 years, so you still want to put your remaining money to work
There are a lot of great brokerages out there – I won’t get into pros/cons of specific ones here, but I use Fidelity, Schwab, Vanguard, Robinhood, and M1 Finance (full disclosure, I get a referral bonus to Robinhood and M1 if you sign up using the links provided). While each has its own pros / cons, all of them offer free trades and their similarities are greater than their differences, so don’t drag your feet trying to pick the best one
Step 8: Pay off low-interest debt (<6%)
You might be surprised to see this at the very bottom of the list as many talking heads advocate for getting rid of all debt ASAP. But the mathematically optimal move is to invest instead of fully paying off low-interest debt. The reason is that you can likely make more money at a higher rate than the rate of your debt
For example, say you have a 3% mortgage. You could aggressively try to pay that off, but there are a lot of high-yield savings accounts out there right now that pay over 5% with effectively no risk. So rather than trying to pay off your mortgage, it makes more financial sense to put your money into something that yields a higher return
I draw the line at <6% right now (i.e. if you have debt under 6%, it makes sense to redeploy it elsewhere), but your line may be different. Also, decisions don’t necessarily need to be made based on what’s mathematically “right”. Some people just don’t want to carry any debt as that makes them feel more secure / better able to sleep at night