If you want to get the most out of your money, you need to know the best order of investing it. I am often asked by people who are trying to get their finances together what should they do with their money first.
Should they pay off their credit cards? their mortgage? When should they invest in their retirement accounts?
Believe it or not there is an order to investing your money. And if you get that order right, you can maximize the return on your investments, take advantage of tax savings, and pay off all of your debts.
Get the order wrong and you could be leaving money on the table.
The best part is, by following the steps outlined below, you will be on your way to financial independence. Everyone wants the freedom to live life on their own terms without worrying about where their next check is coming from.
Well, if you follow the steps below, you can make sure you are on the path to success.
Here's is a quick overview of the order of investing:
- Start a Minimalist Emergency Fund
- Contribute to Your 401k up to Employer's Match
- Pay Off Highest Costing Debt
- Max out your HSA
- Max out your Roth IRA
- Pay off the Rest of Your Debt
- Fully Fund Your Emergency Fund
- Max out your 401k OR Start a Brokerage Account
- Pay Off Mortgage
1. Start a Minimalist Emergency Fund
The very first thing you will want to do with your money is to set up an emergency fund. This is a key step to investing your money wisely.
It is very hard to get ahead in life when the next car accident, broken bone, or thunderstorm could send you further into debt. So you will want to establish a fund with some money to cover you in case of emergencies.
The typically recommended emergency fund is for 3 - 6 months of living expenses. However, when you are starting out, I suggest just having a minimalist emergency fund.
By this I mean, having enough money to cover your deductibles (i.e. for medical, auto, housing). So should you need to go to the hospital in an emergency or if you get into a car accident, you will be able to cover the deductible before your insurance kicks in.
If you can’t be bothered to do the calculations, $1000 is a good starting amount for an emergency fund. You may want to bump that up to $1,400 though if you are enrolled in a high deductible health insurance plan, as this is the starting amount for deductibles.
If, at any time, you must dip into your emergency fund, be sure to replenish it before continuing with the steps.
Where to Put Your Emergency Fund
When starting your emergency fund you want to make sure that it is not so easily accessible that you can draw on it whenever. I recommend using an online high-yield savings account.
With these accounts, you can typically get your money sent to your bank account in 3 days should you need it. Plus, your money will be earning more, as the interest rates are sometimes 100 times higher for online accounts than regular savings accounts.
Here are the high-yield savings accounts that I often hear great things about:
Bonus point good news: These banks won’t charge you fees and even allow you to separate your savings into different buckets. If you want to have a house down payment bucket, a future wedding bucket, you can.
Be sure to check if they have any total contribution limits as I have heard that some accounts do.
Update: Capital One has changed its features a bit. Now, in order to do this, you will have to open a new account for each new "bucket".
If you are a freelancer, someone with unstable income, or someone who worries, you may want to fully fund your emergency fund.
2. Contribute to Your 401k Up to Your Employer’s Match
Contributing to your 401k, if you have an employer match, is definitely one of the first things you will want to do.
After all, it will give you one of the best returns, if not the best, on your money. Many times, it is a 100% return, as many employers will give a 1 to 1 match.
That's free money honey! How can you not take it? Furthermore, anything you contribute to your 401k is tax-deductible or done with pre-tax dollars.
So you don’t have to pay taxes on the money you contribute. In addition, your earnings are allowed to grow tax free and you are only taxed when you withdraw your money in retirement.
Your Contribution
You can fund your 401k up to $20,500 for the 2022 tax year. But you don’t want to fully fund just yet, as there are better uses of your money. This step only requires you to fund up to the employer match.
For instance, if you employer will match 100%, dollar for dollar, of your contribution up to 6% of your salary, then you should contribute 6% of your salary.
So if you are making $50,000 a year, you will want to contribute $250 per month for a total of $3,000 that year. Your company will match that so your total would now be $6,000.
Woop Woop! You just doubled your money!
Note: Some companies may have vesting periods which would require you to work a certain number of hours or months or years before you can get the match.
Employer 50% Match Example
Sometimes employers will match 50% of your contribution up to 6% of your salary. In this case you will still need to contribute 6% of your salary to take full advantage of your employer match.
So if you made $50k a year like in the example above, you would contribute $3k per year and your employer would contribute $1,500 for a total of $4,500 yearly contribution.
Congratulations! Now with your 401k funded up to the match you’ve locked in a guaranteed excellent return on your money. The next step in the order of investing is to start paying off some debt.
Feel free to do this step at the same time you start your emergency fund! Don't want to leave this free money on the table!
3. Pay Down Highest Costing Debt
Most of us aren’t strangers to debt and that is because we all have credit cards.
Unfortunately, credit card debt is the most expensive debt to have, as their APRs (interest rate + fees) are generally the highest. Historically, it has even gone as high as 79.9%. Yikes!
These high interest rate credit cards poke a huge hole in your wallet and the only way to patch it up is to pay it off.
So in this step, you’ll want to pay back those debts with APRs greater than 7%. This will most likely be your credit card debt.
When you pay back your credit card, which may be charging you 15% a month in interest, you have an automatic 15% return on your money. That is a substantial return on your investment and why paying back credit card debt is a top priority.
If you think about it, even investing in the stock market historically only averaged 10% and that is before taking inflation into account. So just by paying off your credit cards you are essentially "beating the market".
Once you’ve finished paying off your credit card debt, if you choose to continue using them, pay them in full each month. You don’t want to reopen the hole that you have already patched.
Paying off your credit card debt will give you greater returns than the average returns of the stock market.
4. Max Out Your HSA
Your health savings account is the best investment/savings account ever created. It is the only one that is triple tax advantaged. That's why this account is crucial when it comes to investing your money.
With an HSA, your contributions aren’t taxed, your money is allowed to grow tax free, and when you make withdrawals for medical purposes they are tax-free. Literally, a win win win!
Furthermore, once you turn 65, it turns into a regular retirement account so you can take money out for non-medical purposes. These withdrawals would be taxed though.
Opening an HSA is not available to everyone. To qualify you must have a high deductible health plan that typically means your deductible is $1,400 or more.
The max contribution you can make per year is $3,650 for the 2022 tax year for individuals and $7,300 for families. To get the most out of this account, you should contribute the max each and every year.
HSAs are great for FIRE (Financial Independence Retire Early) especially if you want to save your medical receipts and cash them in later.
5. Max Out Your Roth IRA
If you have read any of my previous articles, you’ll know I am a fan of the Roth. A Roth IRA is a retirement account where your contributions are not tax deductible but your money grows tax-free and withdrawals are tax-free.
A traditional IRA, on the other hand, is a retirement account where contributions are tax deductible and earnings can grow tax-deferred but withdrawals are taxed as income.
They say you should decide between funding a Roth or funding a Traditional IRA based on whether or not you will be making less in your retirement.
But what they don’t tell you is that by the time that you retire, your spending will probably be much higher than it is now. Ever increasing taxes and a higher cost of living due to inflation will make sure of that.
Not to mention the additional Social Security income that most people forget to include and increased medical bills. Trust me your future self will love you for choosing a Roth instead of a traditional IRA.
Roth IRA Income and Contribution Limits
There are income limits for Roth IRAs so check to make sure you qualify. For the 2022 tax year, single filer's modified adjusted gross income (MAGI) must be less than $144k. For married filing jointly, your MAGI must be less than $214k.
If your income is too high to contribute to a Roth IRA, don't worry. You still have to option of doing a backdoor Roth. I talk about those and other IRAs more in-depth here.
For the 2022 tax year, the maximum you can contribute to a Roth IRA is $6,000 or $7000 if you are over 50. A bonus of the Roth IRA is that you can withdraw contributions (not earnings) tax-free at any time 5 years after the contribution is made.
6. Pay off the Rest of Your Debt
This next step brings us back to our old friend, Mr. Debt. The debt we are going to tackle this time is going to be your second highest debt.
These probably have an APR that ranges from 5-7% and are probably comprised of student loans, car loans, and/or personal loans.
The reason that these are not as highly prioritized as the credit card debt is because, historically, the stock market has had average returns of 10% or more (about 12% in the last 30 years) before inflation.
That means your money would be put to better use in the stock market rather than paying off debt with an interest rate less than 8%.
Furthermore, paying off your loans can take some time as student loan debt is getting higher and higher. And you don’t want to delay when it comes to saving for your retirement.
No one can predict the future so the stock market's return may not be the same as before.
You will want to give your money as much time as possible in the market to compound and grow. Therefore, only after you’ve got some money invested in the stock market, should you turn to the task of paying off your “mid-sized” loans.
In this step you can use whichever debt payoff method you prefer: the snowball method, the avalanche method, or the balanced method.
7. Fully Fund Your Emergency Fund
Now that you have gotten your expensive debt paid off you can breath a huge sigh of relief. From here on out, it is pretty much smooth sailing.
You’re going to beef up your emergency funds with extra money until you have 3 – 6 months of living expenses. Then move on to the next step. (Although in light of recent events, you might wanna go ahead and save 6 - 12 months.)
I like to keep things barebones so I'd say you don't want to include things like eating out, going to the movies, or traveling in your emergency fund. It should only include the essentials such as rent, utilities, food (groceries), health insurance, etc.
8. Max out your 401k or Start a Brokerage Account
Now is the time to take your extra money and max out your 401k. Because the limits to the 401k are so much higher than the IRA accounts, this is probably where the bulk of your retirement funds will come from.
So you will want to make sure it is fully funded. The maximum amount you can invest for the 2022 tax year is $20,500.
The only time you will not want to fully fund this account is if the fees associated with it are just too high. Fees are the kryptonite to the growth of your money and will take a huge chunk out of your investments if you are not careful.
So check how much your fees are. If they are more than 2%, you’ll want to back away fast. Because at that point it will be better to just open up a brokerage account and invest in the stock market that way.
Although, quietly, if the fees are 1% or more, that is a no go for me.
The Pros and Cons of a Brokerage Account
Brokerage accounts are taxable. So any dividends or capital gains you receive from selling your investments are taxed as ordinary income.
That is why, typically, it is better to fully fund your 401k (if the fees aren't too high and they have good options) before starting a brokerage account.
However, having a brokerage account gives you much more flexibility and control over your money. For those on the FIRE journey and need early access to their money, having a brokerage account is essential.
Should you decide to go the brokerage route, try to include the most tax efficient stocks and bonds in these accounts.
Some of the more tax efficient funds include most index funds, tax-exempt municipal bonds, large growth stock, international stock, and EE and I savings bonds.
If you are a freelancer, you have more options and higher contribution limits with a Solo 401k, as you are employer and employee.
9. Pay off Your Mortgage
The final step in the order of investing and on your journey to financial independence is finally, once and for all, paying off your mortgage. This is literally the last thing you have to do and I’m sure you can see the end in sight.
The reason you want to leave your mortgage until the last step is because unlike the other debt your mortgage typically has the lowest APR with people on average having 3.5%.
Therefore, paying it off would only get you a 3.5% rate of return on your money. And you could earn so much more money by investing in the stock market.
Once you pay off your mortgage, however, be sure not to use it as a bank where you can withdraw money at any time by taking out home equity loans or a second mortgages.
Your home is probably your largest asset and with a bulk of your money invested in it. Taking out a second mortgage increases your risk of losing that, not to mention you will once again be in debt. To me, it is just not worth it.
All in All
Who would have thought that the path to success and financial freedom could be laid out in just 9 simple steps? It may seem like a long road but if you just take it one step at a time, before you know it, you will get there.
Now that you know the correct order of investing your money, it is time to turn that knowledge into action. Start up that emergency fund, crank up contributions to your tax advantaged accounts, and pay off that debt.
There is a popular saying that goes a little something like this: People don’t plan to fail, they fail to plan. But now that you have your plan of action, all that is left to do is to follow through.
At the end of this nine-step journey, is your financial independence. So stay focused, your dream life awaits.
Related Questions
When investing in my retirement accounts such as a 401k, IRA, etc. what should I invest in?
When you are investing in your retirement accounts, you want to make sure you are investing in index funds that have low expense ratios. By this I mean that the fees that you will be charged every year is kept to an absolute minimum. For me, anything with an expense ratio of 0.5% or more is way too expensive.
Most funds at the discount brokerages have expense ratios around 0.05% just to give an example of some decent ratios. Just remember that the higher the expense ratio, the more money you will pay each year.
I particularly recommend total stock market index funds as this gives you a broad coverage of the market and these typically have low expense ratios.
My top 3 index funds are total US stock market index fund, total international index fund, and the total US bond market index fund. I’m American so that’s why its mostly US based. But feel free to switch that out for your country of residence. I talk more about investing and which index funds I'd invest in here.
What if my employer doesn’t offer a match?
If your employer does not offer employer matching, then skip that step and go on to the next step, which is paying off your highest interest rate debt (credit cards).
Then you will begin investing in an HSA or a Roth IRA. You can always circle back later and start investing in your 401k despite it not having a match so long as the fees are not above 2%.
How would this order be modified if I were interested in FIRE?
There is actually not that much of a difference. You will want to have a nice hearty chunk of your money easily accessible though. So in step 8, you do half and half or skip out on maxing out your 401k entirely and instead put that money in a brokerage.
Also, the closer you get to achieving FIRE you will want to have at least 1-2 years worth of living expenses in your emergency fund just as a buffer during the down markets.
No need to beef up your emergency fund before that time though because your money needs to be working hard in the market.
Where does real estate fit in to the order of investing?
Real estate requires more knowledge, skill, and possibly training before just diving in. This is because you can lose lots of money simply because you didn’t know what you didn’t know.
But if you have studied the real estate market and how to buy good property, you can definitely invest in real estate. It is in excellent wealth builder sometimes with returns much higher than the stock market.
For investing in real estate, I would put that at step 8. Instead of fully funding your 401k or opening a brokerage, you would do this. Of course, just save maxing out the 401k for later.
Also, you will want to have a much more beefed up separate savings account for your rental properties which cover at the very least 3 months of mortgage payments.
Furthermore, you can opt to move paying off your mid-sized debts until later as well since you could use the extra money you gain from your property to help pay it off faster.
Here’s what the order of investing would look like if you included real estate:
- Start a Minimalist Emergency Fund
- Contribute to Your 401k up to Employer's Match
- Pay Off Highest Costing Debt
- Max out your HSA
- Max out your Roth IRA
- Fully Fund Your Emergency Fund
- Save for your rental down payment
- Pay off the Rest of Your Debt (opt.)
- Start an emergency fund for your rental property*
- Invest in real estate
- Pay off the Rest of Your Debt
- Max out your 401k OR Start a Brokerage Account
- Pay Off Mortgage
*You can fully fund this later but start with at least one month’s mortgage payment
*DISCLAIMER: The Information provided in this post is simply the opinions of the blogger and is given in the spirit of educational fun. It is not investment advice. Please do your own research and decide what is right for you before investing in any asset. If necessary, seek the help of a certified professional in discussing your options.
Great advice as always. You may have done this already, but if you did not, can you write advice about purchasing investment property? I am interested in purchasing investment property.
Thanks.