Ever wonder what should be funded first…Bills, Debt, 401K, IRA, E-Fund, 529, etc…? After much research, there is a way to optimize investments and debt repayment for 90% of us. I’m going to show you the 12 steps and order of priority in which to save money and reduce liabilities.
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Optimize Investments and Debt Repayment Priority
Dear Debt Holding Investors,
About a year after I discovered financial independence (FI) and had completely redone our household’s finances, your mom and I had a bit of an argument. It was early March and bonus season. I walked in the door and was greeted with, “I’m getting my bonus tomorrow, yay…and it’s $17,000. That’s more than I was expecting. What do we want to do with it?”
At this point, I had already showed your mom my plan and what I’ve done to put us on track to achieve financial independence in 10 years. She has not really shown interest in the numbers or the methods even after showing her our customized FIRE spreadsheet. However, she was entirely on-board with quitting her life sucking pharmacist job earlier than anticipated. When I told her to put it in the savings account and let it sit, she got upset. “If we have money, I’ll just book us another vacation.” She’s of the opinion to live in the here and now as we all might be dead next year.
I understand where she is coming from which is why we’re not doing the extreme version of FI and saving 50%+ of our income. We’re still enjoying the occasional night out, frequent day trips, and a few vacations a year. We could probably retire in 5 years, but I don’t think you or her would appreciate the sacrifices we’d have to make as a family just to appease my ambition to retire early.
You see…we were on Step 11 of the optimize Investments and debt repayment priorities checklist featured below. However, in the last few months we had to dip into the Emergency Fund (E-fund) to fix some rotting structural issues on the porch of our house. We also needed to pay for an unexpected set of braces for one of you ;). After taxes, that bonus check would be enough to replenish our E-Fund and get back to Step 11.
Invest or Reduce Debt
“Should I invest or pay off debt?” is a common question. Some advocate to “pay yourself first” as in Rich Dad Poor Dad. This implies investing and then working even harder to make sure you pay your bills. I don’t want that stress, so I’ve developed a more reasonable approach using simple math. I’d rather chase the carrot than run from the stick.
The preliminary step is to actually have income that generates a surplus versus your expenses. You’ll need to reduce expenditures comparable to income that produces a life you are comfortable with. That takes budgeting. If you’re spending more than you earn, then this optimize Investments and debt repayment priorities checklist will do nothing for you. Run some Financial Independence Calculations and come back when you have increased income and reduced expenses to a point where you can make progress.
Priorities Checklist for Paying off Debt and Optimizing Investments
The further you get down this checklist the earlier you can become financially independent and retire, or pursue other passions. Based on personal experience, I’ve omitted real estate investing entirely. Do not go to the next step until you have completed the prior and make sure you’re considering tax avoidance in your investments.
Step 1 – Pay Minimum Required for Bills and Debts on Time
This is a no brainer. You need to pay your bills to maintain a roof over your head, insurance, heat, electrical, phone, food, clothes, gas, taxes, and other basics of life. Neglecting to pay these could cost additional fees and loss of service. Reducing these expenses are key as I’ve shown you in other FI letters.
Step 2 – Invest in a 401K at least to Company Match
The company match is “free money” which grows in addition to your tax free contributions. Read the fine print to determine how much your organization’s tax deferred retirement fund will match and at what frequency. I’ve detailed how to become a 401K Millionaire before and I hope you heed that advice.
Step 3 – Establish a 2 Week Emergency Fund
This is your initial E-Fund that should go into a savings account in case of minor unplanned expenses. You’ll see it in your account and you’ll want to spend it, but be strong. Something always comes up unexpectedly, such as the house repair and dental work that I talked about earlier. You don’t want to be put in a position where you need to use a credit card or borrow to overcome such things.
Step 4 – Max out HSA
The Health Savings Account (HSA) is tax deductible and deferred similarly to a 401K with various investment options. It’s a great health care emergency fund which can be a financial life saver for the unfortunate. If you’ve enrolled in an HSA, max it out to cover routine and unplanned medical expenses for a lifetime.
Step 5 – Pay Off Debt that is 6% or Greater
This is a bit of a gray area depending on the data you observe and the investment allocation chosen. The average return for the S&P 500 index is 9.1% minus the historical U.S. inflation rate of 3.22% equals 5.88%. That means your return on an all equities portfolio is less over time than paying off debt with a 6% interest rate or more. I’ve rounded up to 6% because loan repayments are not liquid and cannot be used if needed. The 6% should be adjusted down to 5% if your portfolio allocation contains at least 20% bonds or other conservative investments. You can easily refinance mortgages and student loans below this threshold.
Step 6 – Max out Traditional or Roth IRA
If your modified adjusted gross income is below IRS limits, max out a Roth IRA when your expected income will be higher during retirement. Roth is best if you plan to save a lot or in the beginning of a lucrative career. If you’re like me and plan to earn much more now, then invest in a Traditional IRA so your tax bracket is lower while you are earning well, saving, and paying off debt.
Step 7 – Max Out 401K
This is how you become a 401K Millionaire! Check the IRS website and determine the max contribution limit for the year. Take that number and divide it by your gross annual salary and round up to the nearest percentage. Login to your 401K provider and make your contribution amount that percentage. Check the IRS website each year and adjust your contribution percentage to match.
Step 8 – Build E-Fund to Cover 3 Months of Expenses
You have your retirement accounts as a costly buffer for a major life crisis, but it’s now time to setup an emergency fund with a bigger cushion. This will help you weather major storms, such as the loss of a job, major medical issue, or car malfunction. We need to establish a safety net for the larger unforeseen events and avoid withdrawals from retirement accounts.
Step 9 – Pay Debt that is 4% – 6%
We’ve paid off debt with an interest rate greater than 6%, established an E-Fund, and maxed out all tax advantaged accounts. There are annual tax consequences to investing further, so I’ve adjusted to a 4% interest rate for this step of the optimize Investments and debt repayment priorities checklist. These types of loans are typically a mortgage, student loan, and car payment.
Step 10 – Contribute to College Savings Fund
If I’m a grandfather and you’ve established a 529 for your own children, congratulations. You’re helping them achieve financial independence at a rapid pace. Contributing to a college fund is a very personal decision, but once you’ve gotten to step 10 – you are in damn good shape. If you have no children of your own (another topic entirely), go ahead and skip to step 11.
Step 11 – Put Income Surplus into a Brokerage Account
There’s no tax advantages here and you’ll want to limit your investment choices that have a very low tax burden, such as a total market index fund. Keep bonds, real estate investment trusts, and other income producing assets in your tax advantaged accounts. You can speculate a little with stock purchases of companies and industry exchange-traded funds (ETFs) that you know and have done your research or due diligence on. I recommend Vanguard or Fidelity for their low cost index investment options.
Step 12 – Pay Off Debt Less Than 4%
If you have great credit or consolidated to an amazing interest rate by reading anything I’ve written, you may see a mortgage, car, or student loan at this low interest level. This a personal comfort decision whether to swap step 11 and 12, but know that both are recommended before you retire completely. You’ll earn more over time with compounding interest than 3 or 4 percent historically, but no guarantees. Interest deductions are fickle in the U.S. tax law after-all. I suggest you invest in a brokerage account first and let it build and then pay off in bulk once you have 5 years worth of expenses covered, plus your outstanding debt amount.
Closing Remarks on Optimizing Investments and Debt Repayment
You can then pay off your low interest debt in full and retire early or supplement income with a job of passion or part time work. I don’t recommend full retirement until you are debt free, your taxable brokerage account can sustain you for 5 years while you do Roth conversions, and your retirement accounts can endure indefinitely at a safe withdrawal rate (SWR) of 4%. More on SWR later, but essentially $1,000,000 provides $40,000 annual income.
Paying off debt and optimizing investments in the correct order will set you up for financial freedom. Don’t get spooked by market conditions. If the DOW or S&P 500 are down significantly, don’t deviate and pay off low interest loans. You may miss out on great bargain opportunities for equities and a bull run of the market. Remember that paying off low interest debt does not provide you a financial safety net as the cash is no longer under your control if in a pinch.
There’s obviously adjustments based on where you are in the process and life circumstances, but the basics hold true. As much as you can automate this – the better. Like your Mom said, “If we have money, I’ll spend it”. Out of sight, out of mind is the best approach. Set up your bill payments, 401K, E-Fund, IRA, 529, and brokerage contributions automatically, every pay period, so you aren’t tempted to overspend.
The best tool to track your progress toward Financial Independence is Personal Capital. I’m affiliated with them and have been using the free service for quite some time. It has really opened my eyes. Aside from a customized FIRE Spreadsheet, PC is the next best thing.
Kylven Ross is the owner and primary contributor of theFIway.com. He has been married for 17 years and is father to a son and daughter living in New England. Professional accomplishments include a bachelor’s degree and industry certifications in the cyber sector. He has spent the last 18 years working in the U.S. Defense Industry and as a Military Police Officer.
He discovered the concept of Financial Independence (FI) during a rather stressful year in the compliance space. After fully absorbing the benefits of FI, he has since committed to turning his household’s finances in the right direction. His experiences are documented as a series of letters that are used to educate his children and others about money. He does not want the next generation to make the same mistakes, but rather achieve financial freedom and find happiness.
Kylven is not a financial advisor, tax expert, or investment professional. Investment and retirement planning activities should not be considered professional advice. Consult a licensed financial advisor for questions regarding your own situation.