Congratulations! You’ve successfully set aside some savings and you want to invest it. But, with so many ways to invest – each with different tax benefits, limitations, and timelines – you’re overwhelmed.
You’ve heard of some options, like:
- You can put up to $19,000 into a 401(k) for 2019, and another $6,000 into an IRA. (Individuals age 50+ can contribute even more.)
- You can put up to $3,500 into a Health Savings Account for 2019. Married couples can put in twice that.
- You can put any amount into regular, taxable investment accounts.
Read on to learn where we think it makes sense to invest your money first, second, third, and so on.
Where Should I Put My Savings First?
We’ve organized our list of recommendations below in order of priority, as a guide to helping you determine where your savings should go first, then second, then third, etc.
Please recognize that not every savings or investment option listed below may be right for you. For example, you may already have a rainy-day fund (Step #1). Or you may not be able to make after-tax contributions to your workplace retirement plan (Step #8). If that’s the case, don’t worry about it! If an option below isn’t possible for you, just move onto the next step. Easy, right?
#1: Prioritize a Rainy-Day Fund: The First Place to Put Spare Cash
Already have a rainy-day fund? Then skip to the next step: paying off debt.
While some may disagree, we think creating a rainy-day fund, before funding any investment accounts, is the way to go. That’s because you never know when you might need cash.
Consider a worst-case scenario: Your car needs an expensive repair. Or your home does. Or, on the upside: You want to invest in a new opportunity, and you need seed money!
But what if all your money is locked up in retirement accounts – like your 401(k)? If that’s the case, accessing that cash can be expensive because there are tax penalties for taking money out of a retirement account too early.
If you choose to borrow on credit, such as using a credit card or a home equity line of credit, you’ll have to pay interest.
There’s a benefit to having cash that’s accessible without penalties or fees.
How Much Cash to Stash
How much cash should you stash? The CERTIFIED FINANCIAL PLANNER Board of Standards suggests up to six months of mandatory living expenses. This means you should save enough cash to pay six months of rent (or mortgage payments), six months of car insurance, six months of groceries, and more.
Hint: You don’t have to save cash for six months of dining out, or six months of gifts for family and friends. Only the necessities. Also, if you want to keep more than six months of living expenses in cash, that’s fine too.
Where Should You Keep Your Rainy-Day Fund?
Make your money work for you! Don’t settle for stashing your cash just anywhere.
Your local bank or credit union usually won’t give you much of a return for storing your money. Instead, consider an online, high-yield savings account. NerdWallet has a list of online savings accounts offering the highest interest rates.
#2: Pay Off Debt with Extra Cash
No debt? That’s great! Skip to the next step!
Your second priority is to pay off debt. Why pay off debt as your next priority? Because paying off debt is a guaranteed investment return.
A guaranteed investment return means that when you put cash towards debt, your investment return is equal to the interest rate on that debt.
Let’s use an example:
You’re carrying a credit card balance with an interest rate of 15%. When you use cash to pay down that debt, you’re instantly earning a 15% investment return. And let me assure you, earning a 15% investment return is a very big deal. In fact, you probably won’t be able to earn a 15% investment return anywhere else. (And if someone does approach you with a guarantee to earn 15% investment returns, please run screaming from them.)
Paying Off Debt is a Really Good Deal
You don’t have to fully understand the concept of paying off debt to take advantage of its benefits. Just know that any money put toward decreasing or eliminating debt is usually a really good deal. The higher the interest rate on the debt, the more you’re saving when you decrease your debt.
Strategies to Pay Down Debt
If you have more than one chunk of debt, how do you decide which loan balance to pay off first? Should you pay down your car loan first, or your mortgage, or your student loan balance?
Mathematically, it makes the most sense to pay off debt with the highest interest rate first. If you have a credit card balance and a home equity line balance, throw cash at the credit card balance first. That’s because your credit card likely charges a higher interest rate than the home equity line of credit.
The other strategy for paying off debt is to focus on the smallest loan balance first. This strategy popularized by Dave Ramsey is based on human emotion – and not math. That’s because we (humans) score an emotional high when we’re able to close out a loan, regardless of the size of the loan, or the interest rate. It’s that ‘check the box’ satisfaction. Getting this emotional reward encourages us to keep at it – paying off debts until they all disappear.
With your debt paid off, and a nice fast cash cushion (your rainy-day fund), it’s time to start investing!
#3: Employer Match on Workplace Retirement Accounts
If you don’t get an employer match for contributions to your workplace retirement account, skip to the next step of funding a Health Savings Account (HSA).
Can I interest you in some free money? If so, listen up! Many employers offer their employees a “match” when employees put money into their workplace retirement account. Your workplace retirement account may be a 401(k), 403(b), 457(b) or SIMPLE IRA.
Sometimes employers offer a dollar-for-dollar match, although sometimes less. Consider an example:
Your employer offers a dollar-for-dollar (100%) match. This match is good for up to 5% of your salary. So, if you’re earning $100,000, and you put in $5,000 into the company 401(k), your employer will put in an extra $5,000 on your behalf. That’s real money!
Not all employers are so generous; matches vary by the generosity of your employer. Sometimes, you may only get 10 cents for each dollar you put in.
Whatever the match, make sure to put enough money into your workplace retirement plan to earn the full employer match. Whether it’s free money in your 401(k), 403(b), 457(b), or SIMPLE IRA, jump on it! Anyone who knows anything about money agrees: do not pass up free money!
Use the Roth Option
#4: Put Extra Cash into a Health Savings Accounts (HSA)
I love the Health Savings Account. I like to call it the “magical unicorn of tax-advantaged investment accounts.” (Only a real money nerd would describe it as such.)
Don’t miss out on these wonderful tax advantages:
- You get a tax deduction when you put money into an HSA
- You get tax-deferred growth while your investments are in the HSA
- You get tax-free distributions when you take money out for qualified medical expenses
To qualify for an HSA, you must be enrolled in a High Deductible Health Plan (HDHP). If you’re already enrolled in a High Deductible Health Plan (HDHP), we recommend maxing out your contributions to the HSA.
If you’re not already enrolled in a High Deductible Health Plan (HDHP), consider switching over for massive tax savings. Know that HDHPs are a very particular type of health coverage, and are not right for everyone.
#5: Employee Stock Purchase Plan (ESPP)
No access to an Employee Stock Purchase Plan (ESPP) at work? Skip to the next step of maxing out your workplace retirement plan.
Why pay retail when you can get a discount? It’s the same for employer stock! With an Employee Stock Purchase Plan (ESPP), you can purchase shares of your employer’s stock at a discount.
What To Do With Stock from an ESPP
Once you’ve bought company stock at a discount, what do you do with it? Hold it forever? No! Sell it!
Financial planning 101 says:
Don’t put all your eggs in one basket.
You put all your eggs in one basket when you buy (and keep) your employer’s stock. That’s because owning some of your employer’s stock means that both your paycheck and your wealth (your investments) are dependent on the same company.
But just because we love reducing risk, it doesn’t mean we should pass up a good deal. You reduce the risk by selling your employer’s stock.
Our recommendation: Take advantage of your employer’s ESPP and buy company stock at a discount – and then immediately sell it for a profit!
#6: Contribute the Maximum to Your Workplace Retirement Plan
No workplace retirement plan? Skip to the next step of funding a Roth IRA.
If you’ve already managed to accomplish all of the above, great job! Now, we’re onto the next step: maxing out your workplace retirement plan!
Since you’ve already contributed the minimum to get the employer match, your next step is to contribute the maximum. The maximum will vary by your age and the type of plan. Those under 50 can contribute $19,000 to either their 401(k), 403(b), and 457(b) plans in 2019. Those age 50+ can contribute an additional $6,000. For those (some government employees) with access to both a 403(b) and 457(b), you eligible to $19,000 to each plan. That means you can put away $38,000 in tax-advantaged money! The maximum contribution to a SIMPLE IRA plan is $13,000 for 2019. Those age 50+ can contribute an additional $3,000.
Review the (Sometimes Hidden) Expenses on Your Workplace Retirement Plan
There is one exception to contributing the maximum dollar amount to your workplace retirement plan: do so only if you’re sure that the expenses on your workplace retirement plan are reasonable. Usually, this means having underlying fees (called expense ratios) of less than half a percent (0.5%). The lower the expenses, the better.
Most commonly, 403(b)s have high fees. If you’re using a 403(b), get extra familiar with the plan’s expenses.
Regardless of the type of plan, if the expense ratios are higher than 0.5%, you may want to skip to the next step: maxing out an Individual Retirement Arrangement (IRA) account.
Your Workplace Retirement Plan vs. the Roth IRA
Why not skip straight to funding the Roth IRA instead of using your workplace retirement plan? Firstly, you can put a lot more money into a 401(k), 403(b), 457(b), or SIMPLE IRA than you can a traditional or Roth IRA.
Secondly, when you use your workplace retirement plan to save money, you’re taking advantage of automation: money goes into savings, directly from your paycheck – before you ever have a chance to spend it. Bonus: Studies have shown this automation helps people to save more (another human psychology thing). We’re big fans of automating your savings because it is so easy!
#7: Max Out a Roth IRA
Once you’ve completed the above, contribute the maximum a Roth IRA. (We’re also big fans of Roth IRAs.)
If you earn too much to contribute to a Roth IRA, consider the back-door Roth technique: contribute to a non-deductible IRA and then make a conversion to a Roth IRA. This usually works best when you don’t have any money in traditional, SEP or SIMPLE IRA accounts. Contributing to a traditional IRA or a nondeductible IRA are also good options. However, know that there are income-based limits on the deductibility of IRA contributions.
Employer Retirement Plan Rollover for a Back-Door Roth Contribution
One option for making a successful back-door Roth contribution is rolling existing traditional IRA (and similar) accounts into an employer’s retirement plan, such as a 401(k), 403(b), and 457(b). This move avoids creating tax consequences during the Roth conversion process.
Only employees may contribute to a workplace retirement plan. Employee’s spouses cannot.
That’s not the case for IRA accounts. A non-working spouse can contribute to an IRA (so long as the total household contributions to both IRAs do not exceed the household’s taxable income). Contributing to a spousal IRA allows your household to save twice as much money in a tax-advantaged account. Don’t miss this opportunity to save more money!
Mind Your Expenses
As with putting money in your workplace retirement plan, remember to keep your investment expenses (expense ratios) low. A great way to do that is to invest in a low-cost, broadly-diversified index fund.
#8: After-Tax Contributions to Your Workplace Retirement Plan
If you don’t have a workplace retirement account, or if your workplace retirement account doesn’t allow after-tax contributions, skip to the next step of funding a 457(f) plan.
Not all workplace retirement plans allow “after-tax contributions.”
If your employer does offer “after-tax” contributions, and you’ve already checked the box for steps 1-7, then keep shoveling cash into your workplace retirement plan – on an after-tax basis. While you won’t get a tax deduction for your contribution, the contributions will still grow tax-deferred.
After-Tax Contribution Limits to Your 401(k) Plan
The deferred compensation contribution limit is $56,000 in 2019 for those age 50 and under. Those age 50+ can contribute an additional $6,000. So, if you’ve already put in the maximum pre-tax contribution of $19,000 into your traditional 401(k) or the maximum post-tax contribution into your Roth 401(k) in step #6, you can still put in an additional $37,000 in after-tax dollars into some workplace retirement plans.
Know that after-tax contribution limits are reduced by any employer contributions. So, if you put in $19,000 in your 401(k), and your employer contributed a $5,000 match, you can only contribute $32,000 in after-tax dollars to your 401(k).
Mega-Back Door Roth
With money in an after-tax account, you may also have the option to perform a “Mega-Back Door Roth.” With basis in your contributions (since you didn’t take a deduction for your contribution), this “after-tax” money can be converted to “post-tax” money tax-free. This move will allow you to distribute this money – and it’s growth – tax-free in retirement.
Again, what’s great about this step of putting money into your workplace retirement plan is that it takes advantage of the wonderful tool of automation.
Don’t forget, only go with this step once you’ve confirmed that the expenses (expense ratios) in your workplace retirement plan are 0.5% or less. If not, you can skip onto the next step.
#9: Deferred Compensation and Executive Savings 457(f) Plans
If you don’t have access to a 457(f) plan, skip to the next step of investing with a taxable account.
One of our last recommendations is to put money into a 457(f) deferred compensation plan. With its tax benefits, why did we put this option so low on the list? These plans are riskier because they don’t offer creditor protection. (A 401(k), for example, offers creditor protection for money inside the 401(k).) Without creditor protection, if the company you’re working for goes bankrupt, any money in a deferred compensation 457(f) plan may be lost.
For this reason, some folks are turned off by executive savings 457(f) plans. After all, who wants to lose their retirement savings because of someone else’s error? That’s why contributing to an executive savings 457(f) plan usually only makes sense when the investor already has enough retirement savings. In those instances, highly-paid executives are simply looking to lower their tax bill.
Again with Investment Expenses
As with all workplace retirement plans, remember to consider expenses (expense ratios) before contributing your hard-earned money to an executive savings plan.
#10: Taxable Investment Account with Low-Cost Index Funds
If you’ve run out of tax-advantaged places to put your money, you can always put money into a taxable investment account. Though you will pay taxes for dividends and capital gains every year, a low-cost, set-it-and-forget-it investment approach can still mean relatively minimal taxes and long-term investment growth.
Make sure to use low-cost index funds – and then leave them alone. Don’t be tempted to tinkle or trade. Just forget about it!
Don’t Do This with Your Cash
Well, I could list many things not do with your extra cash, but here I’ll just say one:
Do not use expensive-but-tax-advantaged investment schemes.
Permanent life insurance (like whole life insurance and universal life insurance) and annuities are an example of this. Though the salesperson disguised as a financial advisor may insist otherwise, these products are not a great place for your money.
Of course, there are always exceptions to the above. For individuals in the highest tax bracket who have already maxed out all other tax-advantaged accounts, sometimes these types of investments can make sense.
10 Places to Put Your Money for Growth
Now you know how, when and where to save your extra cash. No extra cash? No problem. Learn how to track your spending to start saving money. If tracking your spending is too much work for you, then simply focus on your two biggest expenses. Whittle those expenses down to start saving money today!
Disclaimer: This article is for entertainment purposes only. None of this is to be considered tax advice. Before doing anything, speak with a qualified tax professional.