Let’s imagine you stumble onto a suitcase bursting at the seams with cash.
Hey, isn’t this game fun!?
Maybe you’ve got a rich uncle, or your side hustle as a gray market arms dealer just took a lucrative turn.
Or maybe, more realistically, you’re like most readers of this site. You’ve started making decent money, and you wisely want to set yourself up as a financial wizard. But there’s just one problem…
What do you invest in first? What’s the right order of investing?
If our hypothetical suitcase isn’t enough to max out every account and pay down every debt, we’ve got some choices to make. There’s mortgages, student loans, index funds, 401Ks, HSAs, IRAs, VTSAX, and jkfsd;jak.
And yes, that last one was a random mash of the keyboard, because that’s what all the investment options can feel like sometimes.
For all those aspiring investors who’ve ever wondered whether they’d be better suited paying off this instead of investing in that – this article is for you.
Behold:
The Definitive Guide to Investing in the Right Order
All comes with the big ‘ole caveat that every situation is different. If I tried to cover every single scenario, this post might grow so long it’d break the internet and blow up my keyboard.
BUT, there are some general guidelines most of the population can follow to make sure they’re putting their hard-earned money to work in the most optimized way possible.
Let’s dive in:
1. Build Up an Emergency Fund
Yeah, I’m not a fan of huge emergency funds, but we don’t need you missing rent and bouncing checks, either.
Your first order of business should undoubtedly include building up a reasonable buffer of cash. Store it in a savings account or other low risk choice. (Emphasis on low risk!)
The exact amount will be different for everyone, and much depends on your personal risk tolerance.
A new grad with a promising career and no dependents might be just fine with an emergency fund equal to a credit card statement or two. This is much less than the standard advice, but then again, a job loss or other disaster poses a lot less risk when crashing with a friend in exchange for a six-pack won’t shake your life up too much.
Meanwhile, a single mother working a cyclical job and supporting a couple kids has much less flexibility in her lifestyle. And a whole lot more to protect against.
Only you can decide the level of comfort you need. But as a general rule of thumb, if you’re waking up in the middle of the night with cold sweats after another nightmare about running out of money, you might need to up the E-Fund.
One last note about emergency funds. They are financial training wheels, and at some point, it’s fine to replace them with liquid assets. But that’s a few more steps away in our Definitive Guide to Investing in the Correct Order.
2. Contribute Enough to Your 401(k) to receive the full employer match.
Employer matches are literally the best investment ever. So that makes our rule pretty simple. If your employer offers 401K matching, you should be contributing.
Why? 401K (or 457, 403b, or 4-whatever) matches provide an instant, guaranteed, 100% return on your investment.
The g-word is all but forbidden from the dictionary of finance. So this is big.
Say your employer matches the first 5% of your retirement contributions, and you make $50,000 a year. This means the first $2,500 you invest in your 401K instantly doubles to $5,000.
There’s not an investment in the world that offers risk free returns like that. The stock market doesn’t. Rental property doesn’t. Even a lucky run in Vegas can’t compete.
Your company wants to give you a free multi-thousand dollar bonus every year. Take it.
So when it comes to taking advantage of company 401K matching, be like Nike. And just do it.
3. Pay off credit card debt
The average credit card carries a 16% interest rate. This makes credit cards, on average, the costliest form of all debt, and where most people should start their debt reduction.
(When working as a credit analyst, I once saw a guy carrying a car loan for his Porsche… at a 24% interest rate. He’d be the rare exception to the “start with credit card debt” rule.)
Paying down debt with a 16% interest rate has the exact same effect on your finances as earning 16% through a brilliant investment. When returns are this high, you gotta take them.
This same line of thinking is why you see this step appearing after 401K matching (100% return) yet before stock market investing (7% return, historically).
4. Pay off higher interest rate debt
As a rule of thumb, “higher interest rate” debt can be classified as anything 4-5% above the 10-year US treasury rate. Usually, the treasury rate is 2-3%, (See the current rate here) which means you want to focus on any debt higher than 6% or so.
Most student loans fit into this category.
Once this stuff is knocked out, you’ll be amazed at how much income you’ll have to optimize the rest of your finances.
5. Max out Your HSA
If you’re eligible, Health Savings Accounts are a unique double dose of tax advantages. When used for medical expenses, they’re tax free on both contribution AND withdrawal, which edges out both Traditional and Roth retirement accounts.
If you never get around to using your HSA contributions, the HSA turns into a Traditional IRA at age 65. And for early retirees, the HSA might actually be the ultimate retirement account.
6. Max out Your IRA
Either Roth or Traditional… just max it out!
If you expect to be in a lower tax bracket in retirement than you are today, Traditional IRAs have the advantage.
If you expect to be in a higher tax bracket in retirement than you are today, Roth IRAs have the advantage.
On the other hand, feel free to flip a coin, because Traditional versus Roth doesn’t matter as much as everyone thinks.
I like to make my IRA the opposite my 401K is. That way I’m covered for both scenarios.
To get specific, I have a Traditional 401K and a Roth IRA, which means one account will benefit either way.
7. Finish maxing out your 401(k)
Again, the tax advantages here are too big too ignore, which is why the 401K outranks after-tax investments.
I save over $6,000 per year on my taxes just from maxing out my 401K.
Like the IRA, the decision between Traditional vs. Roth 401K is a decision of future tax brackets. But don’t stress too much – it’s hard to go wrong when you’re saving thousands a year.
8. Pay off lower interest rate debt
“Lower interest rate” is 2-3% above the treasury rate, which usually means debt with interest rates between 4-5%.
Note that this includes lower rate student loans and most car loans, but does not include most mortgages.
These interest rates (4-5%) are slightly less than the historical returns of the stock market (~7%), but I still prioritize debt paydown over taxable stock market investing due to:
- The uncertainty of market returns vs. guaranteed debt paydown returns.
- The financial flexibility and mental benefits of becoming debt free.
- The tax obligations of after tax investing
9. Invest in taxable index funds
Emphasis on index funds, as individual stock picking is usually a loser’s game. As far as specifics, it’s no secret I think Vanguard is the best.
10. Pay off your mortgage
If you recently purchased a house, you likely benefitted from a low interest rate environment, and you’ve probably got a couple decades until your loan matures.
With a 15-30 year timeframe, your chances of the stock market outperforming your 3-4% mortgage is very high. So it makes sense to invest your extra cash into index funds, rather than the mortgage.
Swapping #9 and #10 becomes more appealing the closer you get towards the end of your mortgage, or the higher your loan’s interest rate.
Final Thoughts
The above is the most optimized, textbook answer for the vast majority of this site’s readers.
Your individual situation may vary, and any one of these 10 steps will be a far better use of your money than concert tickets, new car purchases, or other frivolous spending. So don’t stress too much about “doing the wrong thing.”
For example, if you’re extremely debt averse, and those last bit of student loans are driving you crazy, there’s nothing wrong with prioritizing #8 above maxing out the retirement accounts.
At the end of the day, as long as you’re investing your money into something, your net worth will sky rocket, and you can rest easy knowing you’re taking smart steps to drastically improve your finances.
Some Frequently Asked Questions:
What do you mean, max?
Each retirement plan has a maximum amount you’re allowed to contribute per year. The IRS adjusts these rules all the time, but as of 2018 the maximum amounts are:
- 401K, 403b, 457, TSP, etc. : $18,500 per year.
- IRA: $5,500 per year.
- HSA: $3,450 for those with single medical coverage, $6,900 for those with family plans.
My employer doesn’t offer a 401K, and/or doesn’t match my 401K contributions. Should I prioritize my IRA instead?
Yep, feel free to move on down the list if any of these steps don’t apply.
My 401K sucks. Should I prioritize everything else above it?
Probably not. Even with high fees, the tax advantages of a 401K are huge, and shouldn’t be overlooked. I crunched the numbers, and as a rough rule of thumb – your 401K is worth maxing out as long as its fees are less than 2.2%.
My employer only matches a little bit of my 401K contributions, not 100%.
It’s also pretty common for employers to match a percentage of your contributions, rather than a direct 1 for 1 matching. For example, some employers will match 50% of your contributions up to a set percentage of your salary.
In this instance, you’re still getting guaranteed free money, so contributing enough to receive the full match should be your priority.
I’m a government employee and I have a 457, not a 401K.
Congrats, you’ve got the most amazing retirement plan ever. 457 plans aren’t subject to the age 59.5 withdrawal rule, so you can access the money penalty free when you leave the employer (or retire early).
Double check that the fees aren’t outrageous and the fund options are okay, then feel free to prioritize maxing out your 457 above your HSA and IRA.
If you’re not a government employee and you have a 457, be careful, as the money in these plans technically belongs to the employer. This means if your employer ever goes bust or gets sued, your retirement savings could be at risk. Also, non-governmental 457 plans can’t be rolled over into an IRA. This is getting off-topic from the point of this article, but needless to say, if you’ve got a non-governmental 457(b) 457(f) or 457(g) plan… read the fine print very carefully before making large contributions.
I heard robo-advisors like Betterment/Wealthfront have tax advantages. Where does my robo-advisor rank?
Robo advisors would fall into step #9, along with taxable index funds. I tend to prefer taxable Vanguard funds over the robo-advisors. Check out my full Betterment vs. Vanguard comparison for all the details.
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Great article. I’m in the UK so things are a bit different, but it’s nice to know I’ve done thing in the correct order so far.
Interesting, earlier today I was discussing why there don’t seem to be more FI bloggers from the UK (as opposed to the US). I think it’s because the complexity of the options available to the average person in the US is far greater than in the UK.
@Hustle Hawk – I am in the UK too and haven’t been able to find any FI bloggers that are UK based – do you know of any?
@Jeebus – I would be really interested in the order you use your accounts in the UK. I contribute 14% of my salary to my workplace pension scheme and get an 11% employer match and then max out my lifetime ISA (as I am not yet a homeowner it makes sense to take the 25% government bonus towards my first house deposit) and then any remaining to a stocks and shares ISA. Is this similar to your setup? Do you worry about not being able to withdraw money from your pension before you hit 55?
Thanks for the really interesting post. Where would investing in rental properties fall for you?
I consider rental property an alternative to index funds, so it’d land at #9.
Agree with this savings / investment order in a suitcase of cash scenario. In a ‘bottom-up’ scenario, i.e. you only have enough money for item, 1 (emergency savings), then 2 (401k match), then 3 (credit cards) etc… I’d probably be tempted to swap 2 and 3 just because of how deadly high interest rates on credit cards can be if say minimum payments were being made (which is, sadly, all too common) and the debt were compounding.
24% to finance a Porsche! Wow! There’s sounds like a title for a blog post about a person’s financial position not always being what it appears to be: ‘Porsche at 24 (per cent. per annum)’!
HH
Agreed. I would add the caveat that if not including a mortgage, your debt:income ratio is out of whack, I would pay off the lower interest debt as a step 4.5 until you get to ~1:1 debt to income ratio.
A person could come out of grad school with $150k+ of student loans built up since undergrad, and only make $75k a year. Although they could afford to max their 401k and Roth IRA, after committing the $18.5k to the 401k and $5.5k to a Roth IRA, combined with even just the minimum on the loans, their remaining discretionary income would be a small portion of their gross income. Like a mortgage, prioritizing the 401k upfront would be a good “forced savings” effect, but in the same way that it isn’t good to be house poor, one shouldn’t feel oppressed by excessive student loan or other debt either. Unlike a house which can be sold so that you can downsize, the only way to get rid of a large amount of student loans or other debt is to aggressively pay them down to a manageable amount, and then I would pick up at step 5.
I’m not sure if this scenario is likely outside of student loans, since the excessive debt load would likely be at higher interest rate in which case it would fall into step 4 anyway, but I think the point remains.
Good point Julian. Definitely lots of unique situations, thanks for highlighting one of the big ones!
Why is it better to max out an IRA, prior to finish maxing out a 401(k)?
Those two are pretty interchangeable, IMO.
For most people, IRAs and 401Ks have the same tax advantages. The main reason I put the IRA first (for most people) is because employer provided 401k options often have higher fees. Meanwhile, anyone can open an IRA through Vanguard and choose an index fund with a rock bottom expense ratio. Vanguard’s average expense ratio is 0.12% and has several funds even cheaper. The average 401k expense ratio is 1%.
The two big caveats there would be if your taxable income was too large to fully deduct the IRA contributions, or if your employer’s 401K options are cheaper than a comparable IRA.
Wow, I really should have caught that, especially since I, per your wise advice, recently opened a Vanguard IRA account and rolled over two previous employer 401(k)s. Rather than continuing to ramp up my 401(k) contributions (currently up to ab out $14,000, not including match), I will begin putting more into my IRA. Thanks for the great wisdom.
If your taxable income is too large to deduct IRA contributions, does it not make sense to contribute to an IRA at all?
The order makes great sense. I know a lot of people that are in a hurry to pay off their mortgage due to the psychological aspect of it.
How might you order it if you were looking to save for a downpayment and you’d already hit points 1-4? I’m concerned about putting everything into retirement and having nothing for the interim 40 years.
I am wondering this myself. Personally, I would split it between 4.5 and 5.5, because if you contribute to an HSA and are paying your medical expenses with post-tax dollars, you could effectively withdraw tax free from your HSA for emergencies or for a down payment. But that may vary on the timeframe in which you plan to buy the item, and your tolerance for short term risk. Short timeframe (less than 5 years) put it at 4.5. Longer timeframe (more than 5 years) put it at 5.5.
Nice article and very sound advice. I was very fortunate to receive an inheritance several years ago which my head start toward FIRE (still a work in progress but I’ll be retired in 2023 @ 56 year’s old).
The first thing I did was pay off the credit card and consumer debts in full (including car).
I did max out my 401-k beginning that year and every year since (now >$100k). I set up a substantial $100k emergency fund and invested the remainder. The only thing I haven’t done according to your list is pay off the mortgage. My CPA recently advised against it and I’ll follow her advice. However I do add additional principal payment of $850. each month, so it’ll be paid off soon enough.
Long time reader, first time poster.
Love this article and what you’re all about money wizard. I think you’ve hit the nail on the head with most of the steps (although I’d pay off my mortgage before investing, but that’s just me). Would love if you could check out my blog inspired by you. I’m sorta the Money Wizard but the Australian version (but I call myself the Money Professor).
Keep up the good work!
You mentioned maxing out Your IRA, but you also state having both a Roth and Traditional. Are you maxing out both? Didn’t think you could do this, I may be wrong. If you can’t max both, are you doing an even split with a combined sum of $5500?
Great post, thanks for sharing the tips.
You can have both a IRA and a 401K. I have a Traditional 401K and a Roth IRA. I max out the Traditional 401K at $18,500 per year and also the Roth IRA at $5,500 per year.
If someone has a higher interest rate on their credit card debt, like say 24-26%, would you recommend swapping 2 and 3? Getting that high interest debt down before investing in your 401k? Or are you not willing to miss out on that 401k match?
The textbook answer is to still contribute enough to get the match. BUT, 24-26 percent is approaching true disaster scenario, so I wouldn’t blame somebody for prioritizing it above the employer match. That rate can spiral out of control in a hurry.
Personally, I’d start taking the bus, side hustling, and eating rice and beans until I got it paid down enough to get back to my employer matching.
Thank you for the answer back MW. I was thinking about this as a worst case scenario and was just wondering if you felt it more important to stop the bleeding or more important to not miss out on any guaranteed money.
I hate to even ask this because of the shame involved – but a few years ago, I mistakenly thought it would be a good idea to take out a 401k loan. I’m currently paying myself 4% interest on that loan (and yes I’m aware of how much money I have “lost” on that loan with the market lately – aside from the last few weeks of course), so where would you put that on your list? With the 4% interest items? Or with the OMG-WHY-DID-YOU-DO-THAT-PAY-IT-OFF-RIGHT-NOW items?
That’s a tricky one, and somewhat depends on the rules of your plan.
On one hand, a 401K loan is not quite as shameful as you’re making it out to be, since you’re actually paying yourself the 4% interest. So the real cost of the loan is the opportunity cost of not having your money invested. This isn’t nearly as bad or financially crippling as something like credit card interest, so I wouldn’t put it near the OMG PAY IT OFF now items.
On the other hand, many 401Ks will not offer employer matching if you have a 401K loan and won’t let you contribute beyond the loan. In this case, you’re missing out on both the employer matching returns, the 401K returns, and the tax benefits, so paying the 401K becomes more urgent IMO.
I’d check with HR about the specific details of your plan to see how urgent the 401K loan really is.
Great post, and I like that you include paying off debt as “investments.” It’s amazing how the math works the same whether the numbers are negative (as in debt) or positive (as in investments).
Small caveat on the 401k match being a guaranteed return: this is only true once the match is fully vested. If you leave the company before you’re fully vested in your 401k, you lose the match. Typically this is anywhere from fully vested on day 1 to three years. Thankfully you’re always fully vested on your own contributions.
Good point there Joe. Always smart to check the fine print before leaving any job.
I like that you mention that investments aren’t the only financial activity that can produce returns. In fact, paying off debt can generate a guaranteed return. Even though you aren’t accumulating wealth by chipping away at student loans and consumer debt, you’ll avoid paying that additional interest which means you’ll have that much more money in your pocket sp down the road you can invest as you please.
That is a pretty logical approach. Thanks for putting it together. Tom
401K – Not uncommon for a company 401K match to have a vesting period.
401K – Can have 401K pretax or 401K roth. Generally considered safer to go with pretax $’s. The company match will be pretax regardless if you do 401K pretax or $401K roth.
HSA – Can invest extra HSA $’s usually after a minimum threshold.
HSA – Make sure it’s a Health Savings account (HSA) rather than a Health Flexible Spending Account (FSA). FSA – If you don’t use it in the year you contribute, you lose that money all together.
Hey money wizard, very interesting article. I was wondering if you could explain a little more into step 10 for me. I guess I don’t see the benefit of investing more money in index funds over paying off your home mortgage sooner. I don’t own a home yet but when I do I am planning on purchasing a home within my means and opting for the 15-year loan. I figure that the sooner you pay off that loan and all the interest that comes with it, you’d come out ahead as opposed to investing that extra money. Even if you made say an extra 20k investing, you might still have to pay that in interest for holding the loan, so possibly come out even? Let me know what you think as you are the money wizard! 🙂
BTW, I understand that the market is 3-4% higher than most mortgage loans so you’d be making more than paying off in interest. Do you recommend just paying the minimum on your mortgage then?
Yep, you got it. That’s exactly what Lady Money Wizard and I are doing right now – paying the minimum on the mortgage and investing the difference. Reason being the market is very likely to outperform the mortgage by 2-4% over a 15-30 year period.
Hey MMM,
Advice. Would you recommend cashing out some ETF investments to pay off a low interest car loan? The loan interest rate is 2.4% and will be finished by late 2019 if keep making the minimum payments. This is my only debt outside of my mortgage and I already max out 401K, Roth and contribute a significant amount to taxable brokerage account. Thoughts?
I personally wouldn’t.
Notice that #8 (lower interest rate debt) is 2-3% above the treasury rate… aka 4-5% total. A car loan at 2.4% is even lower than the typical mortgage, which comes in last on our list.
Plus, if the ETFs have gained in value, you’ll incur a tax liability when you cash out.
I’d ride out the car loan. Then I’d love that old car for as long as it lasts, and put myself in position to buy the next one with straight cash homie.
If you really were sick of the loan, rather than selling ETFs, you’d be better off diverting some money from the taxable brokerage contributions towards the car loan. You’d avoid the tax implications this way, and you could enjoy being totally debt free sooner. Not perfectly optimized, but it may be worth it to you.
I didn’t read all the comments so maybe you already heard this… I would add the catch up amounts allowed for 401Ks and IRas to the max amounts listed.
Hello Money Wizard!
I am very new to the investing and frugality world. I am curious about my current investments and hoping you could clarify somethings for me. I am 23yo with zero debt! Here is my current layout
Maxed my 457b
Maxed my Roth
Throwing my leftover money into VTSAX (roughly 18k)
I just learned about the HSA and am still looking into that. I am just wondering if I should be dumping so much money into the taxable “non-retirement” account at Vanguard. The tax portion of investing is still quite blurry to me
Thanks! I think this was the most helpful article so far. I am really trying hard to reduce my debt and find a way to have more money at hand.
Do you think maxing out retirement accounts is best for everyone? I’ve always been a bit hesitant to lock up capital that could be used for short-term investing or business growth.
Great Article. They should be teaching this stuff in schools.
Hi money wizard,
This is actually something I meant to reach out to you about for a while, its actually on my “to-do” list.
I’m curious…Are you familiar with the Able Account program for individuals with disabilities, who want to save and invest?
While still a very relatively new program, The ABLE Accounts, which are tax-advantaged savings accounts for individuals with disabilities and their families, were created as a result of the passage of the Stephen Beck Jr., Achieving a Better Life Experience Act of 2014 or better known as the ABLE Act … you can learn more searching able accounts or you can visit by going to the Able National Resource Center’s website: http://www.ablenrc.org/about/what-are-able-accounts
I’d like to get your thoughts/opinion on this as someone whos looking to save and invest for their short and long term goals.
Hello! Thanks so much for your blog.
Like you, I have a traditional 401k and a Roth IRA. Would you ever recommend maximizing the 401k before contributing to the IRA? That way, you get the pre-tax advantages of the 401k before using after tax dollars for the IRA. Probably not a huge difference, just wondering what your thoughts are.
If I maximize the 401k before contributing to Roth, I would be fully utilizing all pre-tax options available before doing anything with after tax dollars (employer match, then HSA, then pre-tax 401k, then Roth IRA).
Thanks in advance!
The Roth IRA has tax advantages as well. It really comes down to what you expect your future taxes to be:
https://mymoneywizard.com/deciding-between-a-roth-or-traditional-ira/
My husbands firm allows him to contribute a total of $57,000 (after tax) to his 401k plan. Where would that fall in your spectrum of priorities?
I’ve been following your blog for years, and I share this article with people All. The. Time! Thank you!
Awesome! Thanks for the support and so glad it’s helpful!
I agree, the emergency fund is tricky because common wisdom is 3-6 months salary, which is a lot of money for most people! When I was younger I would set aside some unreasonable amount from my paycheck only to find myself dipping into the fund later on.
As for the HSA, I’m a proponent of simply having the best insurance your employer offers. My logic being, I want to keep my personal finances isolated as possible from health bills, despite how difficult that seems. I wouldn’t want to start looking at an HSA as an investment vehicle over time.
Should something ever happen, the last thing I would want to worry about is having to withdraw cash during a medical emergency from the HSA that I’ve psychologically turned into a retirement account.
I feel it would add another layer of stress, IMO.
Sure, there are tax benefits and I’m sure this strategy has worked very well for many people, especially when you are young. But as someone who has had large medical bills (im 32), I find more comfort in having a low deductible plan.
But…
It’s called Personal Finance for a reason 🙂
Cheers,
Adam
I clearly need to learn more about HSAs. I’ve been feeding $$ into my Roth, but don’t even have an HSA started.
Hello! I refer back to this all the time and share it with younger friends and coworkers all the time. Would love to see an update given new contribution limits and the like. Thanks!
Given the current interest rate levels, would you swap 9 & 10?
Great Article! Would you pay off 0% interest credit cards?where would they sit? I understand 16-30% credit cards definitely need to be paid off ASAP.