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.
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.
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.