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Interactive Learning Experience: Where Does the Next Dollar Go
You have money left over each month and five places it could go. Drag them into the order you would fund them, and watch five years play out as the money runs down your list.
Some runs hit you with a job loss and some do not, so at the end you can replay your exact order hundreds of times and see how often it went badly.
Same money in, same investments, and the order alone can cost you thousands.
Infographic: One Investing Mistake Almost Everyone Makes – The Order of Investing
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Where to Invest First: 401k vs Roth IRA vs Everything Else
Imagine making all the right investments, but still missing out on over a million dollars by retirement!
While studying for the CFP® exam, I found the exact sequence professional financial planners reveal to their paying clients to avoid this – and skipping the third step puts your entire financial future at risk.
Step 1: 401K Up To the Employer Match
Your first dollars should be invested to get the most bang for your buck – and nothing beats free money! Here’s how it works.
Most employers match whatever you put into your 401k account, up to a limit. A common setup is 50 cents for every dollar you contribute, up to 6% of your salary.
So if you earn $60,000 and contribute $3,600, your employer adds another $1,800. That’s an instant 50% return. And some employers even match dollar for dollar!
Here’s just how important this is: If you miss out on this $1,800 employer match starting at 25, you’d lose over a million dollars by the time you retire!
So if you have money to invest, definitely contribute up to the full employer match because no investment on earth gives you an instant 50% return.
Once you fully capture that free money, the next step is to get returns over 20% – that’s almost twice as much as the stock market!
Step 2: High Interest Debt
I know you want to just keep investing. But before making any other investment, your next dollar must go toward paying off high-interest debt.
That means anything with more than 8% interest, so personal loans, high-interest student loans, and especially credit cards.
The math is simple. Paying off a credit card at 22% APR is a guaranteed 22% return. The stock market averages around 11% a year over the long run, so paying off debt is the clear winner.
But remember, low interest debt, like your mortgage and low-rate federal student loans, don’t belong in this step. For those, keep the minimum payment and move forward, because investing is more profitable.
But even after paying off high-interest debt, there’s one crucial step that comes before investing.
Step 3: Emergency Fund
It might seem boring or unnecessary, but one of the most surprising things I learned while studying for the CFP® exam is that building an emergency fund is more urgent than investing – except to claim your 401k employer match.
Without enough money saved up, a single emergency like a job loss could force you to take on high-interest credit card debt or withdraw from retirement accounts, which means triggering taxes and penalties.
Ideally, you should have 3-6 months of essential expenses as your emergency fund.
For example, if you spend $3,000 a month but only $2,000 of that is really essential, you should have between $6,000 and $12,000.
But you don’t need the full amount saved up before you start investing – you can build it up along with your investments.
With that safety net fully in place, step four is where the real wealth-building begins – as long as you avoid a costly mistake.
Step 4: Max Out Retirement Accounts
The next step is to max out your retirement accounts.
There are two main kinds of tax advantaged accounts.
In pre-tax accounts, contributions are deducted from your paycheck and you don’t pay any taxes now, but withdrawals are taxed as ordinary income in retirement.
In post-tax accounts, contributions are taxed right now, but you don’t pay any taxes in retirement as long as you follow some rules.
The right one depends on your income and career trajectory.
Generally, if you’re young, early in your career, and expect to be in a higher tax bracket in retirement than you are right now, a post-tax account is better.
This could be a Roth IRA or a Roth 401k if your employer offers one.
But if you’re already earning a lot and expect to be in a lower tax bracket in retirement, a pre-tax account is better. This could be a Traditional IRA or a 401k.
And depending on your household income, you might be able to invest in both an IRA account and a 401k account. The numbers change every year, but make sure to check.
Step 5: College Savings and Taxable Brokerage Account
The next place to invest your money really depends on your personal situation.
If you are already on track to retire comfortably, it might be a good idea to start investing for your child’s college education.
There are many options for this, but the most popular is a 529. Like a Roth IRA, money goes in after federal income tax, but you pay no taxes on withdrawals when you use the money for educational expenses.
And many states allow you to deduct contributions from state income tax.
But if you are behind on retirement savings or don’t think you’ll have kids any time soon, a taxable brokerage account comes first.
Never sacrifice your retirement for your kids’ college, because they can get a loan for college – but you can’t get a loan for retirement.
And the last thing you want is to become a burden on your kids during your 70s.
But even after knowing about the best accounts to use, investors are still making some easy-to-avoid mistakes.
Check this out to find out how to avoid 4 common beginner investing mistakes that could cost you thousands – before you even realize what went wrong: 4 Investing Traps You’re Falling Into (And How to Escape)
