The Financial Planning Ladder

I’ve been there before.  Barely making ends meet and just trying to build up  an emergency fund so that I could stop going further into debt.  Trying to decide if I should raise my 401(k) contributions, pay off debt more quickly, or start a Roth IRA.  Then I would need to get my tires changed or my furnace fixed and the credit card debt just piles up again.  Recently, I’ve been lucky enough to have higher income and therefore more flexibility with my savings.  Now, the problem becomes how to best maximize my tax-friendly savings. The question I now may ask is, “What do I do after I max out my 401(k) contributions?”  No matter what your income may be, we have a finite amount that we can save and pay down debt.  This post will guide you on how to spend your extra money no matter where you are financially.   

Let’s start with a  chart that explains the different steps in the financial planning ladder.  

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I’ve broken the chart down to 3 categories: The Basics, Max Out Savings, and No More Tax Friendly Savings.  You may never get up to the point in which you are maxing out all of your savings and making extra payments on your mortgage.  That’s all right, but absolutely you should  have a plan to complete all of the Basic tasks in the next few years.  Don’t be frustrated that you may never max out your after-tax 401(k) contributions.  The goal here is to give you an idea where you should be saving your money, no matter where you are financially.  Let’s start off with The Basics.  

 

  1. Minimum Debt Payments & Matching Contributions

 

We have to start at the beginning, and making minimum payments on credit cards, student loans, and a mortgage is the bare minimum.  Yet, we can’t stop there, as at the same time you have to contribute enough to take full advantage of the employer match on your 401(k) or 403(b).  If your employer doesn’t offer matching contributions, contribute at least 5% to your employer retirement plan or an IRA.  I’ve heard people tell me that they will start contributing to their 401(k) once they pay off their debt in a few years.  This isn’t acceptable, as you need to always be making contributions to your retirement savings and the earlier you start the better you will be in the long-term.  You are much better off contributing a little now as opposed to waiting and trying to play catch-up later.  I know that making minimum payments on your credit card and student loan debt isn’t going to get it paid off quickly, but this is the starting point.  The goal isn’t to stay at the base level forever, instead move up the ladder once you finally are consistently able to meet your minimum debt payments while saving for retirement.  

  1.  Build Up an Emergency Fund

It may seem odd that building up an emergency fund  comes so early in the financial planning process.  The reason that an emergency fund is so important is that it helps you avoid going further into credit card debt.  If a person doesn’t have an emergency fund and has a money issue, this will almost automatically force him to go further into debt.  The emergency fund allows you to tap into your savings and not fall further into debt every time a money issue comes up.  Typically, a financial advisor will recommend 3-6 months of known expenses saved up for an emergency fund.  This would be ideal, but let’s start slower than that this early in the financial plan.  Save one month of your pay in a savings account, but make it a minimum of $5,000.  For example, if you currently make $4,000 per month, you would save $5,000 for an emergency fund.  If you are currently earning $6,000 per month, you will want to save $6,000.  This isn’t a vacation fund, or a buy a nice gift for your wife fund, this is a use in the case of emergency so that you don’t fall further into debt fund.    

  1.  Raise your Retirement Savings to 10% of your Income

As discussed earlier, you need to contribute at least the minimum to your retirement savings to get your employer match, or 5% if you don’t have an employer match.  The next step is raising your contribution to 10% of your income.  This 10% is only your contribution and doesn’t include any employer matching contributions.  Raising contributions from 5% to 10% of your income overnight won’t be easy.  If you can’t do it all at once, raise your contributions by 1% per year or if you get a pay raise, increase your 401(k) contributions by half of the pay raise.  The goal is to contribute 10% of your income to retirement savings, but remember not to sacrifice your emergency fund to raise your retirement savings further.  

  1.  5-Year Debt Free Plan

When we talk about debt here, we are talking about revolving debt, like credit card debt.  We are in no hurry to pay off a mortgage here and paying off all of you student loans within the next 5 years may be impractical.  If you have over $50,000 of student loan debt, paying off your debt within 5 years will be very difficult, and you will want to create a 10 year pay off plan.  Credit cards though typically have very high interest rates and should be the first debts to pay off.  Yet, the mistake a lot of people make is feeling like all of their debt needs to be paid off immediately.  Sure the faster the better, but paying off debt takes time and it is a lot easier to do it moderately over a 5 year period as opposed to getting it all paid off at once.  What I see many times is a person throwing too much of their savings towards credit cards to pay it off faster, leaving them with no savings.  Then, another financial emergency comes up, and he has to go right back in credit card debt.  Instead a 5 year plan allows you to steadily make progress on your debt.  This Credit Card Calculator allows you to calculate the monthly payment that you need to make on your credit cards to be debt free in 5 years.   

  1.  Max Out HSA Contributions

You may find it odd that the first savings account that we max out each year is the Health Savings Account (HSA).  Now, this is only applicable for people that have access to an HSA but as companies attempt to keep healthcare costs down, more and more are going towards HSAs.  There are two reasons why maxing out your HSA is so important:  

  1. HSAs are the most tax advantageous accounts available
  2. Health care costs are rising rapidly, and it is important that you have access to an HSA to help pay for healthcare costs in retirement and before if necessary.  

HSAs have a triple tax advantage.  Contributions into an HSA are tax deductible, HSAs grow tax-free and HSAs can be withdrawn tax-free as long as used for healthcare costs.  This triple tax advantage is a huge benefit, and no other savings account compares.  

I’ll make two more suggestions in maximizing your HSA benefit,  Make sure that you are investing the HSA and the money isn’t just sitting in cash.  As I mentioned before, HSAs grow tax-free so the greater the investment growth, the more advantageous the HSA.  Also, try not to use the HSA, rather let the money grow and use other savings to pay for healthcare costs prior to retirement.  Trust me, you will have plenty of healthcare costs in retirement, don’t worry about saving too much in your HSA.  

  1.  Max out Pre-tax/Roth 401(k) limits

By this point you are already contributing at least 10% to your retirement savings. Now, it is time to max out the pre-tax/Roth savings limit. For 2018, your 401(k) maximums are $18,500 if under age 50 plus another $6,000 if over the age of 50. These limits can be all pre-tax, all Roth contributions, or a combination of both.

The Roth option makes sense the younger that you are and the lower the tax bracket. The pre-tax savings option will usually be better for people closer to retirement and who are in a higher tax bracket. The Roth 401(k) makes sense when you are younger because the Roth 401(k) will grow tax-free until you withdraw the funds in retirement. The longer that you can allow those funds to grow, the better off that you are. Also, many times we make less early in our careers so we are in a lower tax bracket which is advantageous when you are making Roth 401(k) contributions as the money goes in after-tax. A rule of thumb that I use is that if you are under age 45 make Roth contributions, over the age of 45 and pre-tax contributions are the way to go. This is just a rule of thumb though and many people are better off continuing to make Roth contributions even up to retirement. Trust me, you won’t be upset having a lot of tax-free income in retirement.

  1.  Max out Your Roth IRA

Yes, you can max out your Roth IRA as well as your 401(k). Roth IRA contributions are capped by the amount of income that you earn and not by how much you contribute to your employer sponsored retirement plan. Typically, only higher income earners have the ability to max out their 401(k) limits, therefore you may not be able to max out your Roth IRA as well. In 2018, a single person can no longer make Roth IRA contributions if income is over $121,000 and over $199,000 if married and filing a joint tax return.

If you have a large amount of after-tax savings, not including your emergency fund, and are under the Roth IRA income limit you should be funding your Roth IRA every year. Moving the money from after-tax savings to a Roth tax-free savings account is a huge benefit. If possible you can “convert” a small amount of this after-tax money to tax free money each year. If you are married, both you and your spouse can make Roth contributions, depending on income limitations, even if your spouse isn’t working.

  1.  Max out your After-Tax 401(k) limits

At this point we are running out of tax efficient savings options, but a few years back the government gave high savers a major tax break. First, if you exceed the pre-tax and Roth 401(k) limits as discussed above you will start to make after-tax retirement contributions. The money goes into your account after-tax, but unlike the Roth 401(k), you have to pay taxes on any gains from this after-tax account when you start taking distributions. Still, the money grows tax deferred which is better than just sticking the money in an after-tax savings brokerage account. In 2018, the most that can go in your 401(k) is $55,000 plus the potential $6,000 catch-up contribution. This $55,000 is the total amount that both you and your employer combined can contribute in a year. This allows you to potentially put away a significant amount of after-tax savings each year.

As I mentioned earlier, the government recently made making these after-tax contributions much more attractive. Typically, these after-tax contributions grow tax deferred and you pay taxes on any gains when you withdraw the funds in the future. The government decided that you can now convert this after-tax money to Roth accounts completely tax free. This conversion allows the money to now grow in a Roth 401(k) or IRA tax-free. Many companies allow you to do an in-service conversion where the money stays right in the 401(k) plan.  It is important to remember that you can convert your after-tax contributions tax free but any growth will be taxed if converted.  Therefore, converting after-tax assets should happen on a frequent basis to avoid paying large amount of taxes on this growth.  This is a great way to make “backdoor” Roth contributions even when your income is too high to make Roth IRA contributions.

  1.  Pay Down the Mortgage

If you have made it to this point congratulations, but unfortunately you have really exhausted all of your tax friendly savings accounts. Not only is paying down your mortgage not helpful for taxes, it potentially hurts your tax deductions. Yet, for many people paying down a mortgage ranks much higher on this list. Truthfully, paying off a mortgage, especially when interest rates are high, can be a huge benefit. With rates near an all time low today though, paying down a mortgage which is basically free money (yes, a 3 or 4% tax deductible interest rate is essentially free) isn’t as attractive. The general rule is that you only want to pay down debt when the interest rate on the debt is higher than the rate that you can realistically get investing your money. I would hope that you could earn more than 3 or 4% on your investments over the long term.

The benefit of paying off a mortgage is having lower expenses in retirement. Therefore, if the goal is to pay off a mortgage, you don’t necessarily need to do it today or next year, instead shoot for having it paid off the year in which you retire. Obviously, if you are planning on retiring in the next year or 2 and have a large mortgage balance putting a lot towards your mortgage now may not be that beneficial. Also, if you aren’t going to even keep your home in retirement it really isn’t necessary to try to get the mortgage paid off early. Instead your savings can be invested, hopefully at a higher rate than your interest rate, and then can be used to buy your new home.

The scenario in which paying down a mortgage makes sense to me is if you have a relatively low balance in which you can actually make a meaningful impact on before retirement and you will stay in the same home in retirement. If not, you may be better off just saving your money in an after-tax savings account which allows you to spend the money anyway you please in retirement, including buying a new home.  As a reminder, read this article  about why you shouldn’t take a large IRA distribution to pay off a mortgage.

  1.  Contribute to a Brokerage Account

Well you’ve officially made it to the last place to put your money. Sure you could go out and buy a vineyard or rental property but we are being a little more realistic here. Once you get to this point, you have exhausted all of your tax efficient savings options and you are forced to put the rest of the money into an after-tax brokerage account. Unlike the other savings options that we discussed, each year you will need to pay taxes on any realized gains, dividends, and interest. Therefore, the investment strategy must be different from the Roth or pre-tax accounts that we discussed previously. The investment strategy in an after-tax account should focus on tax efficiency and limit taxable interest in the account. Obviously, it should not stop you from making money, just limit the taxes you pay on that money.

Although there is a tax disadvantage to an after-tax account, it comes with its advantages as well. The biggest advantage is that you have much more flexibility on how you use the funds. The other savings accounts really are for retirement and taxes and penalties will be potentially be assessed if withdrawn for other reasons. You can use an after-tax account for anything and even large distributions should come with minimal tax liability.  This money could be used for education, to pay the Roth conversion tax liability in retirement, or even just for a long, needed vacation.

This financial planning ladder should give you an idea on where to put your money next, but this isn’t set in stone.  For example, you may want to buy a home and saving for a down payment is important.  Or, maybe you are trying to save for college costs and that is more important to you than putting extra money away in retirement savings.  Still, you need to be hitting all of your Basic Goals up above before doing any college savings or putting money away for a down payment on a new home.  Once you are hitting the first four steps above, then you can consider other financial goals.  If you’re like me, you are deadly afraid of climbing up ladders.  Climbing up the financial ladder may feel about the same, as each next step up could result in a fall.  Also, count on going up and down steps before reaching the top of the ladder.

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