Pay Yourself FIRST — Build the Personal Finance Ladder
In my previous article I have provided a list of books and resources to help you learn more about personal finance. This article will primarily focus on creating and managing banking and investment accounts and provide a summary of investment account options available and how we would want to prioritize them to get the most bang for our buck!
Note that, there is no perfect answer for this topic and the accounts that you may want to create and what’s available to you can vary widely from one individual to another. You should assess your financial needs and check what makes the most sense to you.
If you want to strive to achieve financial independence early in your life you should develop the habit of paying yourself first! As soon as you receive your paycheck every month, make sure you save and invest before you decide to make other purchases. Many articles and literature suggest saving at least 15% to 20% of your gross income for retirement. If you save more and invest your hard earned dollars early, you will be much better off in the long run. Check out my article on the power of compounding and ways to save on monthly expenses.
As you pay yourself first, try to get rid of your non-mortgage debt and at least pay off high interest rate credit cards. Save enough so that you are not stuck in reverse gear because of high interest rate debt. Pay your credit cards in full each month or at least pay the statement balance every month. Staying debt free will enable and empower you to save and invest more. Now let’s discuss the various accounts that you may want to open and contribute to to achieve financial independence.
Personal Finance Ladder
Emergency Fund — as you master the art of managing and eliminating your debt, the very first thing you should focus on, is to save enough for the rainy day. Save at least 3 to 6 months of your monthly expenses. You can save more given your needs. It is good to have these funds liquid and saved in a high-yield savings account (HYSA) so that you can access it easily. Lot of online banks provide higher interest rates compared to brick-n-mortar banks. If your monthly expense is $5,000, you should save at least $15,000 to $30,000 in your emergency fund.
Employer sponsored 401(k), 403(b), 457, Thrift Savings Plans — these are retirement accounts offered by employers where an eligible employee can make contribution on pre-tax basis. The amount contribution amount is deducted from paychecks. Most employers also match employee contribution up to a certain percentage. For e.g., employers will match up to 3% dollar for dollar. Let’s say your base salary is $65,000/year. This will result in bi-weekly payments of $2,500. So, if you contribute $75 (3% of 2,500) biweekly, your employer will match that amount and also contribute $75 to your 401(k) account bi-weekly. That is $1,950 just from the employer on annual basis. Make sure you at least contribute the minimum amount, so that you get the full employer match. That’s free money! The amount that you and your employer contributes is invested in a curated list of mutual funds that are part of the 401(k) plans. The money grows tax deferred and withdrawals are subject to income taxes since you did not pay any taxes on your contributions. The employee contribution to 401(k) and Roth 401(k) cannot exceed the limits set by the IRS and any other plan limits that may exists. Refer to IRS’ website to learn more about contribution limits, age limit for withdrawals and catch up-contribution limit.
Roth 401(k) — Some employer sponsored retirement plans may also offer a Roth option in addition to pre-tax 401(k). The amount is contributed after tax to a Roth 401(k). However, earnings grow tax deferred and withdrawals are tax free. So if you expect that you will be in a higher tax bracket later in life, a Roth option can be more appealing to you. The employee contribution to 401(k) and Roth 401(k) cannot exceed the limits set by the IRS and any other plan limits that may exists. Refer to IRS’ website to learn more about contribution limits, age limit for withdrawals and catch up-contribution limit.
After you have your emergency fund set up, prioritize contributing enough to a 401(k) and/or Roth 401(k) so that you are at least getting the full employer match.
Health Savings Account (HSA) — this is a triple tax-advantaged account where your contributions are done on pre-tax basis, the money grows tax-deferred and the withdrawals are tax free for qualified medical expenses. Note, you need to be eligible to be able to contribute to a HSA. Refer to IRS’s website to learn more about the eligibility and annual contribution limit. Some employers offer HSA accounts where the contributions are deducted from your paycheck. However, if your employer does not offer an HSA and you are eligible, you can open a HSA account by yourself.
If you are contributing enough to your employer sponsored retirement plans to get full employer match, the next account you may want to consider is a HSA.
Individual Retirement Arrangements/Accounts (IRA) — these are retirement accounts that provide tax advantages that you can open yourself with any brokerage firm of your choosing. Unlike employer sponsored retirement plans, an IRA has more investing options and you select stocks/mutual funds that you want to invest in. Generally, there are two widely known IRAs. Refer to IRS’s website to learn more about contribution, income, age limits and required minimum distribution and also a comparison between different IRAs.
- Traditional IRA — you can contribute to a traditional IRA if you have taxable compensation. Contributions you make to a traditional IRA may be fully or partially deductible as determined by your tax filing status. The amount in this account grows tax deferred and generally the money is not taxed until you take a distribution. If you think your tax rate is high now and you will be in a lower income tax bracket in your retirement, then contributing to a traditional IRA can be appealing to you.
- Roth IRA — This is different from Roth 401(k)! You can contribute to a Roth IRA if you have taxable compensation. Contributions you make to a Roth IRA are not deductible. The amount in this account grows tax deferred and qualified distributions are tax free. If you think your tax rate will be higher later in life, then contributing to a traditional IRA can be appealing to you. Unlike 401(k) plans and traditional IRA, you are not required to start withdrawing from your Roth IRA once your reach a certain age. So, the amount in your Roth IRA account can grow tax-deferred forever and you enjoy tax free qualified distributions.
If you are contributing enough to your employer sponsored retirement plans to get a full employer match and have maxed out your HSA, consider contributing to a Traditional and/or Roth IRA.
529 Plans — if you are planning to save for your child’s education, a 529 plan is a tax-advantaged savings plan that is designed to help pay for qualified educational expenses. You can also use this amount in this plan to pay for K-12 education expenses. The savings grow tax deferred and withdrawals are tax free for qualified educational expenses.
Once you have maxed out your HSA and IRA contributions, consider maxing out your contributions to 401(k) and/or Roth 401(k) and contribute to a 529 Plan, if needed.
Taxable Brokerage Account — if you have additional savings left to invest after you have leveraged all the aforementioned accounts to its full potential, you can open a taxable brokerage account at a financial institution/brokerage firm of your choosing. You fund this account using the money that has already been taxed. Any earnings resulted from sale of investments is subject to income taxes. You would pay short term or long term capital gains tax depending on how long you had held your investments.
Fund this account after you have taken advantage of all above mentioned tax advantaged accounts.
After-Tax 401(k) — Now what the heck is this? Feeling perplexed and dizzy? I wouldn’t be surprised! Some employer sponsored plans also offer this option in addition to pre-tax 401(k) and Roth 401(k). If this source is available to you, you can contribute to this source in addition to total limit set by IRS for pre-tax 401(k) and Roth 401(k) combined. As the name suggests, the contributions are deducted from your paycheck on after-tax basis. The amount grows tax deferred and any earnings are subject to income tax on withdrawals. Your employer sponsored 401(k) plan may also allow for “In-Plan” Roth conversion of after-tax 401(k) or may allow you to rollover your after-tax 401(k) to your Roth IRA account.
These are some of the investment accounts that may be available and you may be eligible to contribute to. The goal of this article is to present you with some options that you need to be aware of. Please refer to IRS’ website for more details and contact your HR representative at your firm to see if you qualify for any retirement plans. My intention is to provide you a gist of what’s out there and how you may want to strategize and leverage several tax advantaged accounts. If you are curious, you may also want to check other accounts like SEP IRA, SIMPLE IRA, UGMA/UTMA accounts and see if you qualify for any of those. Sky is the limit!
The key takeaway is to get good handle on managing and leveraging various investment accounts and contribute enough given the target time horizon and target goal you have in mind for your retirement. So, do your homework, save enough and start investing early. Consistently saving and investing even small dollar amounts can help you accumulate enough wealth in the long run. Every cent counts! Every Cent you put to a good use, has a ton of Potential to grow!
This article is for information purposes only and should not be misconstrued as financial advice. The details in this article may not be accurate. Please do your own due diligence and consult a professional financial advisor if you need help before making any financial decisions.
