At risk of stating the obvious, you need money to make money. What’s less obvious is where and in what order to save and invest. After all, everything from tax-advantaged retirement accounts to your cousin’s new start-up seem like possible places to put your hard-earned money.
However, just because you can invest in certain things does not mean you should. If you want to maximize your long-term wealth, you can not haphazardly allocate your dollars. You need a plan – a systematic way to order your savings and investments. While these do not need to be hard and fast rules, they can serve as good rules of thumb to go by.
First, tackle any high-interest debt
Before you invest a dime, consider eliminating all your high-interest debts first. Prioritize paying off your credit cards, payday loans, and any other types of debt charging double-digit interest rates. (However, debts with comparatively lower interest rates like mortgages and auto loans are fine to keep around.)
There are two advantages to this strategy. For starters, axing these burdensome debts can help you sleep better at night. But it’s also good for your financial well-being since you’re effectively earning back the interest you’d otherwise have to pay.
Second, build an emergency fund
Now that your high-interest debts are gone, it’s time to establish an emergency fund. Also known as a rainy-day fund, this stash of cash will serve as your financial cushion if you ever lose your job, require medical care, or experience some other kind of emergency.
In general, try to put away at least 6 months’ worth of expenses, though you can always err on the side of caution and save a little more. For best results, house your emergency fund in a high-yield savings account or a money market fund, like Vanguard’s Federal Money Market Fund (VMFXX).
However, do not worry too much about maximizing yield here. Even if your money is just sitting there collecting dust, it’s no big deal. In fact, that’s arguably the point – to have a stable, readily accessible pool of cash handy for when you need it the most.
Next, contribute to your retirement accounts
Now that you have your short-term financial needs met, it’s time to save and invest for the long-term in a tax-efficient way.
On the retirement front, you can contribute to a traditional or Roth Individual Retirement Account (IRA). With a traditional IRA, your upfront contribution is tax-deductible – and money, once inside the account, compounds on a tax-deferred basis. Upon withdrawal, earnings are taxed as ordinary income.
On the other hand, Roth IRA contributions aren’t tax-deductible. However, funds inside the account become tax-exempt, and you’re neither taxed on earnings nor withdrawals.
In 2022, you can contribute up to a total of $ 6,000 (plus an additional $ 1,000 if you’re 50 or older) to either type of IRA, though Roth contributions are subject to additional income restrictions. To be eligible, single filers must have a Modified Adjusted Gross Income (MAGI) of under $ 144,000, and married taxpayers’ combined MAGI must not exceed $ 214,000.
If your employer offers a 401 (k), you can make use of those as well. In 2022, you can contribute up to a combined $ 20,500 (or up to $ 27,000 if you’re 50 or older) in traditional or Roth 401 (k) s.
401 (k) contribution limits are in addition to IRA limits, so you can potentially sock away $ 6,000 (up to $ 7,000) in your IRA and $ 20,500 (up to $ 27,000) in your 401 (k) in the same year. Of course, this is a significant sum, so do not fret if you can not hit these limits – though if you can, that’s great! Instead, try to at least max out your employer match if possible.
Then, consider other tax-advantaged savings accounts
Retirement accounts aren’t the only ones with built-in tax advantages. If you have a Health Savings Account (HSA) or have established a 529 college savings plan for a child, consider contributing to those investment accounts as well.
HSAs must be paired with a high-deductible health plan (HDHP) and are subject to annual contribution limits. In 2022, individuals can save up to $ 3,650, while families are limited to $ 7,300. Individuals 55 and older can make an additional $ 1,000 “catch up” contribution.
What this means for you
Finally, if you still have money left over after maxing out all your tax-advantaged accounts, you may consider saving and investing in a taxable brokerage account. Or, maybe you can treat yourself a little bit – you decide!
Either way, the message is straightforward: save in a strategic and tax-efficient order that maximizes your short- and long-term financial well-being.
Keep enough for now that you can cover your bills, pay down debt, and weather rough patches – but also save enough for retirement, medical bills, your child education, and other major expenses that might come up in the future.