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If you’ve read anything of mine before, you’ve heard the typical spiel and know I talk about the importance of saving money, paying down debt, investing, and planning for the long term. But what should you do, you might ask, if you understand all of that but can’t do everything at once right off the bat?
For folks working their way up the career ladder, paying off student loans, trying to accumulate some savings, and thinking about starting to invest in the stock market, it’s okay if you can’t do everything at once. If you’re still in the early stages of getting started with your financial future and working within a budget, here is a checklist for how I would prioritize the different options at your disposal.
1. Pay down debt.
When in doubt, pay off debt. This provides an immediate and guaranteed return to you in the form of less interest you’ll need to pay in the future. If you are dealing with multiple forms of debt, start by paying off the highest-interest debt (like credit card debt) and then work your way down through car loans and student loans. The less debt you have, the more financial flexibility you will have in the future.
2. Build up an emergency savings fund.
Have a goal to set aside some cash in a savings account that you can use just in case of an emergency (like losing a job, having an accident, or needing cash upfront for some other purpose). A common rule of thumb is to save the equivalent of what you pay on expenses over three months (so think about what you pay on rent, car payments, food, and so forth over three months).
3. Maximize your 401(k) match at work (if applicable).
A 401(k) is a vehicle to save and invest for retirement offered through many employers. Most workplaces will incentivize employees to save and invest with an “employer match,” which essentially means that your employer will match anything you contribute to your 401(k) dollar-for-dollar up to a certain amount.
In other words, if an employer has a 2% match, when you put 2% of your salary into your 401(k) the employer would match those contributions — meaning you’d double your contributions from 2% to 4%. Free money.
Usually an employer will give you options of different index funds and mutual funds you can invest in through the 401(k), and the best option is typically to go with the lowest-cost funds (like something from Vanguard). You can contribute up to $18,000 of your salary each year to a 401(k) — not something that you’ll be able to do right out of the gate — but make it a priority to get the most of the employer match. This is the closest you’ll get to free money for retirement — don’t waste it!
4. Open (and fund) a Roth IRA.
Another effective place to invest money for the long term (e.g. for retirement) is through a Roth IRA (IRA stands for Individual Retirement Account), which is a type of investment account that has numerous tax advantages. While you contribute your after-tax dollars to the Roth IRA today, that money will be tax-free when you get to the point around retirement when you can start withdrawing money from the account. This makes a Roth IRA especially attractive for young adults who have decades in front of them to invest and grow their wealth — and eventually use the Roth to provide tax-free income in retirement.
The maximum contribution for a Roth IRA is $5,500 per year, so you should be able to get close
to maxing this out fairly early in your career. At the least, contribute what you can to a Roth after you’ve paid off high-interest debt, built up an emergency savings fund, and maxed out your 401(k) match at work. Roth IRAs are another nice option because there are possibilities to withdraw the money before retirement — without any penalties — to do things like pay the down payment on a house. You can also withdraw the principal at any time without a penalty.
A good starting point is to invest in low-cost index funds from a provider like Vanguard. If you’re feeling adventurous and inspired, you might want to consider investing in individual stocks — which means you can directly own a piece of companies like Starbucks, Walt Disney, Apple, and many others.
5. Open (and fund) an individual taxable brokerage account.
Once you’ve maxed out your 401(k) employer match and Roth IRA, you’re in a perfect position to start funding an individual taxable brokerage account. This is similar to an IRA — it’s an account where you can buy and sell stocks, funds, and so on — just without any of the tax benefits (but you’re also able to add/withdraw any amount of money from the account without facing any penalties).
There is one key tax advantage within an individual account like this — if you hold a stock or fund for at least one year and it’s gone up in value, you will only be taxed at a capital gains rate of 15% when you sell. (If you sell within a year you’ll be taxed at your individual tax rate, which is likely higher than 15%.) Any stocks or funds you buy you should intend to hold for much longer than one year, anyway, so this is simply one more perk of planning for the long term with any money you invest in the stock market.
The Bottom Line
This checklist can serve as a framework to set your financial priorities even as you’re starting out. Whether it takes you months or years to work your way through each of these five steps, the key is to just get started and to do what you can. You don’t get extra points for waiting until you can do all five at once. Starting small is far better than not starting at all.
If you have other questions, comments, or ideas related to this framework — let us know!
Follow David on Twitter @David_Kretzmann.
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