When you get dressed to go for a run, there is a generally accepted order to things that works best. For example, you put on your socks before your shoes, and you put on your shirt before your jacket. Any other way just wouldn’t make sense.
Similarly, in personal finance there is a generally accepted order for your financial milestones. It would make no sense to contribute to a taxable account before a Roth IRA, and it would be quite foolish to start investing for retirement if you were sitting on thousands of dollars of credit card debt at 18% interest.
Although the process of reaching your financial milestones may not be completely linear, and although the order of some of these steps is debatable, you really can’t go wrong it you follow the rough outline I present below. Remember, you should be saving 50% of whatever you make, so take that money and start moving through the milestones.
Milestone #1: Get motivated
You didn’t think I would forget step 1, did you? Remember, you won’t accomplish anything in life if you aren’t motivated. If you’re feeling apathetic, go back and read “What does it mean to be Free?”
Milestone #2: Save up a small emergency fund
When attempting to pay off your debt, the last thing you want to do is to go into more debt. Therefore, it will generally make sense to save up a small emergency fund before you actually start paying off your debt. The exact amount to save is debatable, but a reasonable benchmark would be one month of expenses or around $3000. Some have argued that if you have high interest debt, you should put all money towards the high interest debt before putting anything in a bank account. I think that argument could go around in circles forever, so feel free to swap milestone #3 and #2 if it makes more sense to you.
Milestone #3: Pay off high-interest debt (>8%)
If you have debt, you are losing money by the minute and you have an emergency! You need to get rid of your debt as soon as possible, but the highest interest debt takes highest priority. I will define high-interest debt as an interest rate greater than what you could reliably expect to make from your investments. This would include credit card debt, payday loans, or high-interest private student loans. The expected rate of return from investments is debatable, but a reasonable expectation would be between 5 and 7% after inflation. Remember, as you pay off debt, you are essentially getting a GUARANTEED return equal to the interest rate of that debt. Therefore, any debt with an interest rate higher than 7% should be paid off before investing.
Milestone #4: Contribute to your 401k up to the match
If your employer offers you a 401k match, this is free money and you should not pass it up. Let’s look at an example to see how this works. If you make $5000 per month and your employer offers you a 4% match, then you would contribute 4% of your paycheck to your 401k and your employer would match that 4% contribution. 4% of $5000 is $200, so you would contribute $200 per month and your employer would contribute $200 for an instant 100% return! The astute reader may notice that since a 100% return is higher than even the highest interest credit card debt, it might make sense to switch milestone 3 and 4. You could make this argument, but I’m still going to recommend that you stop your debt hemorrhage before you start doing any investing for retirement.
Milestone #5: Pay off moderate interest debt (4-7%)
Moderate interest debt may include mortgage debt or student loan debt. This rate is very similar to the rate of return that you could expect to get from your investments. Therefore, it is mainly a philosophical discussion as to whether to pay off debt or invest. Personally I hate debt almost as much as Dave Ramsey, so I annihilated my loans before investing. You may feel differently and that’s perfectly fine.
Milestone #6: Save up a full emergency fund
After you have paid off all your high and moderate interest debt, I think it makes sense to save up a sizeable emergency fund, perhaps 3-6 months of expenses, in the case of a job loss, unexpected medical bills, or other catastrophe. Your emergency fund should be completely safe and liquid, so the best you’re going to do is a high-yield savings account with 1% interest. Yes, you are losing money on this account since inflation averages 3%. Some have argued that with a stable job, an emergency fund is not necessary and reduces your investment returns. I can see this perspective but would counter that the purpose of an emergency fund is not to be an investment; it is to create peace-of-mind and security and to prevent any further debt accumulation.
Milestone #7: Max out your Roth IRA
In Use it or Lose It, I explained why the Roth IRA is the best retirement account for MOST people. If you have a very high income (and thus are in a very high tax bracket), it may make more sense for you to max out your Traditional 401k first, since any contribution to a 401k reduces your taxable income. For example, if you are in the 33% marginal tax bracket and you contribute the maximum to your 401k ($18,000), then you will reduce your taxes owed by 0.33 x $18,000, or $6,000. However, if you’re really making that much income, you should have no problem filling up a Roth AND a Traditional 401k each year, so it’s really not an either-or proposition.
Milestone #8: Max out your 401k
If you are able to max out your Roth IRA, then you should put all the rest of your retirement savings into your 401k. If you have a high income (>100K), then I would recommend contributing to a Traditional 401k. This contribution gives you an up-front tax break (as explained above) and will grow tax-deferred until you take distributions in retirement, when you will likely be in a lower tax bracket. If you have a mid-range income (<100K) and your employer gives you the option, you may wish to contribute to a Roth 401k (post-tax contributions, grows tax free, distributions are tax-free). Either way, you’re getting a nice tax break from the government, so don’t neglect it.
Milestone #9: Pay off very low interest debt (<3%)
If you have very low interest debt at a rate less than inflation (think refinanced student loans or excellent mortgage rate), then you may choose to let it sit around since you will be able to earn more from your investments than paying down the debt. This makes mathematical sense, or course. However, if you have a variable rate loan, or if you detest the psychological burden of debt, you may choose to pay this off in milestone #5. I had around 400K in student loans at around 2% variable. Since I was concerned about the potential for rate increases and since I wanted the loans killed, I decided to pay down my debt aggressively rather than saving additional funds in a taxable account. It worked for me, but you may choose to do it differently and that’s probably just fine.
Milestone #10: Contribute to a taxable brokerage account
If you still have money left over to save for retirement after paying off your loans and maxing out your Roth IRA and 401k (lucky you!), then open up a taxable retirement account through a low-cost provider such as Vanguard and Fidelity. Even though the earnings are taxed each year, there are ways to reduce the effect of taxes. Check out this post about the taxable retirement account. Spoiler alert: the fear of taxes is not a reason to avoid a taxable retirement account.
Milestone #11: Earn your Freedom!
This is what it’s all about. If you missed it, check out How to Earn your Freedom.
Caveats
Caveat #1: I presented this timeline in a linear fashion. However, it does not need to be completely linear. For example, I paid off my student loans and contributed to a Roth IRA and 401k simultaneously.
Caveat #2: Depending upon your situation, you may want to switch some of these steps. For example, if you are in an unstable job situation, you may wish to save up a full emergency fund before paying off moderate interest debt.
The Bottom Line
Order matters when it comes to reaching your personal finance goals. I presented a rough outline that you may modify to fit your particular situation or values. The most important thing is to get motivated, save 50% of your income, check off these milestones, and go grab your freedom.
What do you think? Which milestone have you reached? Would you add, eliminate, or change the order of any of the milestones?
I have no high interest debt.
I am in a high income situation (>300k)
My student loans are at 4.6% @285k x9 more years (3300/mo)
I can contribute up to 54k to a 401k out of my income pre tax with no match as I am a part owner (the match comes out of my own paycheck basically)
I have 30k saved in emergency fund.
How would you suggest I appropriate my funds? At this point I’m pretty much doing the student loans by paying the monthly payment and also funding the 401k at about 36k/year (10% of income).
With 2 kids and expenses not much other wiggle room for money month to month until my buy in is done in 2 years. I think I’m net positive in savings month to month but it’s quite variable.
Should I just keep doin what I’m doin or move stuff around?
If I understand correctly, you are saving approximately $76,000 each year ($36,000 in the 401k + $40,000 in loan payments).
First and foremost, are you able to save more than $76,000 per year, perhaps $100,000 per year? This would allow you to max out the 401k ($52,000), 2 backdoor Roth IRAs ($11,000), and complete your scheduled loan payments ($40,000).
If you cannot save more (it sounds like you also have funds going toward the buy-in), then I think your current plan is reasonable. The interest rate on your student loan is in the moderate interest rate category and you might be able to get a higher return with investing, so you don’t necessarily NEED to stop all investing and pay off the loans ASAP.
As I mentioned in my post, with moderate interest rate loans, it is mainly a philosophical discussion as to whether to preferentially pay off your loans or invest. If you hate debt or think investment returns will be low, then stop investing, refinance the loans at a 5 year variable at 2.5%, and then throw everything at the loans and kill them off in 3 years. If you don’t mind debt and prefer a mathematically superior solution, then pay the minimum payments on the loan and throw everything else into your 401k. I would try to max out your personal and spousal Roth IRAs as well each year, but if you really prefer to maximize the up front tax break (with the 401k), then you could probably hold off on Roth contributions for a few years and be just fine.
As you can see, this can get complicated fast, but try not to sweat the details. You’re doing a good job saving, you are working towards partnership (with likely savings > 100K per year), and you will soon be checking off all the financial milestones.
I hope this helps. Please let me know if you have any other questions.
Thanks for the info. Yea it seems my situation is a bunch of compromises that all basically wash out in the end. So i’ve kind of taken the 50% road on all. I had my student loans on a 6.2% x25 year repayment until last year refi, so at least I am getting ahead of that now. I feel better putting pre tax money into the 401k than I would putting more on a 5 year repayment because I would probably lose half of my contributions at least doing that.
At this point it might be tough to get another 24k each year. It would be close and things are too variable right now for me to tell. Because it would be 20k more pre tax and then 11k more post tax, which is around 2k/mo post tax. I think I can do it and after the buy in is done I definitely can. I am putting that much in a separate account to see if it can be done, and while I haven’t dipped into it more than once so far in the 4 months I’ve been doing it, I have had to use it to keep my emergency fund healthy.
I have the option of putting up to 18k of my 54k 401k in as a Roth contribution as well. Not sure if that takes out my backdoor ability or not though. Haven’t done that yet due to my high tax bracket. If I had an excess of funds monthly I would but I don’t think we are ready to lose that pre tax contribution yet.
Thanks!
This is great! I love lists that give people a general idea of how to achieve FIRE. It’s not a hard thing to plan, per se, but it’s difficult to execute. It requires rewiring your brain and your daily life to save 50%+ of your income. But it’s possible and worth it. 🙂
I do agree with investing in a 401k if your employer offers a match, even if you’re in debt. That’s thousands of dollars of free money that you’re forfeiting and it isn’t worth it to skip out.
Thank you for the feedback. I’m glad you appreciate the structure of a list. One of my goals with this site is to create an organized “roadmap” that will eventually read like a book, but will be prepared one piece at a time like a blog.
Love the timeline. First time I’ve seen something laid out clearly like that. Thanks!
I’m glad you found it helpful! I tried to make it straightforward by presenting it in a linear format, but in actuality, many of these milestones can be tackled concurrently, and some may wish to change the order of these steps to fit their unique situation.