When you’re first getting on your feet financially, it can be difficult to figure out what to do with your money.
You hear so many ideas that it gets overwhelming.
The overwhelm could cause you to do nothing or even spend all of your money rather than trying to figure out the best use for it.
Luckily, there is a fairly easy path to follow when you’re ready to start saving and investing your money.
While this path may not be perfect for everyone, it’s what I would do if I was just starting out again.
Small Emergency Fund
The first place you should put your money to work is in a small emergency fund. Each person’s finances are different, but I recommend at least $500 to $1,000 for a small emergency fund.
This money will cover many common emergencies without putting you into debt. If your car breaks down and needs a minor repair, $500 or $1,000 should cover it in many cases.
What if you get sick and need to go to the doctor? $500 to $1,000 should cover the bill assuming you have health insurance. That said, larger emergencies can still get you in trouble. If you break a leg, $500 to $1,000 may not be enough depending on your insurance.
It’s tempting to want to stock a full emergency fund up front, but doing so wouldn’t be the best use of your money. Instead, you should consider taking care of these priorities first.
Retirement Plan Match
After stocking a small emergency fund, you should go for your employer match on your retirement plan at work. While not all employers offer this, many do. If your employer is one of them, you have to take advantage.
Why? It’s free money. Let me explain.
When an employer offers a retirement plan match, such as a 401(k) matching contribution, you essentially get free money if, and only if, you contribute to the plan.
While each plan is different most either match dollar for dollar for the first few percent of your contributions or at a ratio such as 50 cents per dollar contributed. For instance, my last employer matched the first four percent of our contributions dollar for dollar.
The Best Rate Of Return I Get
Every time I put one dollar in my retirement account up to the first four percent of my salary, my employer would put in an additional dollar for free. How sweet is that?
I automatically received a 100 percent return on my investment, a return I could get no where else.
Even if my employer only matched 50 cents per dollar up to four percent, I’d still take the free money. After all, a 50 percent return is amazing, too.
The only time you shouldn’t go for your employer match is when you know with 100 percent certainty that you’ll leave your employer before you own your employer contributions, a concept called vesting.
In some companies, you’re fully vested immediately. In others, it takes seven years to fully vest in the employer contributions.
Don’t skip this free money if you’re being cheap. Only skip out if you know for certain you’ll never see it because you won’t vest before you leave.
After getting a 50 or 100 percent return on your investment, where is the next best place to put your money?
Pay Off High Interest Rate Debt
After getting a 50 to 100 percent return on your investment, everything else is pretty disappointing. Unfortunately, you’ll never see the guaranteed 50 to 100 percent return in any other traditional investment.
Instead, you’ll have to deal with lower earnings on your investments.
One of the best ways to get a guaranteed return on your investment is by paying down debt, especially high interest rate debt. If you’ve had a rough time, credit cards interest rates can reach 29.99 percent or more.
Paying off that debt is a 29.99 percent return on your investment.
What qualifies as high interest rate debt is up to you, but I normally say six or eight percent or higher is high interest in my book. Of course, if inflation rises, the benchmark would likely rise as well.
Paying off your debt only works if you’ve vowed to stop taking on consumer debt. If you keep incurring more debt, you’ll never escape this stage and start your journey to wealth.
Paying off your debt puts you in a great position to continue saving. As your payments disappear, you’ll have more money to pay down other debts or start saving and investing even more.
After your high interest rate debt is gone, it’s time to take the next step.
Fully Fund Your Emergency Fund
A fully funded emergency fund puts you in a great financial position. If something awful and unexpected happens, you won’t have to go into debt to fix the problem.
Whether your car gets totaled in a freak accident or you lose your job, you’ll be covered for at least a little bit.
The size of your emergency fund will vary from person to person, but my wife and I like to keep six months of expenses in ours.
We keep our emergency fund in a high yield savings account. Learn more about Savings Builder accounts by CIT Bank in our review.
You could have as little as two months of expenses in your emergency fund if you’re single and work in a high demand industry.
Alternatively, you may have as much as a year’s worth of expenses in your emergency fund if you would have a hard time finding a new job and have a large family that depends on you.
It can be tempting to move on to the next steps before your emergency fund is full. However, doing so would be a major mistake.
The emergency fund is your way of not falling into the bad financial habits you may have had in your past. It allows you to avoid incurring debt for emergencies, which can quickly lead into incurring debt for consumer purchases again.
Filling an emergency fund is well worth the wait.
Retirement And Other Financial Goals
After filling your emergency fund, it’s time to start saving for short and mid-term goals and investing for long term goals, including retirement.
Your money will need to be split between your saving and investing money between the shorter time frame goals and retirement. The mix may change at different points in your life.
What matters is you keep saving and investing.
Retirement savings have a pretty straight forward process to follow, while the process for short and mid-term savings may vary based on your goals and time frames. First, let’s tackle the more immediate goals.
Short To Mid Term Goals
Short term goals are goals you want to accomplish in the next year. Due to the limited amount of time you have to save for these goals, you can’t risk investing or you may not have enough money to accomplish the goal on your goal date.
Keep short term goals in cash in a savings account.
Mid term goals can take anywhere from more than a year to as long as five or ten years. On the shorter end of the spectrum, I still recommend keeping the money for your goals in cash.
However, after three to five years, it starts to make sense to invest the money so you don’t lose buying power to inflation.
If you do decide to invest, make sure you’re comfortable with either not reaching your goal or postponing your goal. A downturn is all it takes to drop your investments enough to make you miss your goal, even with lower risk, lower return investments.
If you absolutely must reach a particular goal by a set date, cash is the way to go in my book.
Roth IRA Or IRA
After getting your employer match, an IRA or Roth IRA is my favorite place to start putting retirement funds.
Why? You get to choose where you open your IRA and you get to choose what you invest in. You’re not stuck with your employer’s choices, which sadly sometimes come with high fees and poor investment choices.
Personally, I keep my Roth IRA at Vanguard and invest in their index funds due to their low cost structure. The low cost structure means I get to keep more of my investment earnings every year.
There are plenty of other great options out there, too. What’s important is you pick one, open an IRA and start contributing.
But what is the difference between an IRA and Roth IRA? While there are many differences, the most important in my mind is the taxation.
With an IRA, you do not pay taxes on the money you contribute to the account, but you have to pay taxes when you take the money out in retirement. With a Roth IRA, you pay taxes on the money you contribute now, but pay no taxes on what you take out in retirement.
No One Knows The Future
Just like you, I don’t have a crystal ball. I don’t know if taxes will be higher or lower in the future. Personally, I picked a Roth IRA because I know how much money I’ll be able to take out for certain.
With a regular IRA, taxes could easily eat up a large portion of my retirement money down the road.
No matter which option you choose, IRAs and Roth IRAs have contribution limits. Each year, the IRS states the maximum amount you can contribute, which you can find here.
It isn’t a huge amount, so you’ll have to find another place for additional retirement funds after you max out your IRA or Roth IRA.
Work Retirement Plan
Your work retirement plan is most likely the next best place to start stashing your retirement investments. 401(k)s allow you to stash a significant amount of money to invest for retirement, which is great for the tax savings.
While some 401(k)s are toxic with horrible fees and investment choices, the majority are at least halfway decent. They allow you to avoid paying taxes on your contributions. You only pay taxes when you withdraw the money in retirement.
If you’re lucky enough to max out your 401(k) or you plan to retire really early, you’ll want to move on to the next and final step.
Taxable Investment Account
The last place to save and invest in the traditional sense is a taxable investment account.
Why is this last on my list? You don’t get any tax savings now or when you take the money out of your account. You have to pay taxes now and pay taxes on your gains later.
However, investing still provides plenty of gains you likely won’t get elsewhere. It allows your money to grow, even though you will have to pay some taxes on it.
A taxable investment account may even have a larger purpose if you plan to retire extremely early. For traditional retirement accounts, you’ll be penalized if you take money out prior to the stated age which isn’t good for anyone.
Instead, you may want to invest some money in a taxable retirement account so you can access some of your investments prior to the official retirement age. You’ll still have to pay taxes, but you won’t have to pay the expensive penalties.
Whatever You Do, Get Started Today
Now you know where you should be putting the money you plan to save and invest. Rather than procrastinating on what to do, get started by starting your small emergency fund today.
If you’ve already completed that or other steps on the list, start on the next step in your journey listed above.
Your future self will be very glad you started saving and investing.
What step are you at in the saving and investing outline listed above? Any thoughts or experiences you’d like to share? Leave a comment below.
Lance Cothern, CPA holds a CPA license in Indiana. He’s a personal finance, debt and credit expert that writes professionally for top-tier publications including U.S. News & World Report, Forbes, Investopedia, Credit Karma, Business Insider and more.
Additionally, his expertise has been featured on Yahoo, MSN, USA Today, Reader’s Digest, The Huffington Post, Fast Company, Kiplinger, Reuters, CNBC and more.
Lance is the founder of Money Manifesto. He started writing about money and helping people solve their financial problems in 2012. You can read more about him and find links to his other work and media mentions here.