A step-by-step guide

Let me preface this by saying this is not an “invest your money into XYZ stock” type of post.

Let’s say you have X amount of dollars, but you don’t know what to do with it besides placing it into your boring Bank of XXX savings account. Let’s also say you’ve already even taken certain steps to secure your financial future like cut down on your living expenses, developed an awesome career, and opened a retirement account for yourself.

While saving money is important for obvious reasons, how much to save and where to put it is another beast entirely.

The following is a recommended order of operations for maximizing the personal and financial gains of your hard-earned money as you progress toward retirement, as crowd-sourced by Reddit’s /r/personalfinance US community. Please think of this as a guide, not as a set of rules, in making your own informed decisions about how to best make your future work for you. The list is based off of certain tenets such as securing your basic needs and maximizing (or minimizing) interest rates. The original version of these steps can be found here, as well as other useful aids, such as this flowchart, and guides for non-US countries. Feel free to comment / critique as needed.

Think of the following steps as a ‘waterfall’ – once your money has filled one particular step, allow the remainder to ‘flow’ sequentially down into the next one.

Step 1: Pay for mandatory expenses

For obvious reasons, paying for your mandatory living expenses, and expenses that allow you to earn a living, is the first step in this process. Basically your food, water, and shelter, plus the support structure for each (such as keeping your job).

Examples of this include rent, utilities, groceries, gas for your car, auto and health insurance, internet, and minimum payments on all of your outstanding loans to avoid default.

Step 2: Build an emergency fund

Whether it’s a $3000 repair bill after your car unexpectedly throws a piston, $5000 in hospital bills after you fall and break your arm snowboarding, or $10,000 in living expenses after you lose your job 6 months from now, having an emergency fund is an important way of mitigating life’s unforeseen speed bumps without throwing you into massive, ballooning, life-altering debt. Life has a way of happening when you least expect it.

How much? Experts recommend keeping 9-12 months’ worth of expenses in your emergency fund. For starters, build it to at least 2-3 months’ worth, or $3000 (whichever is greater).

Where? A highly-accessible checking or savings account (I recommend Ally for its high interest rate, free transfers, and free withdrawals from any ATM in the US) (I have no affiliation), where it can be easily accessed in case of emergency. This money is not for investing, as it usually needs to be accessed in a hurry to alleviate bills, headaches, and loss of wages.

Step 3: Contribute to any employer-matched retirement funds

If you’re lucky enough to have an employer who matches contributions to your 401k / IRA up to a certain amount, make sure to take full advantage of this benefit, as it is effectively FREE money; nowhere else will you find a guaranteed 100% return on your investment. If not, move on to Step 4.

How much? Contribute enough to receive your employer’s full match, but no more (for now).

Where? These funds are typically taken out of your paycheck and contributed automatically into your employee-sponsored 401k / IRA account.

Step 4: Get rid of any high-interest debt

If you have any debt with an interest rate over 5-7% (credit cards, auto loans, student loans, etc), pay this down next. The rationale here is that for any money you invest broadly into the stock market, the best possible ‘safe-ish’ return you can expect is 7% pre-inflation. Hence, using this money to instead pay down any debt over 5-7% is effectively a guaranteed return on your investment at that rate.

How much? Pay these debts down to zero. Until this occurs, this is likely the best place to put your money (aside from Steps 1-3).

Where? Start by paying off the debt with the highest interest rate, and work backwards (NOTE: another method is pay off the debt with the smallest balance first, which can have psychological benefits, but isn’t as beneficial from a strictly-financial sense).

Step 5: Open and max out an IRA

Besides its tax-advantaged status over checkings / savings / brokerage accounts, an IRA typically allows for a greater number of investment options over your company-sponsored 401k.

Before opening an IRA, you will need to decide between a Roth IRA and a Traditional IRA. For a comparison between the two, click here (Roth IRA is the preferred route for most people under 30, but you should make your own informed decision here based on what you expect to be earning when you retire).

How much? Contribute the maximum allowable amount, according to your salary and age (typically $5,500/yr ).

Where? IRAs are typically managed outside of your employer, and need to be opened on your own. Consider opening one with a low-cost investment manager such as Vanguard (my personal favorite), Fidelity, or Charles Schwab. It’s a good idea to align your investments according to a lazy 3-fund portfolio (more on that in a later post) or target retirement fund for the “set-it-and-forget-it” type (ex: Target Retirement 2050 / VFIFX). Plan for 5-7% returns year-over-year.

Step 6: Max out your existing 401k

Now that you’ve maxed out your IRA, maxing out your 401k is the next step. Again, this is financially superior to investing within an individual (non-retirement) account due to its tax-advantaged status, and is vastly superior to keeping your money in a standard checking or savings account where, despite earning some interest, you are almost certainly losing money overall due to inflation.

How much? Contribute the maximum allowable amount, according to your salary and age (typically $18,000/yr).

Where? If you have an employer-sponsored plan, elect to defer the maximum amount from your paycheck, as contributions to your 401k may only come from payroll deductions. If you are self-employed, look into opening a Solo 401k, SEP IRA, or SIMPLE IRA.

Step 7: Continue saving for retirement or other goals

If you’ve reached this step, CONGRATULATIONS!

The final step to the financial waterfall is one of increased freedom, and represents a time for you to sit back and think about your goals.

If you’d like to make a down payment on a house, start a business, save money for your child’s college tuition, or take that round-the-world trip you’ve been dreaming of – now is the most fiscally responsible time to set aside money for it.

For any large purchases you anticipate making within the next 3-5 years, consider keeping the money for them on hand within an FDIC-insured savings account or CD, in order to escape any potential market fluctuations.

If you’d like to retire early, or you’re otherwise unsure of what to do with your money and won’t need it for at least a few years, now’s the time to open an individual investment account (or brokerage) for long-term growth and storage of your additional assets.

Again, just like in the case of your IRA, consider a low-cost investment manager such as Vanguard, Fidelity, or Charles Schwab. Consider aligning your investments according to a lazy 3-fund portfolio (more on that in a later post) or target retirement fund for the “set-it-and-forget-it” type (ex: Target Retirement 2050 / VFIFX). Plan for 5-7% returns year-over-year.

Give yourself a pat on the back

If you’ve completed Steps 1-7 above, you’re well on the road to financial stability (heck, even if you completed Step 4, you’re already ahead of most Americans! [1]).

And while it’s important to note that this savings “waterfall” is no substitute for financial complements such as continued career growth and responsible spending habits (not to mention the non-financial, personal aspects of your life), for now you’ve earned my permission to sit back, relax, and bask in the knowledge that you are poised to gain the best possible benefits from your hard-earned money.