2232: What Comes First: Saving, Investing, or Paying off Debt by Erik Carter with Financial Finesse

[00:00:00] Now before we start, you might want to check out our other podcasts covering topics like personal development and minimalism, money, health, relationships, and more. So to optimize your life in other areas, just search for Optimal Living Daily in your podcast app. Now onto the show.

[00:00:43] This is Optimal Relationships Daily, Episode 2232. What comes first? Saving, investing, or paying off debt by Erik Carter with Financial Finesse.com. Hello everybody and welcome back to another one of our weekly bonus episodes here on ORD.

[00:01:01] I'm Greg Audino, your host of the show, and this week I'll be sharing a previous airing of our finance show, Optimal Finance Daily, which is structured the same as this one but focuses of course on content that covers all things personal finance.

[00:01:15] So get ready for a sample of OFD. Here is Diana with the post and her commentary as we optimize your life. What comes first? Saving, investing, or paying off debt by Erik Carter with Financial Finesse.com.

[00:01:35] One of the most common questions we get is whether to prioritize paying down debt, building up savings, or investing for retirement. Ideally, of course, we would do all three, but most of us have limited dollars with which to work with. So what should take priority?

[00:01:53] It's a topic that has generated some disagreement among some well-known financial gurus. Here are some guidelines to follow. Number one, do you have an emergency fund? If not, building this up should be your first priority. But how much is enough?

[00:02:11] Experts suggest having anywhere from at least 1,000 to 3 to 12 months of necessary expenses. By necessary expenses, I mean things like your rent or mortgage payment, basic utility bills, loan payments, insurance, and food. These are the absolute necessities you would spend money on even if you were to lose your

[00:02:32] job. How much you need partly depends on how secure you feel your job is and what other resources you might have available to you. Some examples of an emergency fund would be a savings account or money market fund and

[00:02:46] possibly investment accounts and a retirement plan that you can borrow from. The latter two are only reliable if they're at least twice what you need since their value can fall considerably, especially in tough economic times when you might need them the most.

[00:03:03] Also keep in mind that you can only borrow up to half the value of your retirement account, so you actually need four times as much in there. Financial credit on credit cards and home equity lines of credit can be considered supplemental,

[00:03:17] but shouldn't be relied on since they can be canceled at any time. One interesting place to put those emergency savings is a Roth IRA. That's because whatever you contribute to a Roth IRA can be withdrawn tax and penalty free at any time and for any reason.

[00:03:34] If you withdraw any earnings before age 59 and a half and having the account open for at least five years, they could be subject to taxes plus a 10% penalty. The advantage is that whatever you don't withdraw can grow to be tax free for retirement.

[00:03:53] This way you're killing two birds with one stone. Just be sure to keep the Roth IRA somewhere safe and accessible like a money market fund until you've accumulated sufficient emergency savings somewhere else. At that point, you can invest the Roth IRA in something more aggressive for retirement.

[00:04:12] Number two, do you get a match in your employer's retirement plan? If so, this should be your next priority. Otherwise, you're leaving free money on the table. Where else can you get such a high guaranteed return on your savings? Number three, do you have any high interest debt?

[00:04:30] By high interest, I mean more than what you can expect to earn by investing instead. That partly depends on your risk tolerance. If you're more aggressive, you might expect to earn a 7% or 8% average annualized return on your investments.

[00:04:48] If you're conservative, it might be closer to 4% or 5% and 6% if you're in the middle. In any case, credit card rates are typically much higher than any of these. So pay them off before investing, starting with the highest interest balances. Number four, do you want to buy a home?

[00:05:07] Once you've paid off your high interest debt, you might want to start saving for a home purchase since you might need to put down 20% of the home value to avoid PMI. Buying a home can also be part of your retirement plan since you're removing most of your housing

[00:05:22] expenses once the home is paid off and the equity can even be used to supplement your retirement savings in a variety of ways. The sooner you buy the home, the sooner you can start building that equity.

[00:05:35] Just be sure it's a home you'll keep for at least three to five years. Number five, are you on track for retirement? Use a calculator to see if you are and if not, how much more do you need to save?

[00:05:49] This should take priority over saving for your children's college expenses since they don't give financial aid for retirement. Try to first max out tax advantaged accounts like your employer's retirement plan, IRAs and even an HSA, which can be used penalty free for any purpose after age 65.

[00:06:10] Number six, do you have any children or grandchildren you'd like to help with education expenses? This should be the last priority. It's not that education isn't important, but that low interest loans are generally able to help them fund it.

[00:06:26] If you do have extra money for education, consider tax sheltered accounts like 529 plans and Coverdell Education Savings Accounts. Your state may also provide a state tax deduction for contributing to your state's 529 plan. And number seven, where else can you invest?

[00:06:47] Once you've maxed out all the tax sheltered accounts, it still is generally beneficial to invest in taxable accounts if they can be expected to earn more after tax than what any remaining debts are costing you in interest.

[00:07:01] Some investments that make the most sense in taxable accounts include tax-free municipal bonds, tax-deferred savings bonds and stocks since you only owe the capital gains rate on capital gains and qualified dividends as long as you hold a stock for at least 12 months.

[00:07:20] Foreign stocks are also eligible for the foreign tax credit when held in a taxable account. While municipal bonds and savings bonds pay very little interest, holding them allows you to invest more aggressively in other parts of your portfolio.

[00:07:36] In the case of your mortgage and possibly student loans, be sure to factor in tax deductions on the interest when you're trying to figure out how much they're costing you. And even without the tax break, the rates tend to be pretty low.

[00:07:50] In fact, mortgage rates are so low, especially after tax, that you might never want to pay it off at all. You just listen to the post titled, What Comes First? Saving, Investing or Paying Off Debt by Eric Carter with FinancialFinesse.com.

[00:08:11] While having an emergency fund is a very good idea, I beg you to not look at your retirement accounts as your emergency fund. You should only consider borrowing from your retirement accounts as a last resort. I'm talking really dire situations where you literally have no other options.

[00:08:30] To dive into why this is a bad idea, I'd encourage you to go back and listen to episode 1622, Understanding 401k Loans. And in terms of taking out your Roth contributions with no tax or penalties, yes, you could do this, but there's a huge opportunity cost.

[00:08:50] Currently, a single person can only contribute $6,000 per year to a Roth IRA and it has amazing tax benefits for your retirement savings. If you raid that money for a short-term emergency need, you can't add that contribution back in years later.

[00:09:08] And this article recommends that you keep these emergency funds in a money market account within your Roth IRA. But what's the point of storing money in an investment account if you're not investing it?

[00:09:21] I think it makes much more sense to look at your retirement accounts as a tax you've paid to your future self. That's simply not your current self's money and pulling from those accounts isn't an option. Granted, it's so much easier to take this position regarding leaving retirement accounts

[00:09:39] alone when you have a well-funded emergency fund, which for most people will be easy access to cash in a simple savings account. In regards to what comes first, savings, investing or debt payoff, I think that's highly dependent on your unique situation.

[00:09:57] But in general, whatever the gap between your income and expenses, try to do all three, maybe just not in equal proportions. So let's say you take half of your available funds and put it towards your debt, and the

[00:10:12] other half is split between saving your emergency fund and investing for retirement. The point is this isn't an all or nothing game. And that should do it for today. Have a happy rest of your day, and I'll see you on the Thursday show tomorrow where your

[00:10:28] optimal life awaits.