How to Make Decisions About Personal Finances

A reader named Natalie asks:

“I’m a 31-year-old single mother with student loan debt of $36,000 and $1,700 on my credit cards. I don’t know where to start to clean up this financial mess. What should I do first—pay debt, build an emergency fund, or begin investing?”

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If you don’t know the next action step to take on any big project—like planning a wedding or moving to a new office—you’ll probably feel stuck and never make progress. The same is true when you need to make decisions about your personal finances. 

Most of us have been in Natalie’s shoes, unsure about the next best financial step to take. In this episode I’ll give you a financial roadmap to follow so you’ll know exactly how to manage your money. Instead of worrying about making a bad move, follow these 5 financial priorities:

Priority #1: Max Out Workplace Matching Contributions

If you have a job that offers a retirement plan, that’s a valuable benefit. If your employer matches contributions, that’s like winning the lottery every month, because you get free money without having to do extra work!

Let’s say you make $50,000 and your employer matches 100% of your 401(k) or 403(b) contributions up to 3% of your salary. That means if you contribute $1,500 ($50,000 x 3%) a year or $125 a month, your company also kicks in $125 a month.

Matching funds are so fantastic because they give you a 100% return on your money no matter what happens in the financial markets. I don’t know about you, but I’ll take a guaranteed 100% return all day long!

That’s why taking advantage of matching funds should be your number one financial priority. Even if you can’t contribute the recommended 10% to 15% of your income for retirement, always contribute enough to max out an employer match—otherwise, you’re leaving money on the table.

Related Content: 10 Things You Should Know About 401(k) Plans

Priority #2: Accumulate Emergency Savings

After maxing out employer matching, your next financial priority is to build a healthy emergency fund. If you don’t have a retirement plan at work with matching, or you’re self-employed, this step is your first priority.

Emergency savings are so important because they keep you from having to rely on expensive credit cards or loans if you hit a financial rough patch, like a medical crisis or a job loss.

Ideally, you should save at least 3 to 6 months’ worth of your living expenses. However, if squirreling away that much seems impossible, just start with a small target like $1,000 or $2,000.

An important part of having emergency money is keeping is completely safe, which is why you should never invest it. Instead, keep it tucked away in a high-yield, FDIC-insured savings account so it’ll be there when you need it.

Here are some of the best places to stash your emergency cash:

• Ally Bank Savings pays 0.95% annual percentage yield (APY) with no minimum deposit, no fees, and convenient mobile banking.

• American Express Personal Savings pays 0.90% APY with no minimum deposit and no fees. 

• ING Orange Savings pays 0.75% APY with no minimum deposit and no fees.

Priority #3: Pay High-Interest Debt

After accumulating some emergency savings, your next financial priority is to tackle high-interest debt, such as payday loans, credit cards, and car loans that are in the double digits. Also, if you’ve missed any debt payments, be sure to get current so you don’t rack up additional late fees and penalties.

Don’t worry about paying low-interest debts, like mortgages or student loans, ahead of schedule because they aren’t costing you much. Additionally, they come with built-in tax deductions, which further reduce their cost on an after-tax basis.    

Priority #4: Max Out a Retirement Account

After building cash reserves and chipping away high-interest debts, it’s time to max out a retirement account. They allow you to save for the future and cut your taxes at the same time.

However, you should never invest money in a retirement account that you might need before age 59½ because you typically have to pay a steep 10% penalty for early withdrawals.

For those with workplace plans, you can contribute up to $17,000 (or $22,500 if you’re age 50 or older), for 2012. But if you don’t have a retirement plan at work, no worries! Anyone with earned income can have an Individual Retirement Arrangement or IRA.

Related Content: What Is the Difference Between a Traditional and Roth IRA?

IRAs generally give you much more flexibility and more investment choices compared to the typical menu of options for workplace plans. However, you can’t contribute as much. For 2012, you can put in up to $5,000 (or $6,000 if you’re age 50 or older) in either a traditional IRA or a Roth IRA—or split the limit (in any proportion you like) into both.

If you have enough cash, you’re allowed to max out both a workplace plan and an IRA in the same year. But depending on your income, contributions made to a traditional IRA may not be fully tax-deductible when you or a spouse also participate in a retirement plan at work.

Related Content: Should You Contribute to Both a 401(k) and an IRA?

Priority #5: Invest in a Taxable Account

Once you’ve maxed out all your tax-advantaged retirement options and still have more to invest, use a regular, taxable brokerage account. It doesn’t come with a tax deduction, but you can access the money any time you want with no restrictions or penalties.

Brokerage accounts are a great place to invest money for long-term goals that you want to achieve in about 10 years or so, like buying a home, starting a business, or taking a dream vacation. Or, if you want to use excess cash to start paying down your low-interest debts (like student loans or mortgages) instead, this is the time to do it.

So, the answer to Natalie’s question about what she should do next is that she should do everything—pay debt, build an emergency fund, and invest! But she needs to do them in the right order that we just covered. Here’s a review of priorities for Natalie:

1. Take advantage of any employer matching.

2. Build up an emergency fund of at least $2,000.

3. Pay down high-interest credit card debt right away, but don’t pay her student loan debt ahead of schedule.  

4. Max out a workplace retirement plan, an IRA, or both.

5. Invest excess cash through a taxable brokerage account.

Following these 5 priorities will help you set financial goals, leverage your resources, and build wealth as quickly as possible.

More Articles and Resources You Might Like:

How to Use a SEP-IRA Retirement Plan

How to Save for Retirement Without a 401(k)

Financial Advice That Will Make You Rich

Roth vs. Traditional IRA Calculator

Have money questions or comments? Send them to money@quickanddirtytips.com.

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