At risk of stating the obvious, you need money to make
money. What's less obvious is where and in what order to save and invest. After
all, everything from tax-advantaged retirement accounts to your cousin's new
start-up seem like possible places to put your hard-earned money.
However, just because you can invest in certain things
doesn't mean you should. If you want to maximize your long-term wealth, you
can't haphazardly allocate your dollars. You need a plan -- a systematic way to
order your savings and investments. While these don't need to be hard and fast
rules, they can serve as good rules of thumb to go by.
First, tackle any high-interest debt
Before you invest a dime, consider eliminating all your
high-interest debts first. Prioritize paying off your credit cards, payday
loans, and any other types of debt charging double-digit interest rates.
(However, debts with comparatively lower interest rates like mortgages and auto
loans are fine to keep around.)
There are two advantages to this strategy. For starters,
axing these burdensome debts can help you sleep better at night. But it's also
good for your financial well-being since you're effectively earning back the
interest you'd otherwise have to pay.
Second, build an emergency fund
Now that your high-interest debts are gone, it's time to
establish an emergency fund. Also known as a rainy-day fund, this stash of cash
will serve as your financial cushion if you ever lose your job, require medical
care, or experience some other kind of emergency.
In general, try to put away at least 6 months' worth of
expenses, though you can always err on the side of caution and save a little
more. For best results, house your emergency fund in a high-yield savings
account or a money market fund, like Vanguard's Federal Money Market Fund
(VMFXX).
However, don't worry too much about maximizing yield here.
Even if your money is just sitting there collecting dust, it's no big deal. In
fact, that's arguably the point -- to have a stable, readily accessible pool of
cash handy for when you need it the most.
Next, contribute to your retirement accounts
Now that you have your short-term financial needs met, it's
time to save and invest for the long-term in a tax-efficient way.
On the retirement front, you can contribute to a traditional
or Roth Individual Retirement Account (IRA). With a traditional IRA, your
upfront contribution is tax-deductible -- and money, once inside the account,
compounds on a tax-deferred basis. Upon withdrawal, earnings are taxed as
ordinary income.
On the other hand, Roth IRA contributions aren't
tax-deductible. However, funds inside the account become tax-exempt, and you're
neither taxed on earnings nor withdrawals.
In 2022, you can contribute up to a total of $6,000 (plus an
additional $1,000 if you're 50 or older) to either type of IRA, though Roth
contributions are subject to additional income restrictions. To be eligible,
single filers must have a Modified Adjusted Gross Income (MAGI) of under
$144,000, and married taxpayers' combined MAGI must not exceed $214,000.
If your employer offers a 401(k), you can make use of those
as well. In 2022, you can contribute up to a combined $20,500 (or up to $27,000
if you're 50 or older) in traditional or Roth 401(k)s.
401(k) contribution limits are in addition to IRA limits, so
you can potentially sock away $6,000 (up to $7,000) in your IRA and $20,500 (up
to $27,000) in your 401(k) in the same year. Of course, this is a significant
sum, so don't fret if you can't hit these limits -- though if you can, that's
great! Instead, try to at least max out your employer match if possible.
Then, consider other tax-advantaged savings accounts
Retirement accounts aren't the only ones with built-in tax
advantages. If you have a Health Savings Account (HSA) or have established a
529 college savings plan for a child, consider contributing to those investment
accounts as well.
HSAs must be paired with a high-deductible health plan
(HDHP) and are subject to annual contribution limits. In 2022, individuals can
save up to $3,650, while families are limited to $7,300. Individuals 55 and
older can make an additional $1,000 "catch up" contribution.
What this means for you
Finally, if you still have money left over after maxing out
all your tax-advantaged accounts, you may consider saving and investing in a
taxable brokerage account. Or, maybe you can treat yourself a little bit -- you
decide!
Either way, the message is straightforward: save in a
strategic and tax-efficient order that maximizes your short- and long-term
financial well-being.
Keep enough for now that you can cover your bills, pay down
debt, and weather rough patches -- but also save enough for retirement, medical
bills, your child's education, and other major expenses that might come up in
the future.
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