Recently, we’ve been talking about some tricky money questions related to investing.
We first looked at whether it makes sense to invest while you’re in debt.
We then looked at whether to prioritize investing for retirement or for your kid’s college.
These are questions that commonly come up when I’m teaching law students and young lawyers. Of course, these questions are best answered when we consider both the emotions and the math of money.
Today, we’ll look at a third question that comes up regularly:
How should you prioritize certain investment account types, especially if you’re still paying off debt?
This is another great question.
If you’re wondering what I mean by different investment account types, you can read about my four favorite account types here.
Below are my thoughts on how I would choose between different investment account types while paying off debt.
Let me know if you agree or would prioritize a different order in the comments below.
1. Invest just enough to qualify for your employer match.
Your first goal should be to invest enough in your 401(k) plan to qualify for the employer match.
Many employers today offer a match to incentive employees to contribute to their 401(k) plans. To qualify for the match, you must be participating in your company’s plan and make contributions yourself.
The match is usually a percentage of your overall salary, usually between 3% and 6%.
For example, let’s say your salary is $100,000 and your employer offers to match your contributions up to 5% of your salary.
That means if you contribute $5,000 (5% of your salary), your employer will contribute an additional $5,000 (5% match) to your account.
In other words, your $5,000 automatically turns into $10,000.
Think about that for a moment.
That’s a guaranteed 100% return on your contribution. You put in $5,000 and you automatically get another $5,000. You won’t find a guaranteed return like that anywhere else.
That’s why if your company offers a match, it’s a no-brainer to take advantage of that match.
For this reason, an employer match is often described as “free money.”
I don’t like the term “free money” because it implies that you have not earned that money as an employee for your company. I prefer to refer to the company match as a bonus you’ve rightfully earned.
The key is to accept that earned bonus by ensuring you are meeting the minimum requirements to qualify.
Whether you think of it as free money or as a bonus you’ve earned, make sure you contribute enough to your 401(k) plan to qualify for the employer match.
2. Pay off all credit card debt.
After you hit the employer match, and before you think about further investments, you should pay off all credit card debt.
Note that credit card debt is in a category of its own because of the extremely high interest rates that accompany credit cards.
Currently, the average credit card interest rate is 20.12%.
The S&P 500 has historically averaged a 10% annual return.
That gap is so large that it’s a good idea to pay off your credit card debt before turning to further investments.
Think about it like this: with credit card debt, you are guaranteed to pay a penalty of around 20% until you pay off that debt. When investing, you can reasonably hope to earn around 10% interest.
Because the penalty you’re paying is twice the rate you’re hoping to earn, the smart move is to eliminate that penalty.
For help on paying off your credit card debt, check out my top 10 tips here.
Why not pay off your credit card debt entirely before investing in your 401(k)?
You may be wondering why I recommend qualifying for your employer match before paying off credit card.
Even with such high credit card interest rates, there’s a good reason to prioritize qualifying for your employer match. We touched on that reason above.
Let’s revisit our example. With an employer match, if you contribute $5,000, your employer will also contribute $5,000.
As we said, that’s like earning a 100% guaranteed return on your money. A 100% guaranteed return is too good to pass up.
No other reasonable investment option offers a 100% guaranteed rate of return. You can’t even reasonably hope to match the 20% penalty that credit card companies charge.
That’s why eliminating your credit card debt should be your next priority after receiving your employer match.
3. Allocate 75% of available funds to other loans and 25% to investments.
Once you have paid off your credit card debt, I recommend putting 75% of your available funds to loans and 25% to other investments.
When I say loans, I am referring to student loans, personal loans, lines of credit, and HELOCs. Note, I am not referring to primary mortgage debt.
It’s not uncommon for law students to have hundreds of thousands of dollars in debt. The same is true for students in medical school and business school.
It’s not just people with student loan debt who face this question. As one example, perhaps you’ve used a HELOC to buy investment property, like I have.
There’s a reason credit card debt is in a separate category from other loans, like student loans and HELOCs.
Unlike credit card debt, student loan debt and HELOC debt typically come with lower interest rates.
The current lowest federal student loan interest rate is 6.53%.
The current average HELOC interest rate is 8.27%.
Your loans may have even lower interest rates. Regardless, the odds are that your interest rate is below the historical 10% average annual return of the S&P 500.
While it’s never a bad idea to eliminate debt, there are some good reasons why you should invest even though you’re in debt.
We explored these reasons and why I recommend a 75/25 ratio in my recent post on investing while in debt:
If you’re on board with investing while paying off debt, the question becomes: where should you invest that money?
That brings us to my next suggestion.
4. Max out your 401(k) plan.
Once you reach this step, you should have no credit card debt. You should also be applying either the 75/25 ratio to invest while you’re in debt, or have no other debt to pay off.
At this point, I suggest maxing out your 401(k) with your remaining available funds.
The reason I suggest maxing out your 401(k) is because these contributions are made with pre-tax dollars. In other words, you get a tax break today by investing in your 401(k).
To put it another way, you will save money on taxes every year you contribute to your 401(k) plan.
Don’t sleep on the impact of taxes on our money decisions. Over the long term, taxes can be hard to predict, but they should not be ignored.
Nobody really knows what taxes are going to be like in the future. Yes, it’s a safe assumption that taxes will keep going up.
But, taxes have always been complicated. I’m guessing they will always be complicated. Even if taxes generally go up, there’s no telling the exact impact taxes will have on your personal situation.
That’s why I prefer to take the guaranteed tax savings now. I’m ok with the possibility of paying more in taxes decades from now. That’s especially true because I have plenty of good uses for those tax savings right now.
That’s why I recommend maxing out your 401(k) before moving on to my final suggestion.
5. Max out your HSA, Roth IRA and 529 plan.
Once you reach this step, you’re in great shape. Reaching this point means you have maxed out your 401(k) plan, which means you’re receiving an employer match.
It means you have no credit card debt. On top of that, you are paying down your other loans with a 75/25 ratio or have eliminated those loans entirely.
Now, you have options. You’ve earned the right to choose the best investment account type for your situation.
Besides a 401(k), my other favorite account types are a Roth IRA, a Health Savings Account (HSA), and a 529 account.
You can read all about my favorite investment account types in this recent post:
Depending on your income, a Roth IRA may be the best account type for additional retirement savings.
If you’re healthy and can cover certain medical expenses, maybe you would benefit from an HSA.
Have kids and worried about paying for college? Maybe a 529 plan is right for you.
The point is you’ve earned the right to pick the best investment accounts for your present situation.
You really can’t go wrong with any of these choices.
What do you think of this plan to prioritize certain investment accounts while in debt?
What do you think about this plan to prioritize certain investment account types, especially if you’re still paying off debt?
Let us know in the comments below.
If you’ve already made it to step 5 and are looking for help with what to do next, the truth is that you have too many options to cover in this post.
To help you start thinking about your choices, you could:
- Invest in a traditional brokerage account;
- Invest in real estate; or
- Pay down your primary mortgage.
If you’ve already made it to step 5, reach out and I’d be happy to help you think and talk about your options.
The best way to reach me is to sign up for my weekly email and reply to any email.
Leave a Reply