How Should I Prioritize My Loan Payments?

I frequently talk to people who are becoming experts in their field of study – healthcare, teaching, law, music, religion, business and sales – but have no idea where they should start financially. They don’t know in the same way that I, as a financial planner, don’t know the best medicine to treat an infection or where to begin drawing a layout to build a house. We are all striving to become experts in our individual fields of study, and we need advice from others when it comes to areas where we are not specialized.

While you may never be called on to build your own house from scratch, you are responsible for building your financial position. And often, good financial advice is hard to come by when you are just starting to save. A lot of firms have an hourly planning or annual management fee that is not conducive to the average person starting out. That is why I am about to give you some “free” financial advice. Since “nothing in life is free” I suppose the cost of this information is the time and energy it takes you to read this long article. It is the outline of the meeting I have had with many people starting their financial journey. These tips will help you start building your financial plan on a strong foundation. Below, you will find a more in-depth explanation of each step.

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Where Should I Start Saving?

My recommendations as a Certified Financial Planner, vary greatly depending on who I am assisting. This road map has been carefully crafted for clients looking to make sound financial decisions as they advance in their careers and in life. These saving areas are meant to be flexible and to accommodate to your unique financial situation.

Emergency Fund

Emergencies happen despite our age. Once you are financially independent, this is something you should be prepared for. If you are single or in a single-income household, you should have between 4 and 6 months’ worth of your expenses in an easily accessible account. If you are married and both spouses are employed, the recommended reserve amount decreases to roughly 3-4 months’ worth of expenses. This should be set aside in a separate account and not tapped unless you lose your job, your car breaks down, you have a large medical expense, your AC unit dies, etc. Having an emergency savings account protects you from needing to take out loans when expenses arise. There are several online saving accounts that currently offer a better rate of interest than a local bank. At the writing of this article, Ally Bank, Discover Bank and Synchrony Bank are offering 1.9% interest on their online savings accounts. There are others as well. Think about parking your emergency savings in an account like this and earn a little extra on your savings without sacrificing liquidity.

Example: If you spend $4,000 per month as a married couple on housing, insurance, food, gas, etc., you should have $12,000-$16,000 in a savings account for unexpected expenses.

Employer Retirement Plan Match

If you have a 401(k) or a 403(b) offered to you at work with an employer match, contribute at least enough to maximize the match offered. This is free money for retirement. Some companies offer a match up to 5%; some say they’ll match half of your contribution up to 6%; some don’t have a match. Find out what yours is and make the most of it. You can defer up to $19,000 of your salary into a 401(k) or 403(b) in 2019. Also, when you put money into a 401(k) or 403(b), you should plan to leave it there for a long time. Retirement plans have penalties for taking money out before you are 55 years old.

Most 401(k)’s and 403(b)’s have Traditional and Roth deferral options. Traditional means tax-deferred; you get a tax deduction now and defer paying any taxes until you take withdrawals someday in the distant future. Roth means tax-free growth; you pay tax on the contribution now and it will grow tax-free so you won’t pay any taxes when you withdraw someday in the distant future. If you are in a low tax bracket, it is wise to take advantage of the Roth option while it doesn’t cost you very much.

Example: Your employer matches 100% of what you defer up to 3% and you have a salary of $50,000. You should defer at least 3% of your salary, or $1,500, and your employer will put in an additional $1,500. So at the end of the year you have contributed $1,500 but you have an account balance of $3,000 prior to any investment growth.

Health Savings Account (HSA)

If you have access to an HSA, it should be high on your prioritized saving list. An HSA is the ONLY account that offers tax savings on both the entry and exit of money. Contributions are tax-deductible in the year you contribute AND the growth in the account is tax-free when used for qualified health expenses! So you receive a tax deduction like a Traditional retirement plan deferral AND the money grows like a Roth IRA (see Roth IRA definition below). There is really no account like it, as you can tell from my extensive use of capital letters and exclamation points for emphasis!

You must be covered by a High Deductible Health Plan (HDHP) in order to have an HSA. An HDHP is usually less expensive on a monthly basis because you are responsible for more of the cost when you do go to the doctor. It makes the most sense to have an HDHP with an HSA if you are healthy and don’t expect to have too many doctor visits or medical expenses in a year. If you are the only person with HDHP coverage you can contribute $3,450 to an HSA in 2018, and if your spouse or family is also on the plan you can contribute up to $6,900.

HSAs are commonly confused with FSAs (Flexible Spending Account). Both are tax-free ways to pay for medical expenses. But the year you contribute to an FSA, if you don’t use it you lose it. The FSA account value starts over at $0 each year. Conversely, the outstanding balance of an HSA can stay in the account for years and can be invested and can continue to grow. It is wise to maximize your HSA each year and still pay for incurred medical expenses out of pocket to allow the HSA to grow tax-free. Everyone will have medical expenses as they age (medication, dental expenses, surgeries, etc.) and an HSA is the best vehicle to save for those in the future. You can even reimburse yourself in future years for medical costs incurred after your HSA is open if you keep the receipts.

Example: You are enrolled in an HDHP and contribute $3,450 to your HSA in 2018. You have a $1,000 medical procedure in 2018. You have three choices to pay for this procedure. One, you could pay directly from your HSA account. Two, you could leave your HSA alone and pay $1,000 out of pocket. Or three, you could pay $1,000 out of pocket, keep the receipt for the $1,000 procedure, and reimburse yourself in 2019 or 2020 or 2050 for $1,000 from your HSA.

Contribute to an IRA (Individual Retirement Account)

A Traditional or Roth IRA is a separate account from anything you have with work. Roth IRAs are especially awesome for younger adults. Each individual can contribute a maximum of $6,000 per year. Again, you do not get a tax deduction when you contribute to a Roth, but all the growth on what you contribute is tax-free forever. Basically, you pay tax on the money now so it can forever grow tax-exempt. Then when you take it out in retirement, you won’t have to pay tax.

Similar to the employer retirement plan, IRAs can have early withdrawal penalties if you withdraw before you are 59½ years old, so plan to leave those savings alone. When you are contributing, keep in mind there is an income eligibility phase-out to take advantage of a Roth; if your Adjusted Gross Income (AGI) is more than $120k (single) or $189k (married) you may not directly contribute to a Roth IRA.

The Roth IRA benefit for younger adults is twofold. First, you are probably in a lower tax bracket starting out in your career than you will be later in your career, so it makes sense to pay the necessary tax now while your rate is low. Second, you have a longer time frame for the Roth to compound and grow tax-free before you need to use it.

Example: You contribute $6,000 to a Roth now and it grows to $40k over the next 30 years. You pay ordinary income tax on the $6,000 this year and in 30 years when you withdraw $40k you will have no taxes due.

You can start an IRA with nearly any custodian or brokerage firm or bank. CAUTION: not all custodians are created equal! Some charge high fees, some invest the money for you, some provide the investing platform and you are responsible for making trades yourself, some limit the investment options available to you, and some have high account balance minimums. Schwab Intelligent Portfolios is a great place to begin your research online. Read about fees and the services provided to find which custodian is right for you.

Try to save 20% of your income for retirement

People spend money on five things: living, giving, saving, debt repayment, and taxes. Set a goal to be saving as close to 20% of your Adjusted Gross Income (AGI) as you can. If you are accomplishing all of the steps above and still have more to save, you can open a regular investment account that is not earmarked for retirement (a Joint brokerage account if married, Individual brokerage if single). You can start one of these accounts with the same custodian that manages your IRA, and invest it as conservatively or aggressively as desired. There is no ceiling to what you can contribute to this type of account, and you can make withdrawals as needed without a tax penalty.

How Should I Prioritize My Loan Payments?

If you have student debt, a car loan or a credit card loan, they should be factored into the priority list above based on the loan’s interest rate. Information about student and personal loan repayment could fill several articles, so I will only mention a few guidelines here. IF your loan interest rate is above 6%, or IF the loan is hurting your credit score because you are missing payments, you probably want to focus on paying it off before you start contributing to an IRA.

Mortgages are treated a little differently than student or consumer debt. The current mortgage environment offers interest rates between 4-5%, which is relatively low. You also have your house, a physical asset, to back up the loan. These two factors lessen the financial urgency to pay it off before contributing to other accounts. The point being, you can contribute to your retirement accounts while simultaneously paying down a mortgage.

Common Financial Pitfalls

I’ll conclude with a few tips of general financial wisdom to help you avoid the most common pitfalls we see clients stumble into.

Don’t Cash Out Your Old Retirement Plans

If you change jobs and have a retirement plan from your previous employer, you can roll it to an IRA or to your new company retirement plan without incurring taxes. If you cash it out prematurely, you will sacrifice a good bit of the account balance to early withdrawal penalties and taxes.

Account Consolidation and Simplification Is a Good Thing

You don’t need to have five IRAs with different custodians to have a diversified plan; actually, duplicate accounts make it harder to truly diversify your investments (see Joel Bengds’ article “Don’t Put All Your Money in One Basket”). It is acceptable to have a lot of accounts if they are all serving a unique purpose – Roth IRA, Traditional IRA, 401(k), HSA, taxable brokerage account – but each individual need not have multiples of the same account. The same thing goes for bank accounts. Consolidate your accounts as much as possible to simplify your life.

Be Very Wary of Annuities and Whole Life Insurance

In most cases, these aren’t prudent for a younger investor. They are often expensive investments that provide a nice commission to the salesman. You don’t want to get stuck in a financial product with poor returns or high surrender charges. There are better investment options available to you, and if you want a second option, find a Fee-Only Fiduciary that will act in your best interest. Never shy away from asking an advisor how they are compensated.

Your Kids Can Borrow to Pay for Education, but You Cannot Borrow to Pay for Retirement

That said, make sure you are funding your retirement accounts before focusing all of your savings on your children’s college accounts.

I often thank my friends who have gone into fields of medicine for committing to that career because I never could (I happen to lose consciousness when I see open wounds). Vice versa, they laugh at me for getting an adrenaline rush over nerdy numbers and saving taxes because that sort of thing confuses them or bores them to tears. A society thrives when its members focus on their strengths and seek help from others in areas of deficiency. This article can’t replace the value of partnering with an advisor, but it can help you get started on the right path to financial independence. After a few years of following these steps and you will be ready to employ a fee-only financial advisor who can partner with you for the rest of your life.