Embarking on a journey towards financial well-being requires a strategic and purposeful approach. Much like navigating through a carefully plotted course, understanding the order of financial operations is crucial for building a solid foundation.
This checklist outlines the fundamental steps in the financial order of operations, guiding you through each stage with the intent of establishing financial stability.
While I often find the order to be advantageous, it is by no means intended to be a recommendation for all. Careful planning and consideration should be given to each individual circumstance.
1. Secure Employer Match
Securing your employer’s retirement plan match is like free money. And it’s a 100% return on your investment, which is nearly impossible to find anywhere else. For this reason, we place this important step at number 1.
For example, if your employer provides a dollar for dollar match up to 4% of your pay, you’d want to defer 4% of your income at a minimum towards the plan.
2. Establish Emergency Reserves
Establishing a pool of funds that stays in cash is critical to maintaining your long-term investment strategy.
Reason being, life happens - and can happen fast. You never know when a medical bill, vehicle accident, or housing expense will present a financial burden. You may even be one payment away from knocking out that credit card (thanks to your dedicated repayment strategy) when disaster strikes – putting you right back in the hole you found yourself climbing out of.
Have enough to cover insurance deductibles and several months’ worth of spending to cover any emergencies or gap in employment.
3. Pay Off High-Interest Rate Debt
Historical returns of the stock market support that a disciplined investor can build wealth over the long-term.
The problem is these returns won’t add up to much if they are offset by credit card interest of 20-30% per year working against you. Pay this off as quickly as possible so that you can begin building wealth with your investments.
4. Contribute to Roth IRA & HSA
The next step in the order involves directing your additional funds towards a Roth IRA, a financial vehicle that offers compelling tax advantages. This investment avenue allows your funds to grow tax-deferred and provides tax-free distributions for qualified withdrawals. With potential benefits like a broader range of investment options and potentially lower costs compared to company retirement plans, a Roth IRA offers flexibility in choosing your custodian, rebalancing frequency, and overall management approach—distinct from employer-tied plans.
In 2024, the annual contribution limit for a Roth IRA is $7,000, with an additional $1,000 allowed as a catch-up contribution for those aged 50 and above. It's essential to be aware of income limits associated with Roth IRA contributions, but exceeding them doesn't necessarily mean exclusion, as the backdoor Roth IRA strategy may still offer a contribution pathway.
The HSA, or Health Savings Account is unique in that it avoids taxes 3 different times:
1. There’s a tax deduction for contributions
2. Funds grow tax-deferred within the HSA
3. Funds are distributed tax free for qualified medical expenses
While the HSA was primarily designed to offset current health care expenses it can also be invested and used to pay for long-term medical expenses as well, including Long-Term Care. It’s estimated that 70% of individuals turning 65 this year will need some level of long-term care in their lifetime, and they will receive care for an average of 3 years.
Lastly, at age 65 an HSA can essentially be treated as an IRA, with distributions being able to be used for any expense (not just medical). The caveat is that distributions for non-qualified expenses become taxable, but this is no different than a traditional IRA or 401k. In this case, the HSA has served as an additional retirement savings vehicle for those who have maxed out other common retirement vehicles.
The HSA has a contribution limit of $7,750 for families and $3,850 for individuals in 2023. Those limits are increased to $8,300 for families and $4,150 for individuals in 2024. Those over age 50 can contribute an additional $1,000 as a catch-up contribution. The HSA must be used in tandem with a high-deductible healthcare plan (HDHP).
I still lean towards prioritizing the Roth IRA first, but this could easily be debated as both arguments have merits.
5. Max Out Retirement Contributions
At this point in the order of operations, you’ve most likely eclipsed somewhere around $15,000-$20,000 in annual savings between company match, Roth IRA, and HSA.
For the greatest tax benefit, we’re now going to head back to the retirement vehicle in Step 2 where you secured the employer match. Deferral limits of $22,500 in 2023 ($23,000 in 2024) allow an investor to “max-out” the 401k plan. If you're age 50 or older, you're eligible for an additional $7,500 in catch-up contributions.
SIMPLE IRAs and SEP IRAs have lesser limits, but still provide modest savings opportunities.
6. Add to Taxable Brokerage Account
With retirement plans maxed out and additional dollars to invest, I often find it advantageous to begin contributing to the taxable brokerage account, or non-retirement account. Despite its name, the taxable brokerage account can still provide tax benefits by way of capital gains treatment and can also provide additional liquidity towards your overall financial health.
7. Low Interest Rate Debt
Finally, making additional payments towards low interest rate debt may be advisable. While mortgage rates have increased as of late, many current homeowners still have an annual rate as low as 3-4%. Federal student loans often tend to fall in that 3-6% range as well.
Over the long-term, the dollars saved by prepaying this debt (3-4% annually), are less than the dollars projected to be earned by investing them in a long-term investment plan (Assuming a moderate investor risk profile). For this reason, low interest-bearing debt finds itself last in the order of operations.
Final disclaimer:
These 7 steps are meant to be used as a guide for your financial plan. While they may demonstrate efficiency from a tax and investment perspective, it doesn’t mean that it is the only way to effectively build wealth. Please consult your CFP® professional for a more comprehensive look at your personal financial situation.
