Financial Order of Operations
Updated: May 22
This is the "financial order of operations" that anyone can follow to generally make the best decisions with cash and make sure they are moving in the right direction. The below steps may be interchanged and moved around based on your individual circumstances, so you have to make sure to do your homework to ensure you are taking the right steps for you.
1. Emergency Fund
Fully Fund an account with 3-6 months of expenses. If you are a single income household, this needs to be closer to 6 months. If you are a dual income household with a stable income, this can be closer to 3 months. This fund is key to have because you never know what life can (and will!) throw at you. This money should be in something extremely liquid, like your personal savings account, a High Yield savings account, or a money market fund. These funds should be accessible to access immediately if need be.
2. Full 401(k) Employer Match
Many employers offer a match to their 401(k). For example, they will match the first 5% of your salary that you put into your 401(k). This type of match is 100% return on your money, and you won’t find that value anywhere else. This is free money, and it must be taken advantage of.
3. Credit Card Debt
This type of debt is usually the highest interest (up to 15% or more). Credit cards are commonly for towards purchases that are quickly, or have already been, utilized (groceries, gas, etc.) or an asset that goes down in value. In other words, you are paying an interest rate on goods that are already gone! This step in the order of operations does not apply to those who pay their balance in full every month. This step is for those that are carrying a balance from the past. It is critical to attack this debt with everything you have and get rid of it.
4. High Interest Debt (Anything over 4-5%)
A student loan is a perfect example of high interest debt. Another example includes a loan used towards funding the start of a business. Regardless, this needs to be eliminated in order to progress to the next steps.
5. Max Out Your Health Savings Account (HSA) if Applicable
An HSA allows for triple tax savings. This type of account is tax deductible on the way in, grows tax free, and tax free on the way out. There is no other account that offers the same level of tax protection. This is only an option for those with a High Deducible Health Plan (HDHP) which is defined as $1,400 for an individual or $2,800 for a family. If this does not apply to you, move on to #6.
6. Max Out Your Roth or Traditional IRA
This is an account that you may hold at any financial institution and offers you a wide array of investment opportunities. The maximum contribution in 2023 is $6,500. There are 2 options: a Roth IRA and Traditional IRA. The phaseouts for eligibility to make Roth contributions begin at $218,000 for married couples and $138,000 for single filers in 2023. The phaseouts for eligibility to make deductible traditional IRA contributions begin at $73,000 for single filers and $116,000 for married filing jointly in 2023. If you are ineligible for either of these, you can potential make backdoor Roth IRA contributions, or non deductible IRA contributions. These are more advanced strategies and may or may not make sense depending on your situation.
Roth IRA: the option that best suites the individual who is currently in a lower tax bracket than they expect to be at the time of retirement. With a Roth IRA you don’t receive any tax benefit in the current year, but your withdrawal in retirement will be completely tax free. In other words, pay taxes on your money now, while you are in a lower tax bracket, and avoid paying taxes later when you are in a higher tax bracket.
Traditional IRA: you get to deduct the contribution on the current year’s tax return, but you will pay income taxes on that money when you withdraw it in retirement.
When in doubt, it is best to go with the Roth IRA to lock in tax free income, and ensure that you have tax diversity in your retirement portfolio.
7. Fund Children’s Education (if applicable)
Now that you have laid your financial foundation, you can, and should, set your children up for financial success. A great way to save for college is a 529 Account. This account allows allows a deposit of $17,000 per year, or up to a one-time $85,000 contribution every 5 years (per child). These funds grow tax free and are tax free when you take them out as long as it is spent on qualified educational expenses.
8. Finish Maxing Out Your 401(k)
Now its time to revisit your employer's 401(k) plan and contribute the maximum amount if possible, or as much as you possibly can. In 2021, the maximum amount you can contribute is $22,500 in 2023. Maxing your 401(k) as early as possible will allow you to reap the astonishing benefits of compound interest upon retirement. You may also want to check with your company's 401(k) provider to see if after tax contributions are allowed. This will be listed int the Summary Plan Description (SPD). If allowed, you may be able to contribute a total of $66,000 to your 401(k) in 2023 when you add up elective deferral contributions, employer contributions, and after tax contributions. This strategy is what's known as the Mega Backdoor Roth IRA.
9. Pay off lower interest debt (things below 5% excluding the mortgage)
An example of a lower interest debt might be a car loan that you have at a low rate, or any other personal loan with a low interest rate. In particular in this category, a car is a depreciating asset. Owing money on something that is depreciating is a liability to your financial well-being, and if something happens to the car, such as it being totaled, you may owe more on the car than its actually worth. After securing your financial foothold, is it best to avoid taking out loans on depreciating assets.
10. Invest in Taxable Index funds or ETFs
Congratulations! By this point, you are in the wealth building stage of life and you are in elite financial condition. Now that you have an emergency fund, a fully funded retirement account, and no consumer debt of any kind, you can jump into investing in a taxable brokerage account. While this type of account doesn't have any tax advantages like your retirement, it does allow you to invest as much as you would like. This is a fantastic way for those who want to retire early to begin investing for those gap years.
11. Pay off mortgage
Steps #10 and #11 are interchangeable, it all depends on personal preference at this stage in the order of operations. Your house is the biggest expense you will ever have, but that doesn't mean you have to make payments on it for 30 years. After you have taken care of all the steps above, you can attack the remaining mortgage debt and own your house free and clear! It it all comes down to what makes you feel better. Depending on how much you want to invest, or how much you want to be completely debt free, you can funnel cash into both a mortgage and a taxable account accordingly. The exact balance between funding steps #10 and #11 is dependent on your personal preference, and what is best for you and you family.