Last week’s post on whether to pay off credit card debt or max out a 401k raised good discussion interesting questions.
It led to a YNAB office chat about how to sequence your “get ahead” dollars – a “get ahead” dollar being defined as one that either reduces the balance of a loan or recruits other dollars (ie investments).
Here’s what we came up with:
*The usual disclaimer: no part of this article is meant as investing advice. I present this information only for discussion purposes.
1. or 2. Pay off high interest debt.
If you’re carrying debt at 7% interest or above, make it your number one priority to pay it off. Trying to get ahead in your retirement accounts while you still have debt is like trying to pedal a bike with the brakes on.
The only possible exception is when your employer-matched 401k contributions give you an instant 100% ROI on those dollars. I say possible exception because it’s hard to be wrong when you make it your top priority to get rid of high interest debt.
2. or 1. Max out your tax-advantaged, employer-matched 401k contributions.
A key distinction here would be that you’re only contributing the amount necessary to receive your full employer match. Once you’re getting all the free dollars you can from the match, put your extra dollars into a Roth IRA (I’ll explain momentarily).
3. or 4. Pay off lower-interest debt.
This would include anything in the 0% to 6% range. My mortgage is at 3.99% interest. Does it make sense to prioritize it ahead of maxing out my tax-advantaged retirement accounts?
The strict math says I’ll likely earn more than 3.99% in the market than I would in an indexed mutual fund protected by a Roth IRA. On the other hand, paying off my home allows me to have a much smaller retirement nest egg.
I personally lean toward paying off my house. We’ll see if that’s still true when I’m finished with my higher-interest debts.
4. or 3. Max out Roth IRAs for yourself and your spouse.
The 401k was originally created to supply up to 20% of your pre-retirement income, but quite a few people seem to think it’s the only retirement vehicle they need.
Not only is a 401k not likely to get you through retirement on its own, a Roth IRA has features that make it more appealing than most 401k plans:
a. After you reach the qualifying age, withdrawals from a Roth IRA are tax-free.
b. You’re likely to have more control over the funds inside your Roth IRA than you would with your company-sponsored 401k. For example, Jesse had to pay an extra fee to allow YNAB team members access to Vanguard mutual funds. I don’t think many employers would do the same, which means you may not be able to access top-performing funds unless you seek them out in your own Roth IRA.
c. There’s less hassle and overhead associated with a Roth IRA in the event you change jobs or companies.
5. or 6. Max out traditional IRAs for yourself and your spouse.
Traditional IRAs give you an up-front bonus on your saved dollars because you make contributions with pre-tax income. In other words, you don’t pay taxes on the money you put into a traditional IRA.
You will, however, pay taxes on the withdrawals you make after reaching a qualifying age. That’s why – other things being equal – we prefer Roth IRAs. They offer the same investment opportunity (currently capped at $6,000 per year, per person) while also offering tax-free retirement income.
6. or 5. Max out Health Savings Accounts for you and your spouse.
Health Savings Accounts are the only financial/investing instrument that allows you to make pre-tax contributions and withdraw the money tax free.
You can also use the money as-needed to cover qualifying medical expenses. In other words, HSAs are great tools.
7. Having maxed out all your tax-advantaged savings vehicles, save any extra money in taxable investments.
How’d we do? Do you sequence your “get ahead” dollars differently?
For a more detailed discussion of saving and investing, check out Jesse’s (YNAB founder) 9 Day Investing Course.