First things first - ep #81

Feb 28

Welcome to episode 81 of the One for the Money podcast. I am always glad and grateful you have taken the time to listen. There are a host of options when it comes to investing and there is an order of priority in which these should occur. In this episode, I’ll share my thoughts on that order.

In the tips, tricks, and strategies portion, I will share a tip regarding 401k contributions for those nearing retirement.

In this episode...

Cash Flow Management [1:58]
Emergency Fund [4:17]
Contributing up to Company Match [5:51]
Paying Down High-Interest Debt [6:20]
Funding an HSA [7:50]
Saving Further into a 401(k)/IRA [9:03]
Extra Savings [10:12]

MAIN
I recently re-read the classic book, The Richest Man in Babylon. It’s a great story on how simple steps can help one build wealth, even those who are mired in debt. The truths contained therein are conveyed so well through the story that I’m having my oldest two boys read the book.
In the book The Richest Man in Babylon, its emphasis was more on savings than investing. Presently there are almost countless ways one can invest. For that reason and others, the investment world can be overwhelming and as a result, many choose not to participate. And that is literally and figuratively unfortunate as far too many fail to make small changes that over time have massive results. This episode is meant to help demystify which investments one should select and in what order.
But of course, before we can even think of investing, we need to ensure we are monitoring our cash flow. That is the money coming in and the money going out. Some call that a spending plan, others call it a budget. I’ll go with the former as it seems more palatable and less restrictive than a budget.
The general rule of thumb when it comes to spending plans is pretty straightforward. One should allocate ~20% of your spending plan to your savings. Those savings can include an emergency fund as well as your retirement and non-retirement savings vehicles. I mention savings first as you should always get in the habit of paying yourself first. It’s an absolute game-changer. As Warren Buffett said so well, Do not save what is left after spending but spend what is left after saving.
Approximately ~50% of one’s budget should be spent on their needs. This would include housing (be it a mortgage or rent), groceries, electricity, transportation, etc. Finally, ~30% of your budget should be allocated to your wants such as a gym membership, eating out at restaurants, travel, etc. However, this should only be the case if all one’s higher interest-rate debt is paid off. I would define higher-interest debt as over 6%, which is not your mortgage. Now some might argue that one’s health is paramount and that you should devote money to gym memberships, etc. I agree that one’s health is critical as I recently shared in episode 78 how the first wealth is health, but one can work out without the need of a gym. Additionally, one can eat without the need to go to a restaurant. For those reasons, these are considered “wants instead of their needs” expenditures.
Now that I’ve set a framework regarding cash flow planning, the next step is to consider what should be the order of where one puts their money. This may seem similar to the baby steps that Dave Ramsey has made famous. I will share a few key differences between those steps. Dave’s Ramsey’s Baby Steps are great as a general rule and the impact he has had on thousands upon thousands of Americans is nothing short of remarkable so I’m in no way trying to belittle his steps.
The first step, which I will call 1a, which is similar to Dave Ramsey’s, is building up an emergency fund. As JP Morgan notes in its Guide to Retirement - Life is uncertain –spending shocks and/or job losses can happen at any time. Emergency savings can help pay for these uncertainties and keep retirement savings intact.
The resource also notes that Workers typically encounter spending shocks more frequently (about once every three months) than income shocks (about once a year) and that one should consider setting aside 2-3 months of pay. If your spouse isn’t working, you will want to increase that to 4-6 months of pay as you only have one income to rely on. It’s much like a single-engine vs twin-engine plane. If the engine goes out on a single-engine plane, drastic action needs to be taken, but if one engine goes out on a twin-engine plane, you have a few more options. The same goes with households with 1 income vs 2 incomes. Those with 2 incomes can have fewer funds allocated to an emergency fund.
JP Morgan also notes that Retirees encounter more spending shocks in larger amounts than workers, likely due to unpredictable costs such as health care, and that retirees should consider setting aside 3-6 months of income.
The next step I would call step 1b, which is contributing to your company retirement plan up to the company match. For instance, if your employer matches 4% of your contributions to your retirement plan, you should contribute up to the company match as that is a risk-free and simple way to double the money going into your retirement account. This should happen simultaneously while you are building your emergency fund. Hence I call these steps 1a and 1b.
Step 2 is building up a more significant emergency fund. Now this is where my advice and Dave Ramsey’s advice will differ. He advocates building a $1000 emergency fund and then paying off any high-interest debt before you contribute money to receive the company match. His reasons are all about maintaining momentum in getting debt-free, but given that a company match is free money that doubles your contributions, I don’t think one should pass it up.
Now, if you have higher-interest debt to pay off, you shouldn’t contribute beyond what the company will match. Most companies match in the 3-4% range, although I have seen some contribute in the 10%, which is remarkable.
I also generally recommend that people build up a slightly larger emergency fund initially than a $1000 starter fund before starting to pay off higher-interest debt. That way a larger emergency fund could cover 2 to 3 months worth of expenses. Building up a slightly large fund is a great way for people to strengthen their savings muscle, and as their savings continue, they can in turn use portions of this emergency fund to help pay down higher-interest debt. The challenge of having a small, $1000, emergency fund is that it doesn’t provide much of an emergency cushion, especially in 2025, and if there is a job loss.
Step 3 I’d recommend is paying off higher interest rate debt. This would be debt that has an interest rate above 7% that is not mortgage-related.
Step 4 would be contributing to a Health Savings Account before contributing further to a 401k or individual retirement account like an IRA. The HSA has many more advantages than a traditional retirement account. I have spoken on these in many episodes. These are the only investment vehicles that are triple tax-free. Yes triple! The contributions are tax-deductible, and both the growth, and distributions (if used for a qualifying medical expense) are tax-free, and so with HSAs, you pay $0 taxes. However, not all people are eligible to invest in an HSA. You must have a qualifying high-deductible medical plan. Additionally, the contributions are limited to the following amounts in 2025: Individual $4150, and Family $8300. For those 55 and older, you can contribute an additional $1000.
You can use the money in the HSA at any time to cover health care expenses. That’s why they are ideal for early retirement. But if you don’t need to use these, then you can really see the benefit when you let the money grow and pay for current health care expenses from other sources of personal savings when possible.
But what if you don’t need all of the money for Healthcare Expenses? It essentially becomes just like a Traditional IRA. Distributions are taxed at ordinary income rates.
For my clients who are younger or “youngish” who think they can wait until later, remember that the earlier you invest your money the longer it has time to grow, and that growth can be significant. Just $2000 invested in an HSA each year for 30 years that earns a 7% rate of return would grow to over $200,000. That would go a long way to help offset health care expenses in your early retirement.
Step 5 would be further contributing to your 401k/IRAs to get to that 20% level of savings. For those who don’t need the savings for other goals (such as a house down payment) and if they are planning to retire after 59.5 you can put 10-15% of that money into a retirement account such as an IRA, Simple IRA or 401k, etc with the remainder in a non-retirement investment account. For those anticipating needing some of those funds before age 59.5 (for a house downpayment or even early retirement), I’d generally recommend saving 10-15% in a non-retirement account and the remainder in a retirement account.
Whether one contributes to a Roth vs a Traditional account depends upon their income tax rate.
The 6th step has numerous options. You can use these extra savings to enjoy extraordinary experiences. Better seats at concerts or sporting events, and more immersive travel experiences. It’s important to have these travel experiences while you have the health to enjoy them.
For others who may want to invest in RE, they can build up funds to purchase these assets. For those wanting to become completely debt-free, they can use these funds to pay off their mortgage.
If your mortgage is fixed at around 4% or less, mathematically it mostly likely doesn’t make sense to pay it off early. But if paying it off early makes you feel psychologically much better, then it can make a lot of emotional sense to pay your house off. I always thought I’d pay our mortgage early but because it’s below 3%, I’ve chosen to invest these extra payments instead.
In conclusion, the order in which you make financial decisions can have a significant impact on how quickly you can realize your goals. I would recommend that as you make it through each step, you take a moment to celebrate. Go for a nice meal or a weekend getaway. It’s important to let yourself embrace and fully experience the accomplishment you just made. Just don’t celebrate so extravagantly that it knocks you back a step or more. Far too often people don’t take the time to stop and “smell” the roses of their accomplishments.
TIPS, TRICKS AND STRATEGIES
Welcome to the tips, tricks, and strategies portion of the podcast where I will share a tip regarding 401k contributions nearing retirement.
Saving in a 401k is a great way to ensure you have sufficient income in retirement and a 401k can allow you to do it in an incredibly tax-efficient manner. Congress recently passed legislation that allows individuals of certain ages to boost their savings eve further. The 401(k) contribution limit for 2025 is $23,500 for those under 50 and those over 50 can contribute an extra $7500 or $31,000 in total. But beginning this year, 2025, those between ages 60 and 63 will be eligible to contribute up to $11,250 instead of $7500 as a catch-up contribution. This means those 50 to 59 or 64 or older will be able to contribute up to $31,000 in 2025, but those 60 to 63 will be able to contribute up to $34,750 in 2025.
I recommend you speak with a certified financial planner to see if it makes sense for you to maximize your contributions. Feel free to schedule time with me using the link on my betterplanningbetterlife.com website.