SUMMARY: Let’s say you have $10,000. Should you use that money to pay off debt, establish an emergency fund, or contribute more to your retirement accounts?
You’ve come into some unexpected money—a bonus at work or a small inheritance from an obscure aunt—and this brings up an obvious question. After the initial excitement wears off, what’s the best way to use this windfall?
Before you begin…
There are two questions to answer before you begin to divide up this pool of money:
- What is my monthly budget?
- What are my financial goals?
Your budget brings your financial health (or lack thereof) keenly into focus. The ratio of income versus expenses will determine how smooth or rocky the road ahead will be. Minimize your expenses and you’ll have more freedom to pursue your goals.
And what are those goals? Save up for a new car? Plan for a secure retirement? Buy your first home? These will have an impact on how you use this $10,000.
Establish an emergency fund
Ideally, you’ll have funds for three to six months worth of expenses at the ready in case of an unexpected turn of events—your car’s transmission dies, a sick relative requires a last-minute flight and hotel, or your company makes layoffs. By “at the ready,” we mean liquid, in easily accessible checking or savings accounts.
If you do need to make use of this fund, be sure to replace what you use at the earliest possible date.
The one action item that should potentially come before an emergency fund is to pay down high-interest credit card debt. If this fits your situation, take care of these obligations before starting your fund.
Claim your employer-matched funds
If your company offers a 401(k) or similar retirement plan—and if they match employee contributions—your next step is to put in the maximum amount allowed in order to claim the full match. If you ignore this step, you leave free money on the table.
Take a bite out of high-interest debt
Now that your emergency fund is set and your employer match is secured, it’s time to tackle your debts (particularly those with an interest rate at or above 4 percent). There are two schools of thought on how to manage this process, both of which assume you’re already making minimum monthly payments:
- The avalanche method. Start with the debt that has the highest interest rate and work your way down. It takes time, but saves money in the long run.
- The snowball method. Start with the smallest balance and work your way up. This allows you to pay off balances more quickly, which can provide an important shot of confidence, but it may cost you over time, as you continue to owe interest on larger balances.
While not as sexy as a 401(k) or Roth IRA, debt service is essential to maintaining a healthy credit score and moving toward your financial goals.
Kickstart your IRA
An IRA can be an excellent partner to (or substitute for) an employer-sponsored retirement account. There are standard and Roth IRAs, the former of which allows contributions of pretax dollars before retirement, and the latter tax-free withdrawals after retirement. Which you choose depends largely on how much income you anticipate having before and after retirement.
Ideally, you’ll contribute up to 15 percent of your gross income until you hit the 2019 limit of $6,000.
Get serious about retirement
You’re off to a great start with your IRA and employer-sponsored account. But don’t stop there. In a perfect world, you’ll put 15 to 20 percent of your gross income aside for retirement. If that’s too rich for your salary, don’t panic. Contribute whatever you can now—every dollar matters.
It may require cutting expenses today, but will provide peace of mind for life after work.
But I only have $1,000...
Never fear. In addition to the priorities mentioned above, there are many attainable goals that a smaller pot of money can help achieve.
- Put tax-free money away for future medical costs with a health savings account (HSA).
- Save for college with a 529 plan.
- Teach your kids the value of investments.
- Prepare important legal documents. Pay a lawyer to draw up vital personal papers such as wills, trusts, living wills, health-care proxies, and powers of attorney.
- Get healthy. Spend your $1,000 on a nice set of personal trainer sessions, or a year’s worth of local produce from a community-supported agriculture (CSA) program.
- Give it away. No matter how important this money may seem to you, there are others who need it more.
Start now, save more
Whether it’s $10,000, $1,000, or $100, your money can go to work for you right away. And the earlier you start, the harder it works. Compound interest is your friend, and tax-advantaged accounts such as 401(k)s, IRAs, or HSAs are ideal places for it to grow without fear of inflation.
Still need help managing your cash? We can help with that. Our wealth advisors are here to make your financial planning a success. Call us or make an appointment today.