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If you earn a high income and want to get your money working for you, then this video is for you. We're going to talk through which accounts you should contribute to first so you can stop treading water and start growing your net worth. Let's jump into it.
The main factor that determines the order here is going to be the return you earn on your money. And by return, I mean how much money do I expect to gain from this investment?
If I invest $100 and one year later I have $110, then I've gained $10. Usually return is expressed as a percentage of the amount you started with. So by earning $10 on my $100 investment, my return is 10 divided by 100 or 10%.
Now with that in mind, the absolute best return you can get on your money in most cases is from an employer 401k match. So the first thing I would do is make sure you're getting the full 401k match from your employer.
This is free money and you don't want to miss out on it. To put in perspective how valuable a 401k match is, if you get a 100% match, then you're immediately doubling your contribution for a return of 100%. Even a 50% match is like growing your investment by 50% as soon as you make the contribution and nothing else comes close to that.
There is an exception to this, which is rare but worth considering. Sometimes an employer will put a match in your 401k, but it's not actually your money until you've worked there for a certain number of years. This is called vesting and it's pretty common for employer matching contributions.
If you know you're going to leave your employer before any of the match vests, then the employer match is irrelevant.
After getting your employer match, the next place I would go is to pay off all credit card debt. And by credit card debt, I'm referring to any balance you carry over month to month. That's the only amount you're going to get charged interest on. So that's the important thing to avoid.
The interest rate is usually more than 20%. As I've talked about before, paying off debt is like earning a guaranteed risk-free return of the interest rate on the debt. So the guaranteed 20%+ return you get by paying off the credit card debt is huge.
So you're getting your employer match and the credit card debt is gone. The next thing I do is build up an emergency fund of cash.
While cash is not going to earn you a big return, the main purpose is to avoid adding more credit card debt in the future at those absurd interest rates.
When an unexpected expense happens or you lose a job, you'll have some cash to fall back on rather than building a balance on a credit card.
How much should you have in an emergency fund? The general answer is three to six months of living expenses. There are a lot of factors that can determine the right amount for you, but if you're in that range, that's a good start.
And you want this money in a high yield savings account. A high yield savings account is a bank account that earns a higher interest rate than the typical check-in or savings account.
The best high yield savings accounts are usually with online only banks. You can often earn several percentage points more per year in one of these accounts compared to your typical brick and mortar national or regional bank.
After you have an emergency fund in place, the next thing I would do is max out your contributions to a health savings account or HSA, if it's available for you.
HSAs are extremely valuable and underutilized. They're only available if you're enrolled in a high deductible health plan though, so not everybody is going to have this option.
High deductible plans are not for everyone, so I wouldn't enroll in a high deductible plan solely for the HSA.
However, if you have the option for an HSA, you can turn it into a completely tax-free investment account, and it's the only account that can do this. You get a tax deduction for your contributions and withdrawals for medical expenses are also tax-free.
I have a couple of videos on evaluating insurance plans to see if a high deductible plan is right for you and also how to maximize your HSA, so check those out if you haven’t already.
The maximum contribution to an HSA in 2024 is $4,150 for individuals and $8,300 for families.
It's important to keep in mind that any employer contributions to an HSA do count towards that max.
Also, if you're 55 or older, you can make a $1,000 catch-up contribution to your HSA, which is in addition to the maximums I just mentioned.
After the HSA, I'd work towards maxing out your 401(k). And for most high-income earners, a pre-tax contribution will make more sense than a Roth contribution.
A high income means a high tax bill, and like the HSA, pre-tax contributions to your 401(k) reduce your taxable income for the year. So you pay less in taxes and you get more money saved.
In 2024, the Maximum 401k Contribution maximum contribution is $23,000 for those under the age of 50. And for those 50 and older, you can make an additional $7,500 contribution, bringing the total to $30,500.
Now, after you're maxing out the 401(k), the next place I would go would be a Roth IRA.
A Roth IRA is another tax-advantaged retirement account, but you don't get a tax deduction for your contributions to this account. Instead, when you pull money out of a Roth IRA, as long as you're older than 59.5, the money will come out tax-free.
The maximum Roth contribution in 2024 is $7,000, unless you're over the age of 50, in which case you can contribute an additional $1,000 for a total of $8,000.
A lot of high-income earners can't contribute directly to a Roth IRA because their income is too high. In 2024, for a single filer, if your modified adjusted gross income is above $153,000, you can't contribute directly to a Roth IRA. And for those married finally jointly, the cap is $228,000.
Even if you're above those limits, there is a way you can still put money in a Roth IRA. It's called a backdoor Roth IRA contribution. Basically how it works is you make your contribution to a regular IRA, and then you convert that contribution to a Roth IRA.
The mechanics to do this correctly could take up a whole video by itself. So I'm going to save that for another day, but just know that even if you have a high income, you can still get money in a Roth IRA.
After that, the next place I'd go is a taxable investment account.
Taxable accounts are plain vanilla investment accounts that you can open pretty much anywhere. And within these accounts, you can invest in pretty much anything you want.
You don't get a tax deduction from these accounts though, but they do offer more flexibility.
Unlike retirement accounts like a 401k and Roth IRA, where you'll be penalized for withdrawing money before you turn 59.5, you can pull money out of a taxable account whenever you want.
The advantage of these accounts over a high yield savings account is you could potentially earn a higher return. Of course, the return isn't guaranteed and you could lose money as well. So it's important to diversify and be aware of the risks that you're taking in the account.
Okay, so we've gone through a general order of investing that should provide a framework to start from for most people, but I left out some accounts that can be very valuable, but aren't for everyone. So I want to hit on those next.
First is a 529 college savings account. These accounts are specifically designed to help you save for college expenses.
I think the easiest way to think of these accounts is they're like a Roth IRA for college. You don't get any federal tax deduction for your contributions, but if you use the money to pay for qualified education expenses, then your investment gains will be tax-free.
Some states do offer a state income tax deduction for contributions. So there could be some tax benefit upfront as well.
The downside of 529s is if you withdraw money from them for anything other than qualified education expenses, you'll be heavily taxed and penalized. If you're saving for college expenses that are a decade or more away, that's a big commitment when we don't know what college will look like, what it'll cost, or even if our kids are going to go to college.
However, 529s can still be a valuable tool and for someone with the goal of helping a child with college expenses, I'd put a 529 plan after maxing your Roth IRA.
Another investment I want to touch on is an employee stock purchase plan or ESPP. These are typically only available to employees of companies that are publicly traded in the stock market.
Every plan is different, but basically how they work is you contribute a portion of your paycheck for a set period of time, usually six months, to purchase your company's stock. When that six month period is up, the amount that you've contributed is used to buy your company's stock, often at a discount to the price in the open market. Sometimes that discount is significant, and so it can be a great investment.
Where to place an ESPP in the order really depends on how the ESPP plan is set up. Sometimes I put one of these plans ahead of the HSA if you get a big discount and there are no restrictions on how quickly you can sell the stock.
In other cases where the discount is small or there's a long lockup period that restricts employees from selling the stock, you can actually skip the stock purchase plan entirely. So you have to evaluate these on a case by case basis.
There's another retirement plan option available to some people that I should mention.
We already touched on the backdoor Roth strategy. Well, this one is called the mega backdoor Roth. Yeah, finance people are not known for creativity.
Basically, this is a way to contribute even more to retirement accounts beyond the limits we've already discussed.
If your employer offers after tax 401k contributions, not Roth, but after tax and in-plan Roth conversions or distributions, then this could be an option for you. In my experience, this is usually only available with large employers.
What happens is that you make an after tax 401k contribution, and if available, you immediately convert that contribution into Roth, either 401k or IRA, depending on how your plan is set up.
In 2024, this could allow you to put up to an additional $46,000 in a retirement plan, which is a huge number.
Now, the rules and mechanics to get this done are complicated, so I'd recommend working with a financial planner to help you with this.
All right, the last investment I want to mention is real estate.
I know a lot of people love real estate, but I'm not one of those people. And it's not that I don't like real estate or that I think it's not a good investment. I just think it's way overhyped.
Real estate can be a great investment for the right type of person, but let me just say that real estate is not passive. It's not. Managing a rental property is going to take time and effort unless you hire a property manager, which is going to cut into your returns.
But real estate can be a good investment with tax advantages for somebody who knows what they're doing. You just need to go in with the right expectations.
Now, I talked through all of these investments as if it's a linear decision, but in reality, it's not a list that you have to perfectly adhere to.
For some people, it may make sense to start using a taxable account before they're maxing their 401(k). Or maybe you sprinkle in an additional 401(k) contribution while you're building an emergency fund.
The point is that your goals and circumstances will determine the right strategy for you.
That's where working with a financial planner can help. At Trek Wealth Planning, we help our clients come up with a plan that's customized for what they want to accomplish. So if that's something that sounds appealing to you, let's have a conversation. You can schedule a free consultation below.
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