There are three things to consider when deciding on where to save your next $1,000.
Defending yourself from financial potholes
Positioning yourself to take advantage of opportunities
Highest risk-adjusted after-tax return
In the chart below I discuss how I would go about deciding where to save my next $1,000. I'd start from the top, ask myself if I am lacking in this area and if I was I would focus on that area first. If I felt confident in that piece then I'd move to the next option.
Cash
The chart above shows that cash is king, and it's as true today as it was 40 years ago. Having cash keeps you out of bad debt, provides emotional comfort, and positions you to take advantage of investment opportunities that may come up. How much cash should you have? If you only have one source of income, then I recommend having enough cash to cover six months of living expenses in a HYSA (high-yield savings account). If you have two EQUAL sources of income, then you can lower this to 3 months of cash in a HYSA.
However, having more cash than the recommended 3-6 months of expenses can act as an opportunity fund. Suppose there is a drastically undervalued car for sale, real estate, or an investment that could return 15%+. Cash above the emergency fund recommendation may be the only way to participate in these opportunities. And this is because those opportunities typically need to be acted upon quickly. You don't have time to get a HELOC, auto loan, or sway a friend to go in on it with you.
401k Match
If you receive a 401k match at work, whether 25%, 50%, or 100%, you should maximize it. Assuming there isn't a cash flow restriction at home. This deal is so good that even if you withdrew the entire amount each year, paying taxes and penalties, you'd still be better off compared to avoiding the 401k as a whole. Of course, I recommend leaving your money invested to compound your gains over time but let's look at the early withdrawal example below.
Example (withdrawing from 401k and paying penalty and taxes at year-end):
You earn $300,000, and your company matches the first 6% of your contributions at a 100% match.
Employee 6% contribution: $18,000
Employer 6% contribution: $18,000
Total = $36,000
Withdraw $36,000 at year-end
A tax of 35% and a 10% penalty = $19,800 after taxes and penalties
Vs. the alternative
Taking $18,000 in salary - 35% tax bracket = $11,700 after taxes
This means you would be $8,100 better off contributing to the 401k, taking the match, withdrawing the funds, and paying taxes and penalties under this scenario. Based on the numbers above, you are guaranteed a 69.23% return, and if you invested the dollars in your 401k, the return could be even higher. However, I only recommend this early withdrawal strategy to help escape high-interest-rate debt or if there is a large cash need at home. Your net worth will be far better off if you can leave these funds invested and compound between now and retirement vs. removing to spend. Keep in mind that not all 401k's allow in-service withdrawals so double check on this before you pursue this strategy.
High Interest Rate Debt
I consider any debt with an interest rate over 10% high-interest rate debt. After you fill your emergency fund and maximize your 401k match, I would aggressively pay down any of this debt to $0. There are some exceptions for early-stage businesses with excellent traction and significant inventory needs, but that likely isn't you.
Remember that paying down debt with a 10% interest rate is the same as receiving a guaranteed 10% return in the stock market, except you don't have capital gains taxes on paying down debt. Because of this, I would rather pay down a guaranteed 10% interest rate debt than risk my money on an investment that may pay 12%—15%.
ESPP (Employee Stock Purchase Program)
These programs typically allow you to buy and sell company stock at specific times throughout the year. Discounts for the purchase price range from 5%-15% and can be a great way to involve employees in the company's success. The difficult question here is when to sell. I prefer holding these items for at least a year after the transfer or two years after the option was granted to qualify for long-term capital gains tax. But I wouldn't want more than 10% of my clients' net worth tied up in their company stock.
If they are charitably inclined, some clients will donate their company stock to a donor-advised fund as a tax savings strategy. You can read more about those strategies in my blog, "Unlocking the Power of Tax-Smart Charitable Giving: 5 Strategies to Maximize Your Impact."
Alternative Investments
If you have access to an alternative investment, such as a private loan to a trustworthy business or person, or if a syndication looks promising, or you want to flip watches, cars, or some other high-value item, then it can make sense to pursue these routes. However, this is a high-risk space, and you must be well-versed in analyzing these opportunities, protecting yourself from downside risk, and knowing your competitive advantage before investing.
HSA
This is the most underrated account I regularly work with. It's the only triple tax-advantaged account in our financial system. You receive a deduction for your contribution, can invest your dollars with no capital gains taxes, and withdraw the funds tax-free if used for medical expenses. I've seen people accumulate up to $400,000 within their HSA account and use it to self-insure against long-term care expenses and be used for healthcare expenses in retirement.
These accounts are also incredibly flexible. You could use them to pay for your gym membership, sunscreen, dental visits, and more. You should be able to find a list of eligible expenses at your HSA custodian.
401k Max / Backdoor Roth IRA Contribution / Mega Backdoor Roth IRA Contribution
Deciding between the above options depends on your current tax bracket, monthly free cash flow, and whether you have a funded IRA.
401k Max: This option depends on if you have a roth 401k option or only a traditional 401k option through work. But it can be a great place to further save money up until the $23,500 max contribution or $31,000 max contribution if over age 50.
Backdoor Roth IRA: This option is attractive if your tax bracket is 24% or below or you have a random low income year and you don't have any IRAs that could trigger the pro-rata rule.
Mega Backdoor Roth IRA: This option is attractive if your 401k allows it, you are in the 24% bracket or below, and you have a large amount of free cash flow per month above current savings and expenses—typically more than $2k/mo in free cash flow.
There is a caveat to being in the 24% tax bracket or below recommendation for the backdoor Roth options. Suppose you want tax diversification and won't have a large window between retirement and social security kicking in to convert your traditional dollars to Roth. In that case, pursuing a roth option may be recommended.
529
If you have kids, a 529 account could be a valuable tax-advantaged account for them. I have two recommendations for people wanting to use 529 accounts to save for education expenses: to not oversave and to know your state's tax advantages for using their 529, if any. You can read more about saving for college strategies in my creatively named blog, "Saving For College—2024."
Taxable Account
A taxable or individual account is also a very underrated account. Yes, you have to pay capital gains taxes on gains, but if you're charitably inclined, you could donate this stock to a donor-advised fund or directly to a charity to avoid those. There is no contribution ceiling for these accounts, and if you have losses, you can benefit from them through tax loss harvesting. Also, these accounts don't have any early withdrawal penalties or withdrawal rules. The taxable account is the best option if you're looking for maximum flexibility and liquidity.
Emotional return
Suppose you are saving the appropriate amount for retirement, using the optimal account structure, and feel confident in your financial future. In that case, I'd recommend investing more in things that offer an emotional return. That could be someone cleaning your home or car, upgrading your usual trips, or being more generous with friends, family and causes you care about.
Luxury Items
Assuming you are on track for your retirement and other financial goals, living generously, and feeling secure in your future, it may be worth saving for larger items, such as a second home, second or third car, airplane, first-class tickets, $10,000 mountain bike, or purse. Although these items will almost always lose money, they can be fun experiences to share with your spouse, friend, or yourself.
I know it's funny to hear a financial planner recommend buying a third car or second home, but some income levels allow things like this to still land in the realm of responsibility. It is something that most people are naturally jealous of, so I recommend keeping these purchases to yourself or between close friends. Hopefully, these purchases will increase your and your families life satisfaction.
Closing
I hope you found this hierarchy list helpful and can refer to it when deciding where to save your next $1,000. Let me know if you'd re-arrange any items on this list and why. Have a great week!
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