This blog is not intended to provide professional financial advice. You should consult a certified financial professional to support you in your individual needs. The purpose of this blog represents my own experience, and should not be used as professional financial advice.
So, you’ve started to pay down your debt, and now you have extra money each month! What should you do with those extra funds?
The first thing to boost your path to financial flexibility, even while you are aggressively paying down your debt, is to establish your emergency fund.
1) Emergency Fund
This fund should cover all of your expenses anywhere from 1-3 months. Once you have your budget, you should be able to establish what this number is, and then make sure you add the savings contribution to your monthly budget. The best thing you can do for this is to automate it…set up one day per month where your allocated number is automatically taken from your account (even if it is just a small amount of money to start).
The great news is, once you have paid off or significantly paid down your debt, you have established the start to financial flexibility! With your extra money leftover each month that you were putting towards debt, now you can allocate those funds to the remaining four strategies to boost your path to financial flexibility. The strategies are as follows:
2) Savings
Ideally, (especially in COVID times), you should really look to have 6-12 months saved, but many start with a 1 month emergency fund and build from there. Again, the number you need to establish this savings fund will be based off of your expenses in your budget. Look to putting your money in high yield savings accounts or CDs. One caution with CDs is that they may have limits on your ability to withdraw money, and this account needs to be liquid and available, so a high interest savings account may be your best bet.
3) Tax Efficient Retirement
(Source information check out the IRS website)
Roth IRA:
This is a retirement account that has amazing benefits! Because the money is put in after tax (meaning you’ve already paid the tax on the money before it goes in), when you hit retirement age, you will be able to withdraw it tax free! One thing to note is that if you withdraw money before the age of 59.5 there are fees associated with this. There are income limits (you must make under certain amount of money per year in order to contribute) and limits on how much you can contribute to this account per year, so you definitely want to do your research on this account, but it can be a great resource for retirement saving.
401k/403b/457b:
These are retirement accounts that are typically offered through your employer. 401ks tend to be offered by for-profit companies, and 403b and 457bs are offered through government agencies, schools, and nonprofits, but they are essentially similar vehicles for retirement savings. Many companies match a certain percentage of what you put in which is, you guessed it, FREE MONEY! You should check with your employer to see if this is a benefit that is offered and start contributing.
For these accounts, the money goes in before tax, so that is less money you owe in taxes during the year, and the benefit is that the money grows tax free before retirement. However, when you go to withdraw from them during retirement, you will be taxed at your tax rate at that time. There are ways to potentially reduce these taxes (something called “Roth Conversions”), but you would definitely need to speak with a financial advisor or do some research on when you could make those conversions. You cannot withdraw the funds until you leave your employer—either by finding a new job, or through retirement. You will also need to pay extra fees if you withdraw the money from the account before the age of 59.5.
There are also limits for yearly contributions to these accounts as well, so if you are able to, you should maximize your contribution to the yearly limit.
Traditional IRA:
These are accounts that you are able to open on your own, independent of your employer. Money goes into these accounts before tax, so you are not responsible for taxes on these accounts during the year, however; when you go to withdraw money in retirement, you will be subject to taxes just as you would with a 401k. Money grows in these accounts tax free until retirement. You will also need to pay extra fees if you withdraw the money from the account before the age of 59.5.
For traditional IRAs there are maximum contribution limits, but there is no income limit for contributions.
4) Taxable Investments/
Nonretirement funds
(Source information found here)
If you have contributed to your savings and retirement accounts, and you still have leftover money you would like to see grow, you are also able to open up a taxable brokerage account. This can be done through low-cost investment brokerage companies such as Vanguard, T. Rowe Price, or Charles Schwab. With these accounts you are able to select stocks and bonds and other investments to see your money grow. I am a huge fan of low-cost index funds and bond index funds. I basically set my allocation to a few index funds, including a total market index fund, and a total market bond fund with a specific percentage allocated to each and ride the rollercoaster. If there are particular company stocks that you are super interested in, these accounts can be a good vehicle for those investments. For these accounts, any capital gains or dividends are subject to tax, and any withdrawals you make during the year are taxed at that year’s tax rate, so keep all of that in mind when you are investing, but unlike retirement accounts, there are not extra fees imposed when you withdraw from these accounts.
5) Real EstatE
Commodities
Cryptocurrency
Many people are interested in further diversifying their portfolio through real estate and other investments. Real estate can be a lucrative investment, because with the money you make on rental properties, you can use these funds to pay your monthly expenses, leaving you more money for savings and retirement, or taxable investments. You can also choose to invest in real estate through something called REITs which is a portfolio of real estate investments without the requirement of maintaining the physical property. The downside to having physical rental property is you will need to maintain tenants as well as the property you purchase, and go through the process of closing on the property, closing costs, etc. There are also specific rules with lending and rental properties, so if this is something you are interested in, do your research and speak with an experienced realtor or financial advisor. For more information, check out this resource!
Commodities are another investment class. Commodities can be physical property such as precious metals, food, or wholesale products. I tend to think of cryptocurrency as a member of this group, since it is something either purchased or mined, and this is definitely something to research to see if it is the right investment for you, as Bitcoin, a type of cryptocurrency, has skyrocketed over the last several months. For more information on cryptocurrency, take a look at this.
Ultimately, investment in the real estate and commodity domain should be explored after the other four ways for boosting financial flexibility…but with any investment, there is always a certain amount of risk involved so you should do your research, talk with a financial advisor, and evaluate what level of risk you are willing to take with your investments.
Diversification is key. Just like you should diversify your income stream, you should also diversify your investment portfolio!