Personal Finance is Personal

My brain functions best with order. I guess this should not come as a surprise being a CPA, first born, type-A individual but at times I am surprised at my unconscious natural desire for order. For those thinkers like me I thought it would be helpful to provide a step by step template for allocating your disposable income to maximize its value, so you can maximize your impact.

I do want to be careful to emphasize that personal finance decisions are, as the name implies, very personal. No matter what article you read, there is no one-size-fits-all solution to managing finances. There is no perfect sized emergency fund or 401(k) deferral percentage so don’t be fooled or guilted into following someone’s path. That being said, there are broad rules of thumb and best practices that everyone should consider when determining their personal financial plan.

Sequential Saving

  1. Initial Emergency Fund and Debt Payoff
  2. Fully Funded Emergency Fund
  3. Health Savings Account (HSA)
  4. Employer Retirement Plans – 401(k)s and 403(b)s
  5. Individual Retirement Accounts (IRAs) & 529 College Savings Plans
  6. Taxable Brokerage Accounts

Start with the Basics

Where do you think most people naturally put their extra monthly savings? My observation is the natural tendency is to open a Schwab or Fidelity or Robinhood account and begin investing in the stock market. In other words, the default for most people is to approach savings completely backwards. Why start with the boring emergency fund and debt paydown? Risk mitigation. Managing and avoiding uncessary risk is a crucial component to a successful financial plan. Paying down high interest debt like credit cards and student loans and building an emergency fund lowers risk and increases flexibility. It is tempting to seek higher returns and skip funding an adequate emergency fund but those “higher returns” will always be in jeopardy if there is not adequate savings to back them up.

The COVID-19 pandemic has brought this concept front and center. Stock market downturns typically mirror economic struggles. Meaning, the need for savings is highest when stock market prices are most depressed. Without adequate savings, this means tapping into long-term investments in 401(k)s, IRAs, or brokerage accounts at depressed prices to meeting current needs which eliminates any higher return potential that was being sought in the first place.

Cash does not generate great returns on paper, but it does protect the returns in the rest of your financial plan and that protection is priceless.

Start with Where You Are

The most important place to start is to understand where you are. It is often easier to focus on where you want to go than to know where you stand today. This is the necessary dirty work. Build a net worth statement and start tracking or just estimating current expenses (template to download can be found at this link). Make sure not to get paralyzed in the details. Estimates work just fine. Once you have a clear understanding of where you are, it makes every other step much easier to implement and stay accountable to.

Initial Emergency Fund and Debt Payoff

If you are fortunate enough to not have any high interest debt, you can move to the second rung, adequately funding an emergency fund. For those who still have high interest debt, consider setting aside enough for an initial emergency fund of a few thousand dollars and then focus on paying of debt. Taking a year (or years) to save enough for a fully funded emergency fund does not make sense while paying 15% interest on credit card debt.

This initial emergency fund should be in a separate account outside of your checking account but easy to access when needed. If it is tempting to use this account for non-emergencies, set it up at another bank or in a money market account so there is a little more friction involved in spending it inappropriately.

I am often asked how to balance paying down debt, establishing an emergency fund, funding a retirement account, and saving for children’s college education. The answer to this question depends on numerous unique personal factors but my approach is to think in sequential steps instead of trying to do everything at once. I also always encourage making sure your dollars have an impact. Do not let debt or a small emergency fund stop you from supporting organizations and causes you are passionate about. The benefits of generous financial management are well documented and often have greater intangible “returns” than the foregone “dollar returns.”

Next Steps

The next blog will dissect the proper size, location, and purpose of an emergency fund. I will explain why I love the ROTH IRA as an emergency fund vehicle for the right person and other variables you should consider when implementing the second rung on the sequential financial savings ladder.