Once you have your basic budget sorted out and start to have excess cash, it can be difficult to figure out where to put that. There are several school of thoughts on where to put your excess cash but today we are going to talk about what I view as the Investment Hierarchy. This investment pyramid has several layers of where to put your cash with justification for each layer. There may be anecdotal cases where the layers don’t make sense, but for the average person they should be a good rule of thumb.
Investment Hierarchy 1st Layer: Cash Flow
The first thing we need to analyze cash flow. We need to take a look at all of our debt repayments and get that paid down as soon as possible. Now, not all debts are created equal. The first debt we need to eliminate is high interest debt. I’m talking about anything over 10%. Before those debts are eliminated we need to spend all our extra cash getting them paid down as soon as possible. This a guaranteed 10% return on investment and it will be virtually impossible to get the same guaranteed return.
Next we need to take a look at our other debts. These include things like car loans, student loans and mortgages. These tend to be lower but will have a significant impact on our cash flow. Car loans should be the first item that you pay off on this list because you don’t get any tax benefit so you are paying the current interest rate. Not to mention having your car paid off in full can save you money on your car insurance.
As you are going along you should also be establishing an emergency fund with your excess cash flow. There are many different recommendations for how many months of expenses you should have saved. In my opinion, it really depends on your comfort level and what your view is of ‘worst case scenario.’ I personally go for a 6 month emergency fund because I know I can draw on some of my investments if things progress longer than that. Others may be comfortable with 3 months or even a year. The downside of larger emergency funds is that your cash isn’t working for you. The benefit is the peace of mind that comes with having a healthy cash cushion.
Debts to Payoff Last
Student loans and mortgages tend to be a little more complicated. This is because of the way the tax law works in the United States. If you are currently itemizing on your taxes each year, than your interest rate after tax is actually lower than the APR. For example, currently you are allowed to deduct interest on $1 million of mortgages or $750,000 if you bought the house after December 15th 2017. If you have $20,000 of mortgage interest and a marginal tax rate of 25% that essentially gives you an extra $5,000 of tax free money each year.
Student loans on the other hand allow you to deduct $2,500 of student loan interest in a given year if your adjusted gross income was $70,000 or less ($140,000 if filing jointly). There is also a phased rollout up to $85,000 adjusted gross income ($170,000 if filing jointly). This can be a smaller tax savings than the mortgage but can save borrowers up to $550.
Now, all debt paydown will improve cash flow and create more opportunity to make your money work for you. However, there is an opportunity cost to paying down large debts and delaying investing and the power of compound growth. We will get into looking at the tradeoff in the next few sections.
Investment Hierarchy 2nd Layer: Employer Sponsored Programs
The first thing I always tell people to look at is their employer sponsored retirement programs. These thankfully have become the norm at many companies and can be a great way to start saving automatically. Not all programs are created equally, but each comes with its own pros and cons that you should be considering.
The most common plan is a 401(k). They come in two varieties, a traditional 401(k), which is often just called a 401(k) or a Roth 401(k). The difference between these two is whether the money is being put in pre-tax or post-tax. The benefit of using these accounts is they create what I call Magical Forever Dollars, or future income. The choice between the two different types of 401(k)s really comes down to what your employer offers and your current marginal tax bracket in comparison to your retirement tax bracket. The Mad Fientist also has a very thought provoking articles regarding the difference between the two.
Other Employer Sponsored Programs
There are a few other common employer sponsored programs that are out there that you should contribute to if you can. The first is a 403(b) plan which is virtually identical to a 401(k) plan. The difference is that they are typically for non-profit organizations. The second is a 457 plan, which is also very similar to a 401(k) but for government employees. The third is a SIMPLE plan, which is essentially an IRA that is sponsored by the employer. It has higher contribution limits than a typical IRA but an employer can only match 3%. There are also SEP plans, which are again like IRAs sponsored by businesses but SEP plans have the highest contribution limits at $58,000 for 2021.
There are also various types of pensions out there. Two of the most common are Defined Benefit plans and Defined Contribution plans. Defined Benefit pensions essentially work by giving you a set payout based on years of service. These are common for government employees and Union workers. Defined Contribution plans are pensions that get a set amount contributed by the employer for every year of active service. These are becoming far less common but some are still around.
Why Employer Sponsored Programs First
One of the most appealing parts of employer sponsored programs in our investment hierarchy is the fact they often have a matching contribution. I like to call these guaranteed raises. For example, your employer may offer you a 5% match on your 401(k) contributions. That means if you make $100,000 a year, if you contribute at least $5,000 to your 401(k) each year, your company will give you an extra $5,000 towards your retirement. Not only that, the money also gets to compound year after year in your investment account based on your annual returns.
If we assume that over a long enough time period the stock market returns roughly 10% than your returns would be as follows over a 20 year period.
|Year||Your Contribution||Employer Contribution||Balance|
As we can see, we contribute a total of $100,000 to our retirement accounts, but because of the company match and the compound returns, our $100,000 turns into $630,024.99 in just 20 years. This is why you should always take advantage of a company match if you’ve paid down all your debt above 10%.
Investment Hierarchy 3rd Layer: Self-Directed IRAs/Retirement Accounts
After you have your emergency fund squared away, high interest debts paid off and your getting your company match, it is important to look at self-directed retirement plans. I put this step above maxing out your employer sponsored program because of the flexibility of deciding your own investments. There are hundreds, if not thousands of different sponsors of employer plans but they usually have a fixed number of investment options. A self-directed account allows you to choose the underlying investment which can be very beneficial.
Most employer sponsored programs offer mutual funds rather than ETFs as their investment vehicle. In doing so, they often have expense ratios associated with them. For example, one of the most common funds in an employer sponsored program is VFINX, which tracks the S&P 500. It has an expense ratio of 0.14%. On the other hand, SPY is one of the most common S&P 500 index and has an expense ratio of 0.0945%. This 0.0455% may not seem like much but there are even more stark difference in other funds. Some target date retirement funds have expense ratios over 1.00% which can really eat into your earnings year over year.
Self-directed retirement plans also give you the benefit of being able to trade individual securities, derivatives and even own real estate for the advanced investor. The real benefit here is the freedom that they allow. There are AGI limits on Roth IRA, and deducting your contributions to traditional, so consult your tax professional before opening an IRA.
Investment Hierarchy 4th Layer: Taxable Brokerage
Let’s say you’ve maxed out all your retirement account contributions and you still have money left over. Or maybe you are looking to get some growth for a long time period but before retirement. This is where a taxable brokerage comes into play. This is an account that you open up at your brokerage of choice and you can either choose your investment or work with an advisor. The main difference is that there is no retirement tax benefit and you can withdraw the money, subject to capital gains of course, at any time. Taxable brokerages have really taken off lately with the surge of low cost to free trading from places such as Robinhood.
For those of us on an early retirement journey, a taxable brokerage account can play a vital role in bridging the gap between employment and retirement funds. Although there are a few tricky technical ways to withdraw retirement money early, it may be easier to fund that stage of life through a taxable brokerage. It also allows you to invest money for shorter term projects, such as making the state pay your property taxes. There are all sorts of different vehicles to invest in and reasons to do. While an employer sponsored plan may be a jet turbine to a successful retirement, a taxable brokerage is the Civic that gets you through the day to day.
Investment Hierarchy 5th Layer: The YOLO Account
Congratulations, you have reached investment Nirvana. As this stage of the game you have all your basic investment needs met. All your debt is paid off, you will have more than enough money in retirement, you are able to retire early and have your taxable brokerage account to cushion your time. You just want to make some alternative investments that could accelerate the timeframe, or create generational wealth. You are also okay if these accounts go straight to $0. This is when it is time to invest in riskier classes of investments. This includes everything from cryptocurrency (don’t hate me), peer-to-peer lending, derivative trading and private equity.
I am not saying these are bad investments, on the contrary, I think they can make people incredibly wealthy. The problem is that it is just as likely, if not more so sometimes, that they will go to nothing. This is why this is the peak of the investment hierarchy, the last stop of our pilgrimage. We have all heard stories about early stage investors making millions, but we have also heard plenty of stories about companies failing. For every Bitcoin boom there is another CrapCoin falling apart. If you have the money, and the heart, why not risk it. After all, maybe you’ll invest $50,000 in the next Amazon and turn that into $3.5 billion.
Investment Hierarchy: In Recap
This isn’t meant to be a how-to guide on how to invest your money. Or a step by step recipe on getting rich. This is merely a guide on vehicles to explore as you go through various stages at life. There are steps that you may never reach, or others that you skip over entirely. The point being is there isn’t a right way or wrong way to invest as long as you’re being financial responsible.
Would you reorder the investment hierarchy? Or have you followed it all your life? Let me know in the comments below!
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The above references an opinion and is for information purposes only. It is not intended to be investment or tax advice. Seek a duly licensed professional for investment or tax advice.