Sequence of Savings

We created the optimal order to save and invest your money.

Image of Peter Campbell
Peter Campbell
January 05, 2023
Sequence of Savings 1

Where should you save your money first? Should you prioritize funding an emergency fund or paying off high-yield debt? Should you max out your employer 401(k) or contribute to a Health Savings Account first? While we all have unique goals and, therefore, different choices to choose from, there is a set of principles that we should all follow when maximizing wealth-building and tax efficiency

We created a step-by-step plan called the “Sequence of Savings,” the optimal order to save and invest your money. 

It is important to note that this is a framework to work from, not a rigid list with no flexibility. As with all financial planning decisions, your unique circumstances should be considered when determining where to place your money. Nonetheless, this framework should help you make these all-to-important decisions. 

1. Build an Emergency Fund

Emergency Fund

The first place to save money is a cash savings account, often called an emergency fund. Generally, the goal is to target between 3 – 6 months of expenses in this account. For a two-income family, the lower end of three months is fine, and for a single-earner or one-income family, six months is more appropriate. While technically, the need is for only fixed mandatory expenses (mortgage/rent, utilities, food, insurance payments, etc.), most people prefer to keep it simple and pick their total monthly expenses.

An emergency fund ensures easy access to money if you have a health event, job loss, or home or car repair. If all your savings are in retirement accounts, you could have taxes and penalties for early withdrawals, so this emergency fund ensures you always have cash available for unforeseen events.

Studies have shown one of the top correlating factors to less financial stress is a high cash savings amount. So while 3-6 months is a good amount, target what makes you feel most confident. Another benefit of having a solid emergency fund is many people can handle investment and market volatility better when they know they have plenty of cash in their bank. Higher cash levels allow them more freedom to ignore the short-term noise from the stock market.

Where should you put your emergency fund?

The best type of accounts for cash savings are High Yield Savings accounts. Most checking accounts don’t pay much interest, whereas high-yield savings accounts currently pay around 3.5%. Some good options for high-yield savings accounts are Ally, Marcus, American Express, Synchrony, and Wealthfront.

2. Pay off High-Interest Debt

Credit Cards

After building up cash savings, it’s time to tackle any high-interest debt, such as personal and credit card debt. Your mortgage is only included here if it has a high-interest rate. Otherwise, your mortgage should be excluded from this step. There is no consensus on what counts as high-interest debt, but Credit Cards with a typical 15% plus in interest are the main target here. 

There are two popular strategies for paying off debt, one is to pay off the highest-interest debt first, and the other is popularized by Dave Ramsey, known as the snowball technique. I prefer to target the highest-interest debt first as, mathematically, that is the better decision and leads to a better return.

With the snowball technique, you target the smallest balance first, intending to build success and small “wins” once you pay off the debt quickly and stay motivated to tackle the bigger debts. Once you have paid off the smallest debt, you roll the payment you made onto the next smallest debt payment. You keep building the debt payment snowball from there.

View paying off high-interest debt as getting a guaranteed return. If you have a $12,000 credit card bill and the interest is 15%, you should use surplus cash to pay that off, as your return would be 15%. That is a much better return than any other investment you could make, and it’s guaranteed.

While paying off the highest-interest debt saves the most money, the most important part of this step is actually to take action. Get started with whichever strategy you can stick with to succeed.

3. Get Your Employer Retirement Plan Match

Employer Retirement Plan

The next step is to get your 401(k) or 403(b) employer match if you have one. Get all the free money you can. If you are in the 10% or 12% ordinary-income tax brackets, consider using the Roth version of your 401(k). The 22% and 24% tax brackets depend more on your expected future income, but a good plan is to split contributions. For people in the 32%, 35%, and 37% brackets, it’s often best to have most of your contributions towards the traditional 401(k) to reduce your current taxes. 

Currently, employer matching contributions can only be pre-tax money. With the recent passing of the SECURE ACT 2.0 Bill, employers beginning in 2023, can now let the employee choose if they want the match to be a Roth contribution. If so, the employee will be taxed as if they earned the contribution as part of their salary.

4. Max out your HSA

HSA

Health Savings Account is my favorite investment account. You get three significant tax benefits, combining the best features and tax breaks of a Traditional and Roth IRA into one account.

  • Tax deduction for contributing
  •  Tax-deferred growth of your money (No taxes on dividends or capital gains)
  •  Tax-free withdrawal for qualified medical expenses.

It is the ultimate account for tax efficiency, with a bonus that many employers make contributions or matching contributions to an HSA for employees.

To qualify for an HSA, you must be enrolled in a High Deductible Health Plan (HDHP). If you currently don’t have an HDHP, each year during the open enrollment, I recommend you review your health plan to see if switching to an HSA-eligible plan is right for you. 

5. Fund an Employee Stock Purchase Plan (ESPP)

ESPP

An Employee Stock Purchase Plan is our next step, offering another opportunity for free money. An ESPP is a program available at many publicly traded companies that allows you to purchase discounted shares of company stock through payroll deductions, often up to 15% discounts. About half the companies in the S&P 500 offer an ESPP, yet many employees don’t participate and miss out on the great potential these programs have.

If you have access to an ESPP with a 15% discount, especially with a “lookback” provision, this should be a priority if you still have money to save after funding steps 1-4. 

While there are no tax savings for contributing to an ESPP, the investment returns due to the discount make it like free money. 

For example, if you have a 15% discount in your ESPP and a six-month offering period, you will have a 17.6% investment return for participating. The math can get confusing, so hang in with me. Percentages up don’t equal percentages down. If you discount $100 by 15%, like you would if you got a 15% discount on a stock valued at $100, it’s $85. However, the percentage increase from $85 to $100 is about 17.6%. The discrepancy is because you’re measuring the same $15 value over $85 and $100, so the percentages are different.

With the S&P 500 historically averaging around 10% per year, getting a 17.6% return over six months for an annualized 35.2% return is too good to ignore. 

The key here is to sell your ESPP shares as soon as they vest. There can be some small tax benefits for holding over a year if you have a “lookback” provision. However, locking in those gains by selling and reinvesting the proceeds in a diversified ETF is usually the best plan. 

An ESPP also has the benefit of automation because the contributions are deducted from your paycheck, automating your savings.

6. Max Out Workplace Retirement Plans

Max 401K

Now is the time to return to your workplace retirement plans and max out your contributions. Maximize tax-efficient saving and investing through either your 401(k) or your Roth 401(k). The 2023 tax-deferral contribution limit has increased to $22,500, with a catch-up contribution for those over 50 also increasing to $7,500.

7. Roth IRA Strategies

Backdoor Roth

If you have made it to this step, congrats, as you are committing to an impressive amount of savings. Now is the time to look at different Roth IRA strategies. You could contribute to a Roth IRA, up to $6,500 in 2023, or if your income disqualifies you, look into backdoor Roth IRA strategies. 

There are workarounds to making a Roth IRA contribution even if you earn above the income limits. One is the backdoor Roth, where you make a nondeductible IRA contribution, then immediately convert the funds to a Roth IRA. Since the IRA contribution was not deductible, the conversion to a Roth won’t cause taxes. Beware of the pro-rata rule if you try to complete a Backdoor Roth and currently have other tax-deferred IRA money.

The ultimate Roth IRA strategy is the Mega Backdoor Roth I previously detailed. In 2023, this strategy could allow a higher-income earner and saver to contribute up to $43,500 into a Roth IRA. You implement a Mega Backdoor Roth by making an “after-tax” contribution to your 401(k). This is money above the regular tax-deferred contribution up to $22,500 in 2023. Then, instantly convert the after-tax contributions to the Roth 401(k) or a Roth IRA in your name. If you have the features in your workplace retirement plan to allow this and still have money to save, this is a great strategy to build tax-free wealth.

8. Taxable Brokerage Account

brokerage account

Now is the time to direct cash to a plain taxable brokerage account. This could be an individual, joint, or Trust account. If you completed step 5 by contributing an ESPP, those funds also ended up in a taxable brokerage account. 

While this account doesn’t provide tax breaks beyond capital gains tax rates on long-term investment gains, it provides the ultimate flexibility. Most other accounts on this list restrict when or why you can access the money. 

Not this account. This account’s optionality makes it challenging to know when to prioritize it. While near the bottom of this list regarding tax efficiency and wealth building, it is a top priority for many people. 

Whether it be buying a home, saving for children’s college, money to exercise stock options, or paying surprise tax bills, this account has you covered. A taxable brokerage account also should move up the priority list for those looking to take a sabbatical, start a business, or retire early. Saving and investing in this account provides many options and peace of mind.

How To Invest In a Taxable Account?

Because a taxable brokerage account is not a tax shelter, it will generate taxes on interest, dividends, and capital gains. You want to create a tax-efficient investment strategy for this account. The first step is to look at low-cost, diversified index funds and ETFs. Pick investments you can truly hold for the long term. The more you trade in this account, the more taxes you could inadvertently cause.

9. Pay Off Mortgage & Other Low-Interest Debt

mortgage

If you are still saving money, now is a time to look at paying off low-interest debt, including potentially your mortgage. Look at these low-interest-rate debts and compare them to what you could do with the money.

It makes sense to pay off a lower-yield debt last as your money can work better for you elsewhere (E.g., anything higher up on the Sequence of Savings). If you have a 2.75% mortgage rate while your savings account is earning 3.5% and 3-month Treasury Bills are paying 4.5%, you might prefer to continue saving and investing than paying off the debt. More importantly, you will likely earn a higher average return in riskier assets, such as stocks.

However, many people aim to get completely debt-free, and no matter what the math of saving or investing says, you need to do what is important to you with your money and what gives you confidence.

In Conclusion

The Sequence of Savings is a framework to help you find the optimal order to save and invest your money. It is not a rigid and static list, as everyone’s personal financial situation is unique. Your goals are unique to you. Therefore, your personal Sequence of Savings should also be unique.

Furthermore, if your income and net worth is significant, the stakes of getting your Sequence of Savings in the correct order are high. If you need a financial professional to help guide you through these steps, please reach out to us. We are more than happy to assist.

Recent Blog Posts

Universal Basic Income Bad Idea Poster
7 STEPS TO PREPARE FOR A RECESSION
INFLATION IS SET TO PLUMMET
Recessions are good