Ep.102 - How to Manage Money Efficiently?
📸 IG handle: DollarSenseLA
WHAT TYPE OF QUESTIONS DOES THIS ARTICLE ANSWER?
One of the most common questions I receive repeatedly goes something like this: “Should I pay off my car first or should I contribute to my 401k?” or “Should I use my emergency fund savings to pay off my credit card debt?” In essence, they are all around one central question - how to prioritize money. After reading this article, you will be able to answer these questions for yourself.
This article not only offers a philosophical framework — the hierarchy of needs with money — that provides the rationale behind how to manage money, it also spells out the concrete steps — the money prioritization pyramid — that helps you apply the conceptual framework to your own life in the U.S.
Lastly, this framework is largely the product of my research, experiences, and thoughts. It is by no means not the only way to handle finances, as there are other schools of thought out there. It’s simply the option that makes the most sense to me.
THE HIERARCHY OF NEEDS WITH MONEY
This framework is inspired by Maslow’s Hierarchy of Needs.
In my opinion, there are three hierarchical stages of needs with money: first to use money to establish financial safety, then to use money to reduce stress, and finally to use money to grow wealth. How you spend money should also be in this order.
Establish Safety: It’s important for both your financial health and mental health to try to build financial safety first. This typically means a steady stream of reliable income that at least covers your spending, so you CAN save. If you earn money but don’t have anything left to save, you should try to cut back on your spending, and possibly even look for a higher paying job.
Reduce Stress: Once you’ve established financial stability with a stable income and some savings as a cushion. You can now use your extra money to help you reduce stress. This typically means paying down the mountain of debt you may have. By debt, I am talking about all debts except for a mortgage.
Grow Wealth: Once you feel secure in your finances and have no debt (except for a mortgage), you are in the “wealth growing” stage, because the main purpose of your extra money is to help you get even wealthier. While trying to grow your net worth, your biggest natural enemy is taxes. As a result, you should invest in tax-advantaged accounts (I recommend 401k and IRA) first.
FROM THEORETICAL TO APPLICATION - THE MONEY PRIORITIZATION PYRAMID
The money prioritization pyramid is a practical tool to help you manage money efficiently. But it does have its limitations. First, this only applies to the United States. Additionally, though I built my money prioritization pyramid for all, it largely comes through the lens of a corporate employee, somewhat influenced by the bias of my own personal experience. Though I attempt to be aware of this bias and to speak to both corporate workers and self-employed, it may be lacking for those who are self-employed, despite my best efforts.
That said, there are 7 steps in the money prioritization pyramid. The way you should use this pyramid is by asking yourself this question- “If I have extra savings, what should I do with it to maximize its efficiency?” With the 7-step tool below, you start from the bottom up and determine it for yourself. For example, if you have already been taking advantage of your 401k match, but you have not built up your emergency fund, what you should do is to put the extra money into your emergency fund.
Now, let’s delve into the details.
STEP 1 - MAKE SURE EARNINGS > SPENDING
Living within your means is the starting point for all of us. Ask yourself this, “are you spending more than you make every month?” If the answer is “yes,” do NOT invest your money. Do NOT contribute to your 401k/IRA. They come later in terms of priorities. Just work on living within your means.
The quickest solution, though it may not be the most effective one, is to cut spending, so you can have savings month after month. However, in reality, this is not feasible when one’s income is too low. I am not quite familiar with other cities, but in the case of Los Angeles, I would say an income of $30K or less is the low end. In this case, instead of cutting back, it’s just way more effective to get to a higher-paying job (if possible).
STEP 2 - TAKE FULL ADVANTAGE OF A COMPANY’S 401K MATCH (SKIP THIS STEP IF YOU AREN’T A CORPORATE EMPLOYEE)
If you work in the corporate world, where your company offers a 401K match, your next step is to take advantage of the 401k match. Why? Because it’s free money. It basically generates the highest return on your money given there’s literally no risks involved.
For example, on the 401k, if your company offers a 50% match up to the first 6% of your salary, you should contribute 6% of your salary. By doing so, you take full advantage of the match, leaving no free money on the table. If your company does something different, such as a 100% match up to the first 4% of your salary, you then should contribute 4% of your salary.
If you are not a corporate employee or your company doesn’t offer any match, you can skip this step.
STEP 3 - BUILD UP A 3-MONTH EMERGENCY FUND
After the 401k match, the best use of your extra money is to build up an emergency fund. I recommend building up a fund that has enough to cover AT LEAST 3 months of living expenses. Based on your own risk tolerance as well as the external environment (you should probably have a bigger cushion when the economy is bad), you can make your own call on the threshold, whether that’s 3 months or 4 or even 6. But 3 should be the minimum. This is crucial in helping you feel financially safe in a tangible way.
Unfortunately, it’s quite easy for people to tap into emergency funds for non-emergency purposes. As a preventative measure, I highly recommend putting your emergency fund in a separate account, that’s different from your main checking account, preferably a high-yield savings account. As of right now, you won’t earn much (~1%), but it’s still better than nothing. I personally use Discover savings. But there are many good options out there.
STEP 4 - AGGRESSIVELY PAY OFF ALL DEBTS EXCEPT FOR YOUR MORTGAGE
Once you have successfully established financial safety (steps 1-3), you then will get the most bang of your buck by using money to reduce stress. Most of us probably have personally experienced the stress of struggling with debt (I know I do). It’s quite common. In fact, according to academic research from the University of Nottingham, those who struggle to pay off debt are 2x as likely to suffer from severe depression. For this reason, I believe the best use of money at this stage is to pay off all debts except mortgages. This means credit card debt, student debt, car loans, personal loans, medical debt, family debt, etc.
Which debt should you pay off first? I know there’s a fierce debate between the snowball method vs. the avalanche method. I personally recommend the snowball method, meaning you pay the minimum on all debt, and use your extra savings to pay off the one with the smallest balance first. Why? I think this method has the extra psychological benefit that encourages us in the long run, because we can visualize our progress much easier and much quicker than all other methods.
STEP 5 - MAX OUT YOUR TRADITIONAL 401K OR IRA
If you’ve paid off all your debts except for your mortgage, you are already a high achiever in my mind! Congratulations! It is not easy to get to Step 5.
After you are debt-free (except for mortgages), you should max out your 401K (max =$19.5K/person in 2020) if you are a corporate employee, or max out your IRA (max = $6000/peson in 2020), if you are self-employed, because this is a tax-advantaged account, where you do not pay taxes when you put it in (but you will when you withdraw).
I personally prefer 401K/IRA over ROTH 401K/ROTH IRA, because I feel I have the ability to control the tax rate I pay when I withdraw at retirement. If you want to understand the differences in detail, here’s a good comparison from Charles Schwab.
STEP 6 - (OPTIONAL) BACKDOOR OR MEGA-BACKDOOR
This step is entirely optional. This step is all about helping high-income earners to put more money into tax-advantaged ROTH IRA accounts after they have already maxed out on traditional 401K or IRA. Most people can contribute to a ROTH IRA, in addition to a 401K, directly without a problem. However, if you max out your 401K, the chances are you are a high-income earner. And high-income earners ($139K/single, $209K/married) can’t contribute to ROTH IRAs.
In 2020, if you are single and your income exceeds $139K, you can’t contribute to a ROTH IRA. If you are married and your income exceeds $209K, you can’t contribute to a ROTH IRA. Here’s where the Backdoor and Mega Backdoor comes into play. These 2 methods allow you to contribute to a ROTH IRA anyway, even if the income exceeds the limit by law. In this article, I am making you aware of these 2 options. But detailed information is linked below to other articles because the explanations are long enough to be their own articles.
Backdoor ROTH IRA: You can convert a nondeductible IRA contribution to a Roth IRA. The limit is $6000/yr per person. Here’s a detailed article from Fidelity on how it works. Oftentimes, you can do this with your brokerage such as Fidelity automatically with little to no manual effort.
Mega Backdoor ROTH IRA: A Mega Backdoor ROTH IRA does the same thing as a Backdoor Roth IRA, except that the contribution limit is even higher at $37,500/yr per person. Here’s a detailed article from personal capital on how it works. The drawback is that this method needs a little more of your attention and your time.
STEP 7 - AFTER-TAX INVESTMENTS
Steps 5 and 6 are all about putting investments through tax-advantaged accounts, and step 6 is only optional in my opinion. At this point, all the tax-advantaged options are exhausted, so you are left with the only option of investing with your after-tax money.
At this point, your options are typically bonds, stocks, real estate, and actual businesses. I do not recommend you touching any of these with your after-tax money unless you’ve completed steps 1-5. Again step 6 is optional, so you don’t HAVE to do it.
If you have extra money still, I highly recommend reaching out to a licensed financial advisor for more personalized advice on specific investments to match your risk appetite.
WAIT, WHERE DOES HOMEOWNERSHIP FIT?
You may have noticed that homeownership is not in the Money Prioritization Pyramid. And this IS intentional. Though home buying is typically a person’s most expensive purchase, the truth is, it’s typically NOT a decision primarily driven by financial motivation. In fact, according to the National Housing Survey, the #1 reason people buy a home is to raise a family and provide access to a good education. How about it being good financial investment? Well… that’s reason #5, behind a number of other things.
In other words, in the real world, most people do NOT buy a house because they think it’s the right FINANCIAL decision. Instead, the decision to buy a home is often driven by social norms such as marriage, physical necessities such as needing more space to raise a growing family, and even behavior drivers such as wanting a place to be able to customize.
Since buying a home is not strictly a financial decision, I believe it could happen, in parallel, to any of the 7 steps, as long as it’s after Step 1. In other words, you CAN save for a house and save for an emergency fund a the same time, especially if you know your family size is soon too big for your current apartment. Similarly, you CAN also save for a down payment for a house, while you are trying to pay off your student debt, especially because most people can’t pay them off completely until years down the road.
Long story short, saving a down payment for a house can happen at the same time as any step, as long as it’s after step 1. Unlike the relationship of steps in the pyramid (step 3 depends on the completion of step 2), homeownership is on its own, and it does not depend on any of the steps in the pyramid. For example, we personally bought our home after we paid off all of our debt (step 4), but we could’ve done it without paying off our debt, and would’ve been fine anyway.
IN CLOSING
You may be thinking to yourself, wondering how long should it take you to move from one stage to another. It does NOT matter, not only because the tool is not designed this way, but also it is not a productive way to view it.
There’s NO expected time. You are NOT expected to be able to max out on your 401k by age X. Personal finance is deeply PERSONAL. Just focus on yourself, making sure you are moving up the steps in the money prioritization pyramid.
📸 IG handle: DollarSenseLA