Paying Off Debt vs. Saving: How to Prioritize

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Few things are more important than your financial situation, and it’s understandable that you want to get it right. But be careful — you could end up spending so much time and energy worrying about the right way to do something that ultimately, you don’t do anything at all. This is called analysis paralysis, and it happens when you overthink a situation and get stuck there. There’s a lot of thinking going on, but very little action. Put an end to that cycle by knowing what financial goals you should prioritize, and why. There’s no hard and fast ranking of where to put your money that would address every financial situation, but you can start with this simple guide to ease out of feeling overwhelmed, and transition to feeling empowered and capable of taking action. Keep in mind that you don’t have to 100% complete each step below before moving on to the next. For example, you don’t have to have a full 6-month emergency fund before you start evaluating your insurance. Balance is key!

Priority #1: Save for a Cash Reserve (Emergency Fund)

Do you have a cash savings account that you could access anytime to help get you through an emergency or to cover an unexpected cost? If not, this is your number one objective right now. You need to build a cash reserve to protect you when things go wrong. Life happens, and your monthly cash flow can’t always cover the financial impact when the unexpected occurs. Without an emergency fund, you risk building up debt or eating through some retirement savings (which are better left alone to grow and compound!). Set a goal to save up 3 to 6 months’ worth of living expenses in a savings account that you can access anytime. Look for high-yield accounts so you can make the most of your cash. Check out local credit unions or check online banks like Ally or CapitalOne 360. These institutions tend to offer better interest rates on savings accounts than larger, traditional banks. NerdWallet has a well-curated list: The Best Savings Accounts of 2016. Keep in mind that the more financial responsibilities you have, the larger you’ll likely want to build up your emergency fund. And yes, no matter what level you choose you build to, this is a big sum of cash. But remember, you don’t have to establish a fully-funded reserve all at once. Break this goal down into smaller pieces: save $50 per month to your emergency savings if that’s all you have to contribute. Slow progress is better than no progress! Just get started with what you have, and build from there.

Safety Net: Set Up the Right Insurance

An emergency fund acts as a sort of insurance that guards against unexpected, necessary expenses that exceed what your monthly budget can handle. But you also need formal insurance coverage to protect yourself and your assets. Look at what insurance policies you have now. Do they provide adequate coverage? Are you paying for more than you need? Review what’s in place and make adjustments as necessary. Then consider what insurance you don’t have, but may benefit from. Disability insurance protects one of your most important assets: your ability to earn an income. And if others are financially dependent on you, look into term life insurance so they’re also protected in case you were to no longer be there to provide care. If you need help sorting through insurance policies and understanding what’s best for you, consider working with a fee-only financial advisor. It’s important to see someone who works as a fiduciary, which means they put your interests ahead of all others. Choosing a fee-only planner means that they won’t sell you insurance products, either, so you can feel assured there’s no conflict of interest because they won’t be pushing a policy that’s not the best for you just so they can earn a commission.

Save for Retirement: Free Money through a 401(k)

After ensuring you have the right insurance (and the proper coverage) and starting to grow your emergency fund, your next order of business is grabbing any free money that’s on the table. In other words, contribute to your 401(k)! Most employer-sponsored retirement plans offer some sort of match. The amount of the match will vary from company to company, but this match is an opportunity to give yourself an automatic raise. Let’s say your company offers to match your 401(k) contributions up to 3%. This means that for every 3% you contribute to your own retirement, the company will contribute 3% too. This allows you to save a total of 6% to retirement — but only 3% comes out of your paycheck. Plus, 401(k)s are tax-advantaged accounts. When you contribute funds, that money is tax-deferred — meaning you don’t have to pay taxes on that income this year. Paying less in taxes may mean you have more money available to save, invest, and pay off your debts (next section!). Side note: Remember to avoid the most common 401(k) mistakes to get the most bang for your buck! At the very minimum, contribute enough to your 401(k) to get the employer match (whatever that percentage is at your company; if you’re not sure, ask HR). Each year, aim to bump up your contribution by 1% to 2%. And with every raise you earn, devote half the increase to your 401(k). If you can max out your 401(k), go for it! That’s $23,000 for 2024. If you can’t max out your account, that’s okay. Ideally, you’ll build up to saving 15% to 20% of your income in your 401(k) over time.

Paying Off Debts: Student Loans, Credit Card Debt, etc.

Knowing where and how much to save becomes even more complicated a question when you have debt you’re working to repay. Whether it’s a car payment, student loans, or credit card debt, making that monthly payment toward the balance gets old fast. You may want to throw everything you’ve got at eliminating your debt — and if that works for you, it’s certainly an option. But be careful you don’t get sucked into a race to the bottom. If you throw all your discretionary income to debt repayment, you will be debt-free sooner. But your money only went to getting you out of the red, and wasn’t going to work on building wealth for you during that period. Your net worth will be at $0 if you don’t contribute to your 401(k) or build a small cash reserve. So consider balancing debt repayment with other financial priorities. What does that look like? It starts by creating a debt repayment plan so you know what steps you’ll take each month to reach your goal. Tally up all your debts so you understand what you’re working with, then list out the balances and interest rates on each. To make the most of your money, focus on knocking out the debt with the highest interest rate first; this one costs you the most to hang on to each month. Anything above a 10% interest rate is a high priority to repay. Anything below, while still not good (debt is debt, after all!) costs you less in interest. There’s also a chance you can make better use of your money by investing it to grow wealth. Historically, the stock market has returned 10% over time. And while past performance provides no clues as to future results, it’s a good bet that your money will be working harder for you when you invest it than when you funnel it all toward a student loan with an interest rate of 4%. In short: know what kind of debt you’re dealing with. Understand how much you owe and the interest rate on all the balances. Then make a plan that you can stick to, and steadily chip away to eliminate the red from your balance sheet.

Extra Investments: Contribute to a Roth IRA

You’re already contributing at least the match to your 401(k), right? Remember, a big advantage to a 401(k) is the opportunity to defer taxes on your income. You’re not getting away tax-free, though. You’ll pay taxes on that money when you withdraw it. Create a balanced strategy by using another account that offers a different kind of tax advantage: a Roth IRA. The money you contribute to a Roth is money you’ll pay taxes on this year — but then your earnings get to grow tax-free. You won’t pay taxes when you withdraw your money in retirement. If you want to max out this account, contribute $7,000 if you’re under 50 and $8,000 if you’re over age 50.

More information about how to allocate savings: 401(k) vs. IRA: How to Decide

Feeling Solid? Max It Out!

If you’ve checked all the boxes above, you can take things to the next level by aiming to max out your 401(k) and Roth IRA. At this point, you can set big goals for building wealth and achieving long-term goals — and consider how you can move past just saving and investing in retirement accounts. Create goals that you want to achieve, and milestones you want to hit with your wealth. Look to eliminate all your debt, build your cash savings beyond that 3 to 6 months’ worth of expenses in your emergency fund, and start investing in taxable individual brokerage accounts to accelerate your progress even further.

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Kali Hawlk is a freelance writer and co-founder of Off The Rails, a mentorship platform for creative women. She's passionate about helping others do more with their money, their work, and their lives.

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