When it comes to saving and investing for the future, it can be overwhelming trying to figure out where to put your money first. Should you focus on retirement accounts, college savings, building an emergency fund, or other goals? Here at Legacy, we developed a Hierarchy of Savings as a guide to help you prioritize your savings in an orderly and effective way.
First, we look at any outstanding high-interest debt that should be paid off before long-term investing. Once you become debt-free, the Hierarchy of Savings provides you with a step-by-step framework for where to allocate your funds based on your unique needs and financial goals.
The first priority is taking full advantage of any employer-sponsored retirement plans available to you. Contributions to 401(k)s, 403(b)s, and the like come out of your paycheck before taxes, lowering your taxable income. Plus, many employers offer matching contributions up to a certain percentage. This is essentially free money that you should be sure to maximize!
The second tier is building up a robust emergency fund. Aim to set aside 3-6 months’ worth of living expenses in an accessible savings account as a safety net. Depending on the type of work (salary vs. commission, for example) you may want to adjust how much you have set aside. With an emergency fund in place, you avoid needing to tap into retirement savings or go into debt should an unexpected expense or a job loss happen.
Next, if you have access to a Health Savings Account (HSA), this can be a powerful savings tool. HSAs offer a triple tax advantage: money goes in tax-free, grows tax-free, and can be withdrawn tax-free for qualified medical expenses. HSAs make great supplemental retirement savings once your emergency fund is established.
The fourth step is to maximize contributions to employer-sponsored plans like 401(k)s if you haven’t already reached the annual limit. Similarly, step five is to fully fund an IRA each year. Between the two, you could save over $20,000 annually to turbocharge your retirement nest egg.
Sixth, if educational expenses are part of your financial plan, opening a 529 savings account allows tax-advantaged investing for future education costs. These funds can be utilized not only for college but also for elementary and high school tuition.
Next, once you’ve optimized all of the above specialized savings vehicles, any additional funds can be invested in a taxable brokerage account. While not tax-advantaged, this provides flexibility to save for any long-term goal beyond the limits of retirement and education accounts.
Finally, more advanced savings tools like annuities and permanent life insurance come at the end to meet specific income, inheritance, or risk management needs for those nearing or in retirement.
While this Hierarchy of Savings provides a general framework, each individual’s and family’s optimal savings flow will be unique. The hierarchy acts as a guide but your personalized financial plan and goals dictate your actual priorities. Our advisors can help you develop a tailored plan to efficiently allocate your savings and take advantage of every tax-favored account available to you on your path to financial security. Reach out today if you need help determining the smartest savings order for you and your situation.