You get a bonus at work, a tax refund, an inheritance, or receive an exceptional gift. It’s not a life-changing amount of money, but enough that you have to stop and consider what to do next. The answer is below.
Follow this simple seven-point guide to get the most bang out of your bucks. The money flows down the steps; once one is filled up (or paid off) you move on to the next step.
- Set aside $1,000.
If you don’t have any savings, a small emergency can turn into a financial disaster as you need to take on high-interest debt to cover immediate expenses. Based on a 2013 survey, the Federal Reserve reported that 48 percent of respondents couldn’t cover an emergency expense of $400.
To protect yourself, try to build an immediate-emergency fund of $1,000 that can be tapped during a medical emergency or when your car breaks down.
- Pay down high-interest debts.
According to Credit.com, a typical American will spend $279,002 dollars on interest payments in their lifetime. You may not be able to avoid taking out an auto loan or a mortgage, but with your new-found money you should first pay down high-interest debts.
This includes credit card debt and for our plan any other loans that have an interest rate of seven percent or more. (For those with credit card debt, the average credit card debt in America is estimated to be somewhere between $7,100 and $10,902.) It’s hard to find a better risk-free investment for your money than paying off high-interest debt.
- Establish an emergency fund (i.e. a rainy-day fund).
An emergency fund should be easy-to-access, low-risk, and large enough to cover your monthly expenses for three to six months. The $1,000 from step one is part of this emergency fund. Grow it and you’ll be able to cover expenses if you’re between jobs, get hurt and can’t work, or if there’s a large medical or mechanical emergency.
- Get the full employer match for your retirement account.
If your employer offers a retirement plan, such as a 401(k) or 403(b), they may also match part of your contributions. In other words, when you put money into your retirement account they will also put money into the account. Often this is referred to as “free money” because you don’t need to do any additional work.
As of 2015, you can contribute up to $18,000 to your account ($24,000 if you’re 50 or older) during a single year. The intent of this step isn’t to contribute the maximum, but to get the max employer contribution.
Employers handle matching contributions differently, and it can get confusing. There are some online calculators that can help you determine how much you should contribute to maximize the employer contribution (often employers set a limit to their contribution). However, you may also want to speak directly to your HR department or whoever handles the 401(k) program.
- Invest in an Individual Retirement Agreement (IRA).
If your employer doesn’t offer a retirement plan, open an IRA and save for retirement on your own. Even if your employer offers a plan but doesn’t match contributions, an IRA might be a better option because you’ll have more investment options.
Each year you can contribute up to $5,500 ($6,500 if you’re 50 or older) to an IRA. The accounts offer tax advantages (there are two versions for individuals – you can review the differences here), but you may have to pay a penalty to withdraw money from an IRA before you’re 59-and-a-half years old.
You can open an IRA at a bank, credit union, an investment management company like Vanguard, or alternative investment companies like peer-to-peer lenders. Once the money is in an IRA, you still need to decide where and how to invest it.
- Pay down other debts.
Congratulations, if you’ve gotten this far you don’t have any high-interest debts left, you’ve set aside money for your emergency fund, and you’ve started to save for retirement.
We prioritized retirement savings over debts with an interest rate below seven percent because if you invest your money in an S&P 500 index (often used to represent the U.S. stock market) the average return is over seven percent. Now, it’s time to pay off the rest of your debts.
If you have a car loan, personal loan, student loan, or other debts with an interest rate below seven percent, you’ll make extra payment during this step. If you can’t pay off the loan in full, tell the loan servicer that you want to apply the extra payments to the loan’s principal.
If your loan has a prepayment penalty, you might have to pay a fee if you repay the loan before the maturity date. Check to see if this is the case. If so, you may not want to pay off the loan early.
Some people treat a mortgage differently than other debt. It’s up to you whether you want to include a mortgage in this step or not.
- Max out your employer-sponsored retirement account.
If you have an employer-sponsored retirement account, you’ll now go back and contribute until you hit the annual maximum. Be sure you’ve first maxed out your IRA contribution and paid off debts. The IRA takes precedence because it offers similar tax advantages as 401(k)s and 403(b)s. However, you have more options
What about spending the money now?
Looking over the list, you likely noticed that each step involves paying off debt or saving for later. That doesn’t seem like much fun, you likely want to celebrate your bonus or use the tax refund to buy that new toy you’ve had your eye on. It’s okay to take some of the windfall gains and use it for immediate needs or wants, but try to limit yourself to just a small portion – maybe ten or 20 percent.