I have some extra money each month, what should I do with it?
From FinancialPlanning
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MIFP's Hierarchy of Saving
Over the years, a fairly consistent checklist has developed on MIFP -- a hierarchy showing what to do with extra cash. Posters differ on the details, but here's the basic idea...
Before you Save
Make Sure you have Essential Insurance
If, for example, you are driving an uninsured car, and don't have health insurance, you're one mishap away from financial ruin. It's very easy to do $20,000 worth of damage on a drive around the block, or to run up a similar figure in medical bills, through no fault of your own.
There are considerable differences of opinion about what insurance is "essential" but most people agree that at least some of them qualify as top-priority for your first extra $50/month.
Pay off credit card debt
Credit card interest is money down a black hole. The first step in financial planning is treading water, and that means paying off credit card debts.
Pay your Taxes
This goes on the list because unpaid taxes run up interest and penalties at rates comparable to some credit cards. Whether it's a debt owed for prior years, or you're under-withholding for this year and setting yourself up for a big payment next April, get this covered.
OK, Time to Save
Set aside an Emergency Fund
What's an emergency fund? Glad you asked.
Invest for Shorter-term Goals
Everyone has some financial goals for the next 1, 3, 5, 10 years...a new car, a home, grad school, college for the kids, etc. The "hierarchy" below steps through a bunch of retirement-savings alternatives, but alongside those, you should invest for these shorter-term goals in accessible accounts (most retirement-savings alternatives have penalties for earlier withdrawals).
Contribute to a Tax-deferred Investment Account
Everyone needs to save some money for retirement, so that's a very common "first destination" for additional savings. The tax code allows you to do this through a variety of tax-deferred accounts. You aren't able to tap into the money until retirement, but you'll pay no taxes on investment earnings and gains in the meantime.
Option 1: Retirement Savings Plan at Work
If you have a 401(k), 403(b), or similar plan available at work, that's often the best place to start. Your money is set aside before income taxes are assessed, so you're able to save more than you would have received in your paycheck. For example, if you pay a total of 25% in state and federal income taxes on your marginal earnings (meaning, on the "last $100" that you earn each year), you end up with only $75 in your pocket after tax, for $100 earned. If you divert that money to a 401(k) instead, the full $100 is invested, where it can grow for many years tax-deferred.
Some posters recommend only contributing to a 401(k) up to the level of the "match," and then moving down the list to other destinations for your savings. "Match" is an additional cash contribution by your employer, in a certain proportion to the amount you defer from your paycheck. Not all retirement savings plans have matching, but when they do, it's "free money" for those who participate.
Option 2: Traditional IRA
If you don't have a retirement plan available at work, but you do have earned income, you can instead contribute to a Traditional IRA. You'll receive the same tax-deferral benefit, though the contribution limit is quite a bit lower.
Note that you can contribute to a Traditional IRA even if you participate in a retirement plan at work, but the contributions aren't deductible on your tax return. These "nondeductible contributions" aren't as appealing for most people as the deductible ones.
See the FAQ section on IRAs for more details on these alternatives.
Contribute to a Roth IRA
If you've gone with Option 1 (saving through a plan at work), you may be able to contribute to a Roth IRA as well. Roth IRA contributions aren't deductible on your tax return as Traditional IRA contributions are, but the earnings in the Roth are never taxed. For those who expect higher tax rates in the future, during retirement, the Roth IRA may be an appealing alternative. For those who want to "hedge their bets," contributing a bit to both a Roth IRA and a tax-deferred account with an immediate tax deduction may be the answer.
Total IRA contributions (both Roth and Traditional, combined) are limited to $4,000 for 2007, plus an extra $1,000 if you're age 50+. Higher-income earners aren't able to contribute the full limit to a Roth IRA; the cut-off point depends on the filing status on your tax return.
Max out Retirement Savings at Work
If you followed the advice of some posters to first contribute to a 401(k) or similar plan up to the match, then move on to a Roth IRA, additional dollars after the Roth IRA contribution might go in the 401(k). For 2007 the limit on annual salary deferrals to a 401(k) is $15,500. If you do that plus the maximum Roth IRA contribution ($4,000), that's $19,500...and you can pat yourself on the back for having a well-above-average savings rate.
Invest more through a Taxable Account
Back to this again. Not all financial needs occur during retirement -- not by a long shot -- and the potential spending needs before that point are endless.
Other Alternatives
This page is presented as a list, but the items below really run in tandem with the savings hierarchy above. It's not an either-or choice, but rather balancing these different savings goals alongside debt management and spending.
Paying off Debts
Auto Loans
Depending on the interest rate, you might pay off your automobile loan as quickly as possible, even if it means delaying savings. If you're paying 10% interest on the loan, paying it off is in effect an immediate 10% return on your money.
Student Loans
Recent consolidated loans are at such low interest rates that most people are better off paying these off at the normal schedule. But if your rate is high, or you simply want to pay down the debt for some reason, this is another use of cash.
Home Equity Loans
Some people put this in the same category as credit-card debt, especially if you've paid off credit card debt with a home equity line of credit. While the interest may be tax-deductible, it's still money down a black hole. And in some cases the home-equity line is masking a spending problem that is best addressed now, as a first step in getting your finances on track.
Mortgage
Whether to pay off your mortgage early is addressed on a separate page.
Life Insurance/Annuities
While it's rarely mentioned in the context of this question, life insurance (or "additional life insurance") and annuities are other potential uses of extra cash. This alternative is discussed on a separate FAQ page.
Take a Vacation
Every now and then someone points out on MIFP that hoarding money isn't the only goal of good financial planning. Maybe the best thing to do with that extra cash is to spend it!
