First Steps to Financial Independence

When you are in your 20s, you are more focused on your career than personal finance. There are no shortage of sites and books that will tell you what to do, but this post boils it down into a few simple prioritized steps for getting started. You’ll want to proceed in this order:

  1. If you have a 401k with a company match, at a minimum contribute to the matching percentage level first. A 401k is already an excellent savings vehicle, but becomes supercharged when your company has a matching percentage. If you are a new hire, though, be aware that many companies have a certain number of years before you are vested which can be as much as 3 or 4 years.
  2. Build up a 6 month emergency cash cushion. It’s critical that you have this cushion to avoid credit card or other high interest debt or even bankruptcy in case of an emergency like a job loss or critical medical situation. This money should be in a brokerage cash reserves, a checking account or a savings account. It doesn’t have to be FDIC insured. It will probably earn less than 0.1%, but that is the price of having a low risk savings account.
  3. Pay off all credit card debt in the order of largest interest rate. This is easy, risk free returns and one that gets overlooked by many younger savers. It makes no sense to get a 7% risky return with standard investments, when you are paying 12 to 20% in credit card debt. Pay off the credit card first, even if it takes you months or years. Guaranteed returns are hard to beat.
  4. Pay off any other debt like student or car loans that have an interest rate greater than 5%. Once again, it makes no sense to invest in a risky investment returning around 7% when you have a zero risk investment that will guarantee a return close to 7%. Car loans and leases are the single biggest obstacle to meeting your retirement goals. Everyone needs transportation, but you should not be paying twice the value of a vehicle because you have to pay years of interest. Buy a used car and pay the minimum you can to get a safe and reliable car.
  5. Contribute the maximum to your company 401k, if you have that option. Depending on your income, you will want to contribute to your company’s Traditional 401k and not the Roth 401k. The simple rule when deciding between a Roth and Traditional 401k or IRA is to contribute to a Traditional IRA if your tax bracket is equal or higher than what it will be in retirement. A high earner in a marginal tax bracket of 28% or higher should always contribute to a Traditional 401k or IRA. It’s more difficult when you are just starting out, since your income and tax bracket are lower. So the default option should be to do pre-tax contribution to a Traditional 401k since it immediately reduces your tax burden. At a marginal tax bracket of 15%, the Roth becomes the logical option. The brackets between 15% and 28% are the area where it is not as obvious, but if you are unsure, go with the Traditional 401k or IRA.
  6. If you have a child that will eventually go to college, contribute to a 529. If you are somehow saving enough to have maxed out your 401k, the 529 can be a very good savings vehicle, especially for high earners or someone with a recent windfall. All earnings are tax free if the proceeds are used to pay for tuition, room and board and some other items like a laptop.

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