Originally posted October 25, 2019. As I wrote in the FinancialVerse – A Common Sense Approach for Your Money, there are 10 Must Do’s to manage your financial life. One of those is to have a cash budget. If you can’t measure your net cash position each month, you can’t manage it.
A question I often get is once I have a budget in place and I find my cash inflow exceeds my outflow – What do I do with this extra money? Where should I put it? Should I put more into my 401(k) first or should I pay off a loan? I am confused. What should I do?
Based on my experience I have developed what I call the Cash Savings Hierarchy for your consideration.
In presenting the Cash Savings Hierarchy, I have tried to come up with a simple approach to a very personal decision process. After you are able to comfortably pay your living expenses each month, including basic insurance coverage (auto, home and life) and minimum debt service, and can see that you have extra cash in your checking account—you are ready to implement the Cash Savings Hierarchy. It is a rational process with the following steps:
Establish an online savings account. Online accounts typically pay higher rates of interest on your savings than offerings from the brick and mortar banks and are easy withdrawal money from when you need it. Use this account to a begin to accumulate your excess cash and segregate it from your checking account cash so that you are not tempted to spend the money. One way to do this is to set up regular transfers from your checking account to the online savings account.
Use the online savings account to build your emergency fund. Remember as was discussed in the FinancialVerse, you need to create a fund of the greater of $10,000 or six months of basic living expenses. Keeping your emergency fund in an account that you can draw on quickly, if needed, should give you peace of mind.
I know that once your emergency fund is fully funded the questions of whether you should repay debt or accumulate cash for the purchase a home will arise. Accelerating debt payments as the first action would be my personal choice. Being free of the negative impact on debt payments is as liberating a financial event as any other. Take a look at the work of Dave Ramsey and his books in this area to help you on this journey. As far as the action to purchase a home there is no easy answer as to whether this is the right thing to do. In certain regions of the country, it is better to own versus rent your home, while in other areas purchasing a home is almost impossible or not economically viable. You will need to speak with a real estate and financial professional to determine what is the best course of action in your area.
Your next step should be to begin to fund your 401(k) plan, if one is available to you, to secure the full employer contribution. Remember the sooner you start saving the greater impact it will have on your retirement. Many people miss out on using the 401(k) plan offered by their employer and the employer matching contribution offered. Most employers match your contributions up to a certain level. Per a recent report from Fidelity Investments, the average employer matches contributions up to 4.7% of your salary in 2019. Remember 401(k) employer matching funds are found money. If you can save 4.7% of your salary and the employer matches that amount, you would be saving 9.4% of your salary for your later years, which is a healthy start on what you should be putting away.
After you are contributing enough to your 401(k) to earn the full employer matching contribution I would then look to take the excess and fund one of three choices depending upon your individual situation. These choices would be:
Cash value life insurance with the goal of accumulating funds for later in life and creating permanent life insurance coverage.
Setting up a Health Savings Account (HSA), if you qualify based on the type of health insurance you have.
Lastly, I would begin to fund a 529 College Savings Plan for any dependent children you have.
At this stage I would suggest you work with a qualified financial professional to determine which option would be best for you.
6. If you still have cash left after fully funding steps 1 through 5 I would then meet with an investment professional to develop a plan begin to invest for the future as agreed with the professional. A qualified financial professional can work with you to determine what investments best meet your risk and return needs.
Generating more cash inflow versus outflow each month is a key milestone in the FinancialVerse. Once you do, you are able to focus on putting cash into your emergency fund, paying off debt, and investing for your later years. There is no one way to accomplish this and you will need to decide what is best for you from both a financial and psychological standpoint. The FinancialVerse Cash Savings Hierarchy provides you with a framework to use. Remember you need to save at least 10% to 15% of your annual income to be able to pay for the expected costs of your life expectancy. Deciding on an approach and sticking to it are the keys to success in saving money for all your needs.