Often, after making a financial turnaround, people have one big question: Where should the extra money go? Should I pay down debt, or should I invest?
Mathematically, the analysis is simple: Put money toward whatever option will earn the greatest after-tax rate of return. Once you’ve exhausted that option, move on to the next best.
Of course, there’s no way to know for certain what an investment is going to earn over a given time frame, so you have to do a little guessing. My general framework is as follows:
1. 401(k) Match
Priority #1 should be to take full advantage of your employer’s 401(k) match. It’s an immediate 100% return, guaranteed. (In fact, if you qualify for the Retirement Savings Contribution Credit, you could be getting a guaranteed return of 110% or 120%.)
There’s just no beating that.
2. High-Interest Debt
After exhausting your 401(k) match, high-interest debt is the next in line. Paying off consumer debt is equivalent to getting a guaranteed after-tax return equal to the interest rate.
In my opinion, any nondeductible debt carrying an interest rate of 7% or more is worth tackling before any further investing. Guaranteed 7% after-tax rates of return just don’t occur anywhere else.
3. Retirement Accounts
After eliminating high-interest debt, it’s time to move on to tax-advantaged investing via an IRA or 401(k) account (or other employer-sponsored retirement plan).
Due to better investment options and lower costs, it’s generally best to max out your IRA before maxing out your 401(k). (Also, for many investors, a Roth IRA is more tax advantageous than a 401(k) account.)
Mortgages tend to carry significantly lower interest rates than other debt due to the built-in collateral. Also, home mortgage interest is (somewhat) deductible. As a result, the after-tax rate of return earned by prepaying a mortgage tends not to be as high as what you’d earn via a diversified portfolio in a tax-sheltered account.
That said, there’s still something wonderful about a) knowing what rate of return you’re going to get, and b) being completely debt free.
5. Taxable investments
For most people, I tend not to recommend bothering with taxable accounts until practically all debt has been paid off and every tax-advantaged avenue for investing has been exhausted.
[Exceptions: 1) building up an emergency fund, and 2) investors who intend to retire prior to 59.5]
6. Subsidized Student Loans
Federally subsidized student loans carry a very low interest rate. Further, that interest is tax deductible (regardless of whether or not you itemize). Call me crazy, but at an after-tax interest rate of less than 2%, I wouldn’t pay so much as a dollar beyond the monthly minimum payment.