Learning goals for this section: I want you to understand the order in which you should put money in different components of your personal financial system.
Introduction
Now that you know about personal financial systems and their components, it’s time to talk about how to actually go about creating and funding one. The first thing you will need is money to put into your system. Typically, this start-up money comes in the form of your salary. So we will talk about how to take your salary and feed it into your personal financial system.
Figure Out Your Saving Rate
The first thing you will do is take a good look at your spending and calculate how much you spend per month. This includes rent, groceries, random spending, loan payments, etc. Take this value and subtract it from your monthly income. The number you get is how much money you should be saving every month. We’ll call this number your Monthly Savings.
By saving, I mean this is the money that should go into improving your personal financial system. You want to make this number as large as possible at the beginning. This may mean cutting back on buying random stuff and trying to whittle down your spending as much as possible (without going crazy). As mentioned before, try to get this number to be at least 40% of your salary. The more you save, the faster you can create a robust financial system.
This is a good opportunity to take a hard look at your spending. Have you picked up some bad habits such as buying dumb shit you don’t need? Stop doing that. Create a healthy budget and stick to it.
Emergency Fund
Now that you’re saving money, you first need to create a preliminary emergency fund. Before you start putting money in your 401k, you should have at least one months worth of expenses, minimum. Like I said before, I prefer a six month emergency fund but once you have a one month emergency fund you can start slowly investing in your 401k while you continue to build up your emergency fund. You can use your checking account or your savings account to hold your emergency fund. Just make sure to never touch this money unless you absolutely have to.
401k
Note: If you aren’t employed, jump to the next section: IRA.
Once you have one month's worth of expenses saved up in your savings account, you can start slowly investing in your 401k while continuing to build your emergency fund. The goal here is to first take advantage of your employer’s 401k matching.
Typically, employers will only match up to a percentage of your total salary. So let's say you make $50,000 and your employer matches up to 5% of your salary, they will match up to $2,500. Your goal should be to first max out this match. Different employers do different things, so I won’t be exhaustive in explaining this here.
So you’re going to take your Monthly Savings and you’re still going to allocate some of that money to increase your emergency fund. With the rest of your Monthly Savings, you’re going to invest in your 401k so that you meet your employer match. First reminder, this match is literally free money so we want to take advantage of it. Second reminder, invest in index funds in your 401k.
Once you have invested enough in your 401k to take advantage of your employer match, you have a few options. The first is to take a look at your debts and pay down any high interest debt. You can read up on debt-paying strategies here: Debt Payment Strategies. If you don’t have any debts, keep on performing the balancing act of increasing your emergency fund and investing in your 401k past your employer match. Once your emergency fund is at a number that you’re comfortable with, start allocating all of your Monthly Savings into maxing out your 401k.
IRA
Before you get to this step, you should have set up a six-month emergency fund, maxed out your 401k and paid down all of your debts. If you haven’t completed all of these things yet, do those first. Those are way more important.
Once all of the above things have been completed, you should take your Monthly Savings and put it in an IRA (either Traditional or Roth). You can contribute up to $6,000 a year to your IRA. Max it out!
If you have maxed out your IRA, you should think about increasing your emergency fund to contain at least one year's worth of expenses.
Brokerage Account
Alright, if you have maxed your emergency fund, maxed your 401k, paid off all your debts, maxed your IRA, then you’re in a pretty crazy situation. In this case, you have maxed out all of your tax-advantaged accounts and should start investing in index funds through your brokerage account.
Brokerage accounts should be your last choice mainly because you have to invest after-tax money and you are taxed on all of your gains. So it’s suboptimal for retirement but if you’ve already exhausted your retirement accounts, you’re in a good position to use one.
Pour the rest of your Monthly Savings into index funds through your brokerage account.
Conclusion
The main take away from this section is that you should build an emergency fund and start investing in your 401k. Anything extra is great but you should focus on building that solid foundation first. Just taking those first steps will set you up for success.
None of this is set in stone. Everyone’s financial situation is different and you should tailor the advice here to accommodate your particular situation.
Additionally, all of this will take time. This is not something that happens overnight, it takes many many years to create and fund your personal financial system. While there is no rush, it is best to start as early as you can. This allows you to spend more time in the market so your money will compound and grow. This is a lifetime goal, so don’t stress too much.