The wealth ladder: How to save for your future one step at a time

Knowing where to put your money sometimes feels as hard as earning the money itself. Once you have a chunk of money, it can is really difficult to decide what to do with it. Common questions I often see being asked online are:

• How much should I keep in savings? 
• Should I pay off my house?
• Where should I invest?
• Should I pay down debt before investing?

We are going to run through a tutorial on what I like  to call "the saving ladder". It is framework of questions I ask myself and the steps I take when deciding what to do with my money.

Step 1: Build a rainy day fund

This step is the most important. Without a rainy day fund you are taking a risk. Not having a rainy day fund is risky is because something that is out of your control will hurt and set you back without a cash buffer. Some common occurrences that can come out of nowhere are:

• Car breakdown
• Unforeseen appliance replacement at your house
• Medical expenses 
• Losing your job
• Economic downturn

Without a rainy day fund anyone one of these expenses will be very stressful and possibly set back your financial future. Think of a rainy day fund as reducing stress for future you.

How much should be in your rainy day fund

The suggested size of a rainy day fund is anywhere from 3 to 6 months of current spending. 3 months is on the lower/riskier end and 6 months is more conservative. Some factors to consider if you want to save 3 or 6 months are:

• How easily can I get another job
• If I had to really stretch my budget, could I?
• Could I get other forms of cash in a pinch?

These will all factor into your decision on how much you want to save. Younger people tend to be closer to the 3 month end while older people will shoot for 6 months. 

Here is an example of what a rainy day fund could look like:

• Total monthly spending: $3,500
• Rainy day fund range: $10,500 - $21,000

Also take into account if your spending habits change. For example if you have a child and your monthly spending goes up, you should consider running your numbers again and contributing more to your rainy day fund.

Where to save your rainy day fund

This one is easy. Save your rainy day fund at any bank that you currently are with. If you are concerned with losing value on your money, consider looking into a higher yield savings account. As long as the money stays in cash and you can have near-instant access to it, you will be fine.

Step 2: Pay down high interest debt

If you have any debt that has a high interest rate (roughly over 6%) you should next work on paying that down. Some common forms of high interest debt are:

• Credit Cards
• Personal Loans
• Payday Loans
• Car Loan

I would say the rule of thumb is if you are paying over 6% interest on it, you need to pay it off before investing in anything else. I chose 6% as the inflection point because 6%-7% is what you should be getting from investing the market over time. 

I also wanted to specify that I kept car loan in this list on purpose even though you can often get rates under 6%. The reason I added car loans is that cars a depreciating asset. If at all possible, I would suggest not taking any debt for a car. Every time you drive it, they go down slightly in price which in a way is inflating the percentage you pay on it.

The opportunity cost of debt is so high that $5,000 of credit card debt actually costs you over $19,000. Think of paying down your debt as getting a guaranteed return. Instead of market gains, your saving on interest. It all contributes to the same balance, your net worth.

Step 3: Tax Advantaged Investment Accounts

The next step is contributing to tax advantaged investment accounts as much as you can. I specify tax advantaged because investing in these types of accounts:

• Save you on your tax bill
• Allow you to invest more money up front (tax free)
• Are often matched by employers

If you want a more in-depth discussion about the advantages of a 401k, check out our post about it here. Some of the possible tax advantaged investment accounts are:

• 401k
• 403b
• 457
• IRA
• Roth IRA

Note that the Roth IRA is actually a post tax investment account. I still consider it tax advantaged because you won't pay tax on it when you sell in the future. Look in to see which account (regular IRA or Roth IRA) is right for your goals.

If you aren't already contributing to an account pre-tax, you should look into it. Most employers offer some sort of account like this and there are options if you want to do one on your own as well. If you were able to max out even just a 401k ($19,000 a year), here is what the growth could look like over the next 20 years:

How much should I contribute to tax advantaged accounts?

The answer for this one is pretty simple, as much as you can! Most of these accounts have limits as to how much you can contribute into them per year.  Try to max these out if you are able to do so. Maxing a 401k and IRA gives you $25,000 of tax advantaged investing a year. This compounds over time and can accelerate your path to FIRE immensely.

Before we jump into step 4 and 5, I wanted to preface both of these. If you get to the point where you are at step 4 or 5, you are ahead of the game. These next two steps are somewhat personal preference and depend on your risk tolerance. If you find yourself reading step 4 and feeling like step 5 is the better first option for you, do that. I will preface that choosing step 4 is probably better for people who:

• Feel stressed having debt
• Are more aggressive investors
• Are younger and can have more time in the market

Step 5 is probably the better first step for you if:

• You want to pay off all debt ASAP
• Debt stresses you out

Ok, now that that's done let's get back to it.

Step 4: Post Tax Investing

Once you have all of your monthly expenses, have done your pre-tax investing and still have money left over, it's time to invest more! Post tax investing is investing with money that has already had taxes taken out of it. This is how many people invest using platforms like RobinHood or E Trade. You can invest as much money as you want after tax.

If you are at this stage, find a platform that you feel comfortable with and put your money there. Things to make sure are that they offer the funds or stocks you want and that fees are low. There are many platforms out there so find one that fits your needs and stick with it.

Step 5: Pay off low interest debt

As I said before you can do step 5 before step 4 if it fits your investment profile. Paying off low interest debt can help reduce the stress of having debt and feel like a weight is lifted off your shoulders. I personally get stressed out about debt and would likely choose a blend of step 4 and step 5 together. Some examples of low interest debt are:

• Student Loans
• Mortgage

The balances of these loans can often be huge and seem overwhelming. There is a big mental part of having a lot of debt that many choose to do step 5 before step 4.

I use the savings ladder framework to help make my decisions in saving for my future. I revisit the list every year as I plan my finances for the year. There is no silver bullet for building wealth, but knowing the proper steps to take is the fist run on a ladder to building serious wealth.