What Comes First? A Step-By-Step Guide to Financial Independence. Steps 3 & 4: Complete Your Emergency Fund & Set Up a Retirement Fund
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Welcome to the third installment of Independent Beginning’s Step-By-Step Guide to Financial Independence inspired by Dave Ramsey’s “Baby Steps”. In the first installment, you learned about Step 1: Set Up an Emergency Fund, and in the second installment, you learned about Step 2: Pay Off Your High Interest Debts. Once you have completed these steps, you are ready to move on to Steps 3 & 4: Complete Your Emergency Fund & Set Up a Retirement Account.
Step 3: Complete Your Emergency Fund
With all of your high interest debt now paid off, it is time to put all of your energy into completing your retirement fund. That means that all of your extra income that doesn’t go towards paying the bills (minimum payments & other bills) should go into your emergency fund account. As mentioned in Step 1, you will want your emergency fund to eventually equal 6-8 months worth of expenses. The actual amount you choose to put in your emergency fund will depend upon your individual situation. How stable is your job? How high are your monthly expenses? How quickly can you find a new job if you lose your current one? Each of these questions and more will play into your decision. When in doubt, it is better to have too much in your emergency fund than too little.
Step 4: Set Up a Retirement Fund
I decided to place this step at the same place that Dave Ramsey places this step. However, I want to make it clear that not everybody agrees with Dave Ramsey about this step’s placement. Some people argue that people should start their retirement accounts before paying off their high interest debts or completing their emergency funds. I can see pros and cons to both sides. While paying off your high interest debts and completing your emergency fund are two extremely important steps toward financial independence, it is also true that the earlier your start your retirement account the more it will be worth in the future. I still am not sure which option I plan on using once I am out of school and making money. For simplicity’s sake, I decided to keep this step in line with Ramsey’s “Baby Steps”.
How much should you invest in your retirement account? There is no right or wrong answer to this question. Really, I think your best bet would be to max out your 401K & Roth IRA contributions and then invest all extra money in a non-retirement account. For more specific advice, Dave Ramsey suggests investing 15% of your annual pre-tax income into retirement accounts. The more you can afford to invest, the better.
Where should you put your retirement account? There are several different location options for retirement accounts. If your company offers a 401K, especially one where they match your contributions, then this is probably the first place you should invest. 401k’s are tax-deferred, which means you do not pay taxes on that income until withdrawal. If you do not have a 401k available to you, or if you have already maxed out your contributions to your 401k, then your next best bet is probably a Roth IRA. A Roth IRA allows you to invest money that grows tax free. This means that while you still pay income tax on the money you contribute, any interest/capital gains will not be taxed and all withdrawals (that meet the requirements) will be tax-free. A normal IRA is probably your third best option. Similar to a 401k, an IRA is a tax-deferred account.
With your emergency fund complete and your retirement account set up, you are ready to move on to Step 5! Check in tomorrow to see what it is!
Articles so far in the series:
- Step 1: Set Up an Emergency Fund
- Step 2: Pay Off Your High Interest Debts
- Steps 3 & 4: Complete Your Emergency Fund & Set Up a Retirement Fund
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