When it comes time to begin your journey to financial independence, it can be hard to know where to start. There is so much information out there that it can get overwhelming. This is the biggest reason I started my journey to financial independence later than I would have liked. I didn’t know whether I should pay off debt, increase contributions to a pension, Invest via an ISA (or Roth IRA for US citizens) or simply to stick any money I have into a mutual fund and let it compound over time.
Thankfully, Ramit Sethi has set the order out in his book I Will Teach You To Be Rich: No guilt, no excuses – just a 6-week programme that works. Sethi calls it the ladder of personal finance and it has 5 steps.
Step 1: Take full advantage of your employer’s Pension or 401(k) match, if offered. This is free money so make sure you invest up to the employer match as a minimum. You can not get this risk free 100% returns which an employer match offers you anywhere else.
Step 2: Pay off your credit card and other debt. Your APR is probably high, and getting rid of this burden is a “significant instant return,” Sethi says. Debt is an absolute destroyer of wealth and thus you want to get rid of it as quick as possible. Have a read about the snowball method if you are having trouble eliminating your dent.
Step 3: Open a Roth IRA and contribute as much as you can to it. For those in the UK, I would suggest investing in an ISA. With an ISA, you save via after tax income and any amounts you earn within the ISA are tax free. When it comes time to withdrawing the money, it is tax free as well! I personally use an ISA for my investments. I find an ISA much better than a pension because I know I have paid the tax on my income upfront and have no further taxes to pay later. With a pension, this is more uncertain as you get taxed on your withdrawals from the pension. I do not trust future governments to keep the tax system the way it is at the moment. With the current debt mountain the government has, I see the future having higher income tax rates and lower personal allowance figures. I do not want to have to deal with this uncertainty and certainly don’t want to pay more tax than is required by law. For this reason, i prefer an ISA.
Step 4: If you’ve maxed out your ISA and still have money you want to invest, then invest more in a Pension. The ISA limit for 2016/2017 is £15,240 and this jumps to £20,000 for the tax year 2016/2017 so the ISA limit is getting bigger. If you have maxed out your ISA, Kudos to you. Have a look at how to save when you have maxed out your ISA. If those options are not good for you, simply invest via a pension.
A pension gives you the ability to invest more money than you have as you can invest in a pension with your gross income – your income before any income taxes are paid. So if you are a basic rate payer, you only need to put £800 in your pension in order to invest £1,000. The government tops up this extra £200.
But remember that you are taxed when you withdraw money from a pension. Additionally, pensions have far more stringent rules than an ISA. If you were to withdraw money from a pension, you have to be at pensionable age (currently 55 but ever increasing!). If you withdraw before this, HMRC can hit you with taxes of up to 55% for unauthorised payments!
Step 5: Still have money to invest after maxing that out? Open a regular non-retirement account and invest it there. Read my article on the best stocks and shares dealing website to see which platform is best for you.
It is really that simple. Each step builds on the previous one, so when you finish the first, go on to the second. If you can’t get to number 5, don’t worry. You can still feel great, since most people never even get to the first step….remember opening these accounts and getting started is the most important step.
For some people, some of the steps won’t be applicable. For example, if you are self employed, step one does not apply. If this is the case, simply move on to the next step.
If you enjoyed this article and want to know more about what steps to take in order to build your net worth, read my article on ‘I have X, what do I do with it’. This article is great if you have received some money (a lump sum) and don’t know what to do with it. I have set out the order in which you should increase your pension contributions, pay down debt, pay a deposit for a house or simply invest!