PEMDAS For Investing

What on earth is PEMDAS you ask? Let’s try a little reminder - Please Excuse My Dear Aunt Sally. If you still don’t remember, PEMDAS is an acronym for the order of operations in math. When solving a math equation, you begin by solving anything in Paratheses, then Exponents, Multiply, Divide, Add and Subtract. The beauty of something with a defined order of operation is that it doesn’t change. It doesn’t matter if you’re taking Algebra 1 or advanced calculus, you still abide by the same rules. While personal finance is dubbed ‘personal’ for a reason, there is still an order of operations that should be followed when thinking about where to put your investing dollars.

Before getting into the order of operations for investing your money, there’s something I’d like to reiterate. You should have an established emergency fund with no short term debt before beginning to invest. Investing your money is a long term action, you’re setting aside money today to prepare for your future. If your short term needs aren’t met and exceeded, you can’t truly prepare for the long term. I wrote a piece on handling short term which you can read HERE.

Now for the good stuff.

  1. 401k With Employer Match

    Many employers that offer 401k plans offer a “match” where the company will contribute to your 401k matching your contribution up to a certain percentage. Regardless of what the percentage is, this is your first move. There is no other place where you will get an instant 100% return on your money. NOWHERE. They’re offering free money to help YOU retire. Take what’s yours - if you aren’t, you’re literally throwing money out the window. All 401k and 403b plans are limited to an annual contribution limit of $19,500. It’s okay if you can’t max that out, just please please PLEASE contribute to get the entire match your employer offers. If you have questions, your HR department can help you.

    As an aside, if you’re self employed or operate your own business and don’t have the opportunity to contribute to a 401k through your employer, you are entitled to something called a SEP IRA which is essentially a self directed 401k. You can learn more about setting that up HERE.

  2. Roth / Traditional Individual Retirement Accounts (IRAs)

    After taking full advantage of the matched contribution from your employer, the next most effective thing you can do is contribute to an IRA. You are unable to have an IRA if you make too much money (you can read about limits HERE), but generally speaking the limit is $6000 (7000 over 50) per year. I’ve seen some conflicting information about which is more effective based on age, roth or traditional - may do a piece on that in the future. The point is to use all the tax advantaged vehicles you have available to you.

    Here is where the personal part comes in. If you only contributed to gain the match in your 401k and then maxed our your personal IRA, you have a few options. You can go back and contribute up to the max for your 401k amount or pursue any of the below vehicles.

  3. Health Savings Account (HSA)

    The HSA and the next option I would consider interchangable and also depend on your life situation.

    The health savings account is actually the investing vehicle that offers the largest tax advantages, but comes with several caveats. Think of this account as a an IRA but for medical expenses. You may contribute up to $3550 for an individual or $7100 for a family per year into an HSA. One cool benefit of this contribution is that it is tax deductible. Your money can grow tax deferred on gains and withdrawl so long as the money is used for qualified medical expenses. So that adds up to 3 separate tax benefits in one vehicle; contributions are deductible, withdrawls are tax free, and gains on money are also tax free.

    The big caveat kicker for HSAs is that in adition to requiring of being over 18, not being claimed as a dependent, and not currently on Medicare, you need to be covered by a high deductible health plan through your insurance. If you’re generally healthy and don’t require the low deductible on your insurance, this is a great way to set aside some money for medical expenses in the future.

  4. 529 Plan

    The last vehicle that may be more fitting for your needs than the HSA is the 529 plan which is a tax advantaged account that allows saving for education expenses. The term education here is used very loosely - this can go towards apprenticeships and other costs associated with higher education. This is an outstanding way to start saving for a child’s college fund early to take advantage of the compound growth over time. There are also rules that allow the transfer of funds between kids if one decides to pursue something else other than college. There are no limits to contributions to 529 plans, however if you contribute more than $15,000 per contributor, you may be subject to a gifting tax.

    Setting one of these up is a great way to get family and friends involved in preparing for your child’s future - a $50 dollar contribution from grandparents or relatives to a child’s 529 on their birthday each year would go a lot farther for their future than one more toy. Just a thought.

One of the beauties of each of these vehicles is while they are designed to be rigid and promote long term saving, you have flexibility. Each has its own rules about withdrawals, but just because you contribute money to one and you end up not needing the money in that way, doesn’t mean your money is lost. For example, let’s say you save up $25,000 for your child’s education in a 529 plan by the time they turn 18. They choose not to pursue any higher education so you have the money sitting there. You are able to transfer it to other family members, or you can also just withdraw the money. You’re subject to income tax and a 10% penalty because it is not a qualified expense, but a tax advisor could work with you on determining withdrawal times to minimize the hit to your savings.

The most important takeaway of this is that understanding that saving is the absolute, number one most important thing you can be doing to prepare for your financial future. One of the biggest mistakes people fall into is something called “lifestyle creep”. This happens when you continue to get promoted at your job and make more money, but you spend incrementally more based on that.

The harsh reality is that it doesn’t matter how much money you make, it matters how much you save. These are the tools you need to help you save more effectively. When you get an end of year bonus, you weren’t planning on that money so put it away. When you get a raise at work, you were already living on less than your new salary so why not take 90% of your increase and save it. Automatic withdrawals are your friend when it comes to these things, don’t give yourself a chance to see the money because your emotions will get the better of you every time.

If you have questions about these vehicles, need help setting them up, or have an idea for something you’d like to learn about, drop me a comment here.

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