One scenario I frequently encounter involves successful families and business owners with substantial estates seeking to optimize their investment strategies. These individuals often come to me with a clear goal: accelerate portfolio growth. However, to their surprise, I sometimes recommend a more nuanced approach that prioritizes other financial strategies first.
For instance, we might focus on restructuring lines of credit that could potentially offset investment gains, or we might develop tax optimization strategies to minimize lifetime tax burdens. These approaches, while less obvious than direct investing, can often yield more significant long-term benefits.
In this article, I’ll provide a high-level overview of potential pathways for your capital based on straightforward financial mathematics: Will the return on your investments outweigh the costs of your liabilities? Could your money be working smarter, not just harder? And finally, are there overlooked opportunities in your current financial structure that could yield substantial benefits?
Investing versus Paying Down Debt
There’s no doubt about it – investing can make one wealthy, but generally speaking, it’s a lengthy process. Yes, some people can get lucky with a particular stock, just as Keith Gill (aka ‘RoaringKitty’ on X) did when he turned a $50,000 investment into upwards of $250,000,000 (as of June 2024).
Most of us will not be like Keith Gill. As financial advisors, our goal is to help you build wealth slowly and surely, and every risk we take is a measured one. To obtain the heights Keith Gill has reached, one must concentrate a significant amount of money into just a few stocks, known as concentration risk. Those stocks can just as easily collapse as they can soar to the moon, and we don’t like gambling with your hard-earned savings like that. Instead, we focus on diversification, portfolio rebalancing, and dollar-cost averaging. No, it’s not exciting, but it’s a time-proven method.
However, even that system doesn’t work if you have debt that drags down your investments. Before investing, why not put the math on your side? Even then, nothing is guaranteed, unlike that interest rate on your credit card. That – you have to pay, no matter what.
In this article, we’ll describe how to get the cards back on your side so you can start building long-term wealth. Naturally, your situation is unique, so this is just a general guide rather than a financial plan. A personal consultation is necessary to incorporate every aspect of your financial situation.
Establish an Emergency Fund
Eighty-nine percent of Americans feel they would need three months’ worth of their salary to safely make it through a financial emergency, yet only forty-four percent of Americans actually have that much saved up for emergency purposes (we’re not considering retirement savings or illiquid assets).¹
Many may think that this is only an issue for low-income earners, but things couldn’t be further from the truth. Even high-earners making more than $200,000 a year have a difficult time saving, with about a third living paycheck to paycheck (with 15% of those admitting to non-necessary expenses as the reason).²
Let’s imagine that you unexpectedly lose your job tomorrow. How do you plan to pay for life’s expenses until you get another one? If you don’t have an emergency fund, you may find yourself resorting to your credit card or borrowing from your 401(K), exacerbating the precarious financial situation you’ve found yourself in. We’ll get into credit cards in the next section, so we’ll focus on emergency withdrawals from a retirement account first.
If you withdraw from an IRA or 401(k) before age 59½, the IRS is likely to charge you a 10% early-withdrawal penalty, and then you’ll owe ordinary income tax on what’s left. A $10,000 withdrawal is quickly reduced to $9,000. Then you’ll have to subtract income tax from that. There’s even the possibility that your withdrawal could bump you up a tax bracket, throwing your whole tax plan off track for the year.
You’re also slowing down the growth of your portfolio. Ten thousand dollars growing at ten percent a year for twenty years would grow to nearly $67,000.
Alternatively, you may be able to borrow from your 401(K) if your plan provider allows it. However, you’ll have to pay your loan back, plus interest. Again, you’re losing valuable time in the market, and if you default on your loan, you’ll still be penalized and owe income taxes. If you leave your job, you could face an accelerated repayment as well, potentially placing severe strain on your finances.
Emergency Fund Calculator
Take Your Company Match
If your employer offers an employee match, you may as well take it, as it’s a 100% return on your investment, something rarely seen in the world of investing. Plus, that free money will eventually begin to snowball, potentially becoming the deciding factor in your retirement’s success.
Say you earn $100,000 a year and maximize your contributions every year in your 401(k), contributing the 2024 limit of $23,000 annually. You also receive a 3% match from your employer, year after year. This match translates to an additional $3,000 annually (3% of your $100,000 salary).
To keep things simple, let’s compare the difference after thirty years, assuming a 10% rate of return for the first 25 years and then a 5% rate of return as you shift to more conservative investments:
Without Company Match Final Total: $2,886,926.39
With Company Match Final Total: $3,263,482.01
Thus, with the company match, you end up with approximately $376,555.62 more after thirty years. Again, that’s a simplified scenario, and it doesn’t take into account any pay raises you may receive. It also assumes a steady rate of return, which is assuredly not guaranteed.
Pay Off High-Interest Lines of Credit
Imagine you’re a professional earning $100,000 annually with $15,000 in credit card debt at a 24.62% interest rate (the average rate at the time of writing³). You have two options: make minimum payments of $450 monthly on your credit card while investing $500 monthly in a diversified stock portfolio, or aggressively pay $950 monthly towards your debt before investing.
Scenario 1: Minimum Payments and Investing Concurrently
In the first scenario, after five years, you would have paid off your debt, having paid approximately $10,519 in interest. Your investment, assuming a hypothetical 10% average annual return, would grow to about $38,718. However, you would have paid a significant amount in interest.
Scenario 2: Aggressive Debt Repayment before Investing
In the second scenario, you’d pay off your debt in about 20 months, paying only $3,314 in interest. You’d then have about 3.33 years to invest $950 monthly. After five years from the start, your investment would grow to about $44,880, and you’d be debt-free.
It may be exciting to put money into your investment account each month, but mathematically, it likely doesn’t make sense if you have high-interest debt. Instead, it’s probably better to double down on that debt and only begin investing once its paid off. Even if the stock markets fall, you’re still likely to see a constant influx of dividends that will smooth the volatility of your investments. Remember, there’s no guarantee in investing, but there is a guarantee of that credit card debt snowballing.
Invest in Retirement Plans
When it comes to investing in retirement plans, you have several options, such as an IRA or a 401(k). The choice between these plans often depends on the offerings available in your 401(K); if they have high fees or limited options, you may want to stick with an IRA, if possible, as income limitations do apply.
By contributing to both traditional and Roth accounts, you can create a tax-diversified retirement portfolio, taking a deduction as necessary to keep taxes low while building up a strong Roth component. This approach gives you the flexibility to manage your taxable income in retirement, allowing you to withdraw from the account that offers the most tax advantage based on your financial situation at that time.
Pay Off Low-Interest Debts
Very generally speaking, if you have other debts that are lower than 6%, you may want to invest first and pay those debts off alongside investing. However, if you’d prefer to get out of debt as fast as possible out of the principle of things, that’s also possible. It all depends on your stage in life, your risk tolerance, and your personal values.
Optimal Investment Calculator
Invest in Taxable Investment Accounts
Finally, consider funding taxable brokerage accounts, within which you can purchase a wide variety of investment products, such as stocks, bonds, ETFs, and mutual funds. While these accounts don’t offer immediate tax benefits such as a Traditional 401(K) or IRA, they can still offer a significant amount of tax efficiency. Stocks can generate a lower capital gains tax rate, while ETFs have tax-efficient structures that minimize taxable distributions, for example. Plus, a brokerage account can add another layer of tax diversification to your portfolio.
In Conclusion
The journey to financial independence and building wealth starts by living below your means, avoiding high-interest debt, and investing your funds with tax-efficiency and long-term growth in mind. Of course, that’s easier said than done. The social pressures to ‘keep up’ are enormous, and social media certainly doesn’t help.
However, if we want to achieve financial freedom and build generational wealth, we have to challenge the status quo. Ultimately, every financial situation is unique and exceedingly more complex than the general steps we’ve outlined here, so tailored advice from a financial advisor can ensure your finances align with your individual goals and circumstances. By putting the math on your side and making informed decisions, you can build a secure financial future and increase the odds of achieving long-term wealth. If you’d like to sit down and discuss your financial situation and discover ways to optimize your financial situation, press the button below.