The Financial Planning Pyramid: A Step-by-step Guide to Building Wealth
Spending money is easy, but managing it wisely can be a daunting task. Many people don't know where to begin when it comes to financial planning or investment. Understanding how to prioritize different accounts and creating an efficient financial plan helps avoid financial stress and paves the way for long-term wealth-building.
To help, I came up with a financial planning pyramid that consists of 18 levels, each with specific actions to take to help you manage your money effectively. The levels are based on the tax benefit and general value added to an overall financial plan.
Some of the levels will not be an option to some people, such as an ESPP plan. If the level is not an option, does not apply, or is fully funded, then it is appropriate to move to the next level.
Level 1: Emergency fund
The first level of the financial planning pyramid is the emergency fund. This involves setting aside at least $1000 in savings for life's unexpected events like job loss, car repairs, or medical emergencies. This money can be placed inside of a normal or high-yield savings account. However, it should be put somewhere outside of your normal checking account to prevent you from spending it!
Level 2: High-interest debt
The second level of the pyramid is paying off high-interest debt such as credit cards and personal loans. Focus on paying off your debts with interest rates over 10% to avoid accumulating interest charges.
It is sometimes appropriate to refinance this debt using credit card balance transfers or possibly a HELOC (if you own a home with sufficient equity). However, sometimes this can merely worsen the problem. If you are well established and have credit card debt I recommend taking a close look at your spending habits. It's possible you have become victim to "lifestyle creep", in which our wants start to overtake our income.
Level 3: 401k match
The third level of the financial planning pyramid is taking advantage of employer-provided 401k matches. If your employer offers a 401k match, make sure to contribute at least enough to maximize it.
If you don't take advantage of the match, you're essentially leaving free money on the table that could potentially grow over time with compound returns! It's important to remember though that this money is not easily accessible until retirement age (59 1/2) without incurring penalties.
Level 4: Safety net
The fourth level involves building a safety net by setting aside 3-6 months worth of living expenses in a high-yield savings account. This safety net provides a buffer for short-term changes in your life's circumstances. Households with multiple sources of income, say a married couple who both work, may be on the lower (3 months) end of this scale. However, a single person is likely on the higher (6 months) end of the scale. Applying this rule is as simple as taking your monthly expenses, including all spending, rent/mortgage, loan payments, utilities, and insurance, and multiplying by the number of months.
Level 5: Basic insurance
Once you have a safety net, it's essential to evaluate the basic insurance policies such as car insurance, renter's/home insurance, and life insurance. Everyone starts out life with their neighborhood insurance broker selling them the "lowest rate". Meanwhile, they don't realize they're being sold the "lowest possible amount of coverage". These policies should match your current level of wealth. A good insurance broker can help you evaluate your current coverage and compare it to what you should have for your situation.
Level 6: Medium-Interest debt
Level six of the pyramid involves paying off the remaining debt with interest rates greater than 5%. This includes student loans, personal loans, and auto loans. Although these may not have the same interest rates as credit cards, they still represent a financial burden on your overall household income. Prioritize paying off the loan with the highest rate first while making minimum payments on the others.
Level 7: HSA max
An HSA (Health Savings Account) through your employer's HDHP (High Deductible Health Plan) can be a powerful tool for tax savings and health care. HSAs offer tax advantages and can be used for medical expenses not covered by insurance. These accounts are triple tax-free, meaning the contributions, interest/dividends earned, and withdrawals for qualified medical expenses are all tax-free.
Most HSA accounts can be invested once they reach a certain threshold ($1,000-$2,000) based on the account provider. These invested dollars allow your HSA to grow just like a 401k or IRA.
Some employers even offer to contribute to your HSA. Be aware that the employer contribution reduces the maximum amount you can contribute. Before any employer contribution, the max you can contribute for 2023 is $3,850 for a single person and $7,750 for a family plan. These amounts increase each year.
Level 8: Basic retirement plan
At this stage of the financial planning pyramid, it is essential to consider contributing more towards your retirement plan such as an IRA or 401k. Aim for a target of around 10% of your income going into these types of plans. When deciding whether to opt for a Roth IRA/401k or a Traditional option, it's important to consider your current tax bracket and estimate which will be most beneficial when it comes time to withdrawing the funds in retirement. If you're uncertain, it might be worth considering hiring a financial planner to get expert advice on selecting the best option for your circumstances.
Level 9: ESPP
Consider participating in an Employee Stock Purchase Plan (ESPP), if available, to reap the rewards of discounted company shares. Through these plans, you can purchase up to $25,000 worth of stock per year at a 15% discount - that's around an additional $3,750/year in income for those who fully participate! The company will deduct your pay and use it to purchase the shares at the end of each 6-month period. To diversify investments, most people choose to sell their shares at the conclusion of each term. However, this does mean that a portion of your compensation is funneled through company stock twice per year!
Level 10: Advanced insurance
At this level, you should evaluate advanced insurance policies such as life, disability, long-term care, and umbrella insurance. It is essential to identify any potential risk events that could derail your wealth-building goals. A good insurance broker can help you assess your current coverage and make sure it matches up with your current wealth level. Additionally, now is a good time to review your will/trust documents. If you do not have these, there are relatively inexpensive services online available.
Level 11: Short-term goals (1-5 years)
With the advanced safety nets in place, you can start investing for short-term goals like a down payment on a house, tuition payments, or vacation savings. It's best to put this money into a high-yield savings account or invest it in risk-free bonds since they are intended for short-term use and have specific purposes. Risky assets should be avoided when investing money for the short term.
This is where most people stop. They feel accomplished and are living a good life. Typically, achieving this level means you are taking vacations every year, buying the cars you want, and ignoring the costs that will come up later in life. If you want to look out for older you, and your children, or just want to know what are the next steps, keep reading.
Level 12: Max IRA
Maxing out your IRA is the next step in the financial planning pyramid. After reaching level 11, you should increase your retirement contributions until you reach the annual contribution limit.
It may seem like a daunting task but it’s worth taking on since tax-deferred accounts are one of the best ways to save for retirement. The money saved here will go towards creating future wealth and will allow you to live comfortably during retirement - something that requires extra effort as life expectancy continues to rise.
Level 13: Max 401k
The same advice as the previous level applies, although you should prioritize maxing out your IRA over your 401k as the 401k plans tend to have fewer options and include fees associated with the plan itself.
In my experience, many people try to max out their retirement accounts but they forget about their 1-5 year goals. The result is they overextend their cash flows and have to borrow money (creating 10%+ debt, taking them back to level 2). Take a moment to look back at your cash flows and ensure enough is going towards your short-term goals before moving to the next level.
Level 14: Education fund for kids
Funding a child's education is next on the list! Why so far down on the list? Well, the previous levels all have considerable benefits that otherwise would be lost if you funneled all of your money into your children. Additionally, we do not know if college will have the same cost/benefits in the future. (This coming from the author who went back for his MBA, a $60k+ expense).
If you start early, funding a child's education can be as little as $200/mo, but the amount and strategy differ depending on how many children you have, what kind of school they will go to, and your state of residence. A comparison of 529 plans, Roth IRA, and taxable investment accounts should be done here.
Level 15: Long-term goals (6-20 years)
Here it is! The future dream home, the vacation house, the vacations where you really splurge. This level requires the heavy use of taxable investments at a brokerage. You'll buy stocks/bonds outside of your retirement account to compound growth to buy those dream items later down the road.
Level 16: Premium retirement
If you're not satisfied with your current savings rate, or perhaps had a delayed start in putting money towards retirement, you may consider strategies such as a Mega Backdoor Roth or Backdoor Roth IRA to boost your retirement savings. These strategies allow for additional contributions that can be transferred to a Roth account. Unlike the previous levels, these strategies are best executed with the advice of a professional.
Level 17: Max child's HSA/IRA
If you have used all of the previous strategies, and still find yourself with additional funds each month, you may consider maxing out the child's HSA or IRA. This can be done to further protect your wealth in case of an unforeseeable event while also giving your children a head start on their retirement savings. Like the premium retirement strategies, navigating the rules around funding a child's HSA and IRA should be executed with the advice of a professional.
Level 18: Heirs/Charity
The final level of the pyramid involves protecting and leaving a legacy for your heirs and charitable organizations. This includes setting up a life insurance policy inside of a trust and contributing to it annually, taking advantage of annual gift tax exclusion, utilizing Qualified Charitable Distributions from your IRA accounts, and/or setting up a Donor Advised Fund.
The financial planning pyramid provides a clear road map for managing your finances better. With each level, you become more financially independent and secure. By prioritizing your financial goals, you can make smarter money decisions and achieve long-term financial stability. Remember that the financial planning pyramid is not a one-size-fits-all solution, and it's essential to adjust this pyramid to meet your unique financial goals.
If you ever feel overwhelmed or stuck, reach out to us at Mainstay Capital for a free consultation. We’re here to help you take the next steps and get to the top of your financial pyramid! With our personalized approach, we have helped many individuals achieve their goals. Let’s work together and find a plan that works for you!