Foundation First

It was a low point.

I was on the phone with a non-profit who specialized in debt consolidation and financial counseling. My wife and I had just laid out our total financial picture to the counselor on the other end of the line. We were waiting for her to come alongside us with some practical suggestions for getting out of the mountain of debt we were sitting in.

The counselor paused for a moment, then said – “based on your debt to income ratio, Mr. Burns – our unfortunate recommendation is that you go ahead and declare bankruptcy.”

I’ll never forget that moment, It was like a blow to the gut. Everything we had dreamed of felt like it was crashing down around us, and it seemed like we would never break out.  That moment is the reason I’m a financial planner today.

Perhaps you’ve had a moment or season like this – perhaps you’re in one right now. In 2014 an American Psychological Association study found money to be the number one stress point for Americans, with over 72% of adults across all ages and income levels reporting regular stress related to their finances. And the stress doesn’t just go away as income goes up – SunTrust did a significant survey in 2015 and found that twenty-five percent of respondents making over $100,000 annually still lived fully paycheck to paycheck.

Financial stress is awful – because it’s private. If you’re struggling financially, you don’t want your friends or family to know about it. You may not want your spouse to know. You feel ashamed that money is always tight, and you live in the world of “should.” I “should” be saving more…I “shouldn’t” have all this debt…”I make plenty of money, I “should” have no problem covering my expenses every month. You shame yourself, but nothing seems to change. If this hits close to home, remember that I speak from personal experience!

After confronting these issues in myself and helping hundreds of clients on their own journeys, I’ve found something surprising about money problems: The answer isn’t necessarily finding more money to save, the answer might just be changing where you are saving. You’ve got to build your foundation first!

I just met with a young college graduate, the daughter of a long-time client. She had landed a solid job and recently received a letter describing her 401(k) options. She wanted my opinion on how much she should contribute each month to the plan. She said they would match up to 3% if she gave 5%, but she was thinking of saving closer to 8%. What were my thoughts?

I asked a question that may have taken her off guard – “How much money do you currently have saved in an emergency fund? In other words – if an unexpected expense comes up, how much money could you immediately get to without using a credit card or calling your parents?” She responded that she had about $800 in a savings account. I told her that was a great start, but she shouldn’t contribute a dime to her 401k until two things had happened:

1. She had three months of living expenses saved into her emergency fund. For her, this would be about $9000.
2. She had fully funded 1 year’s worth of a Roth IRA Contribution – $5500.00.

At that point, she could

3. Fund her 401(k) up to the match, while continuing to send any extra dollars to her Roth IRA.

She looked at me like I was from Mars.

“I just took a personal finance class,” she said. “They stressed the number one thing I could do would be to contribute as much as possible to my 401(k). They said the match was free money…Shouldn’t I take the free money??”

You might be wondering the same thing. Let me be the first to say that I love employer matches, and I love saving in 401(k)’s! But you can’t afford to put any money into plans like that until you’ve built a financial foundation that can carry you through the inevitable emergencies of life. Corny as it may sound, think of your financial world like a tree. Long term savings are the leaves and branches high in the tree, you can’t cultivate those until you have a solid foundation. Otherwise a few bad storms can jeopardize the whole thing.

Let’s take a minute to unpack each step in this process:

First – Save three months of living expenses. This is not three months of income, it’s how much you (and your family if applicable) need to live comfortably for a three month period. Don’t cut corners on this. I just worked with a family that needs twelve thousand a month to pay all their expenses – their emergency fund is thirty six thousand. All other savings need to stop until this account is fully funded – Even if that means taking a year or two away from your 401k.

(pause here – how much would your monthly anxiety reduce if you had three months of expenses sitting, liquid, for any emergency that came up? Would you wake up feeling more confident? Would your stress about  a job loss go down?)

Second – Fully fund one year’s worth of a Roth IRA contribution – $5500. I don’t mean you have to fund it in one year – it might take you more time to save that much – but no starting on the 401(k) until you’ve contributed a full $5500. A Roth IRA is an individual retirement account, but unlike your 401(k) it is funded with after tax dollars. So you have to pay taxes on the money you put in this year, but then it grows tax free…forever. And no tax is owed on money you pull out of it in retirement! There are numerous advantages to Roth accounts that I won’t dive into here, but there is one unique aspect that many folks don’t realize: Because you already paid taxes on the contributions that you made to your Roth, you can pull any money contributed back out at any time without tax or penalty. In other words – if you put $5500 into a Roth this year, and then it grows to $7000 as the market goes up, the initial $5500 you put in could be taken back out at any time. The extra $1500 of growth would need to stay in the account until you are in retirement (or else you’d pay a 10% penalty on it)., but the key here is that the deposits to your Roth can be taken back out in an emergency.

(Let’s pause again – so now you have three months of living expenses sitting safe and liquid in savings, plus an additional $5500 liquid in a Roth IRA. Think about how much flexibility you’ve built into your life now! You are totally prepared for the unexpected…and now you’re actually ready to dive into long term savings)

Third (and finally) – Now it’s time to save up to the match in your 401(k) and take advantage of that “free money” that your employer is offering. Why only up to the match? Because for most folks it’s a better idea to put extra dollars beyond the match into their Roth IRA’s every year. If you’re putting enough away that you get the full match on your 401(k), you max out a Roth, and you still have dollars left over – then feel free to contribute above and beyond to your 401(k).

Now when you hit the unexpected emergency – which is invevitable! – you no longer have to start the cycle of using credit to cover it then paying your life away in interest charges. You pull the needed dollars from your emergency fund and you take care of it. Then (and this is key) you pause excess contributions to any other accounts and you make your focus filling the emergency fund back up again. Once that’s done, then all your savings can continue on as normal.

I recognize these are general, generic guidelines. The principal of “foundation first” applies to everyone, but the practical application can vary. For instance, you may not have a 401(k) match available from your employer. Or you may be an entrepreneur without any retirement plan currently set up (entrepreneurs actually have access to the best retirement accounts available, so you have great options!). You may make too much income to contribute to a Roth this year (based on IRS guidelines), or you may pay so much in taxes that it’s better to put your extra money in a 401(k) for the tax write off. Your specific situation will determine the best strategy, but the essential guideline is don’t put money into accounts you can’t get to until you have enough set aside to handle life’s emergencies. Or more succinctly, foundation first!

I meet with a lot of people who have a significant amount of money in their 401(k)’s, but they are stressed every month about their finances. They have a hard time finding dollars to make it through emergencies. They have loans on their 401(k)’s and they are paying interest on credit cards every month. Yet they would never dream about stopping their retirement contributions, even temporarily; because those 401(k) contributions are the one financial decision they consistently feel good about.

If that sounds like you, consider a paradigm shift. Pause all your long term savings. Ignore the surprised look on your HR representative’s face. Ignore the cautionary advice of the folks in your neighborhood. Put all your effort into getting three months of expenses put away. You’ll be amazed how much it will change your quality of life if you address your foundation first.