7 steps to making your paycheck work for you
Prior to the pandemic, a 2019 Charles Schwab survey found that 59% of American adults were living paycheck to paycheck. Further, 44% have credit card debt and only 38% have an emergency fund. And living paycheck to paycheck wasn’t necessarily found to just be a low-income problem. A more recent study conducted by advisory firm Willis Towers Watson found that 18% of six-figure earners were also living paycheck to paycheck.
While the skyrocketing cost of housing and education, the prevalence of high-interest consumer debt, and now the global pandemic have made getting ahead financially much more difficult, understanding how to allocate your paycheck before it’s in your hands to spend is the first step to getting out of debt, building wealth, and obtaining long-term financial freedom. So next time you get paid, here are the seven places your money should go — besides straight into checking as a lump sum.
Step 1: Your Retirement Fund
Your retirement contribution will generally come out of your paycheck automatically via an employer plan, but if you’re self-employed, I recommend automating a biweekly transfer from your take-home pay straight into a Roth IRA. I like to contribute up to the employer match, which will generally amount to 5–15% of your pre- or after-tax income. If you have the option of choosing a Roth, or after-tax account, I recommend going this route over the traditional IRA or 401k as it will save you thousands in taxes on your future account withdrawals. Taking the Roth route will also allow you to lock in your tax rate while taxes are still historically low.
Step 2: Your Checking Account
Deposit your net pay into your checking account. If you’re a W-2 employee, your net pay will typically be your paycheck as you see it. Essentially, your net pay is your income less taxes and employer benefit deductions such as retirement contributions and health insurance premiums. Instead of thinking of your checking account as either a savings account or a wad of cash to spend between now and your next paycheck, treat it as the hub for all of the other transfers that take place once you get paid. Ideally, you’ll have the next set of transfers automated out of your checking account before you have the opportunity to spend a penny on the nonessentials.
While your checking account should neither function as a savings account nor provide you with undue temptation to spend, I do recommend keeping enough cash in your checking account to cover all of your expenses between now and your next paycheck, as well as a margin of safety that makes sense for your budget. The reason for this is to avoid taking out payday loans or going into other high-interest debt at all costs.
Step 3: Your Starter Emergency Fund
According to Bankrate, only 37% of Americans have enough in savings to afford a $500 emergency. This means that when an unexpected expense comes up, the majority of Americans are going further into debt to cover it. So in order to avoid going into debt when life inevitably happens, keeping at least one to two thousand dollars in savings while you work to pay off any high- interest debt is absolutely critical. That’s why you should throw as much money as you can afford — over and above paying your bills — at this goal until you hit at least the thousand dollar mark. Once you have more than one to two thousand dollars in your starter emergency fund, start skipping this step on pay day and go straight to Step 4.
Step 4: Your High-Interest Debt
Once you have your starter emergency fund in place, contribute as much of your net pay as you can afford to pay down this debt ASAP. Start with the highest interest rate debt and continue until you have paid off any debt outstanding that’s over 6% APR. This could be your credit card debt, an auto loan, or a payday loan if applicable. Once you’ve wiped out your high-interest debt, proceed with the remaining steps simultaneously.
Step 5: Your Nest Egg or Low-Interest Debt
Set aside 15% of your net pay for either building long-term wealth in your brokerage account or paying off low-interest debt such as student loans or a mortgage. If you’re relatively young and have your student loans paid off, I recommend growing your brokerage account over trying to pay off your mortgage early. The reason for this is that you will get a much higher return by investing consistently in the stock market than you would by paying off your home early.
Step 6: Your 3–6 Month Emergency Fund
Set aside 10% of your net pay while you save up 3–6 months of expenses. Doing so will leave you covered and out of debt in the event of an accident, job loss, or any other more serious financial setback. Once you have your emergency fund built up, either set aside this same 10% of your net pay to save for longer term financial goals such as purchasing a home, or invest it for long-term wealth creation as in Step 5.
Step 7: Your Bills
Once you have one to two thousand dollars to fall back on in case of an emergency and are out of high-interest debt, you’ll have 75% of your net pay in your checking account after your investment and emergency fund transfers have taken place. Ideally, your bills shouldn’t total more than 50% of your income. But depending on the cost of living in your area, this may not be possible. For this step, pay off your needs only. Doing so will give you a much more accurate read of your overall cost of living. Then, once you see how much you have left over, you may find that you’re able to save a higher percentage of your income while still making room in your budget for the things you love.