I recently received this question in the comment section from a reader:
“In order to have a taxable account built up, was there a year you skipped maxing out your 401k/IRA/HSA? Or did you have enough savings to max out every year and still deposit into the taxable brokerage account?”
Instead of directly answering this question to start, I wanted to write a broader post about the topic of Financial Runway: The amount of readily accessible financial resources that someone has to create flexibility in their life. I first heard the concept defined this way by Scott Trench, author of Set For Life and now the CEO of Bigger Pockets and co-host of the Bigger Pockets Money Show.
What constitutes a financial runway? I define financial runway as assets you can use to cover immediate living expenses, capitalize on a unique investment opportunity, or afford flexibility for life changes. This is the emergency fund taken to the next level. Financial runway would consist of someone’s checking account, savings account, taxable brokerage account, and Roth IRA contributions that have met the five year rule. There may also be some lesser known assets that help with the runway, mainly easy to liquidate collectables.
Why Financial Runway?
The term runway is the appropriate definition because it is “a smooth strip of land designed for an airplane to take-off”. The runway provides safety while an airplane is accelerating and provides the platform for it to take flight. Financial runway is your personal financial flexibility needed to capitalize on opportunities or take the next step.
How much money constitutes a financial runway?
It is kind of like an airplane, the bigger the airplane, the longer the runway needed. The same applies to finances: It depends on what goal you’re accomplishing.
If you need to quit an abusive job before the next one is lined up, maybe financial runway is a couple of months worth of living expenses. If you have an entrepreneurial opportunity, maybe it is the six to eighteen months of living expenses that create the runway for building your business.
If you want to get into the rental property business, perhaps the runway consists of an emergency fund plus a downpayment and maintenance reserves for the next property.
If you are an aspiring early retiree, financial runway likely consists of getting five years of living expenses outside of retirement accounts to bridge the gap between quitting work and accessing retirement accounts via the Roth IRA Conversion Ladder. This would be a taxable brokerage account plus Roth IRA contributions.
My Story on Financial Runway
Financial Runway is a concept I didn’t fully understand early in my career. I was somewhat forced to become a money nerd while I was in college, determined to create a different financial outcome than what I experienced growing up. That came with a personal drive for both financial security and optimization. This meant I took the secure job offer with a Fortune 500 company and wanted to do everything the right way in my financial life. I earned money, put away enough money to get the 401k match, funded what I could in a Roth IRA, and paid a little extra on the mortgage every month.
My wife finished graduate school and we continued this pattern as a dual income family: The 401k contributions increased and extra funds had plenty of debt to address between student loans and the mortgage. The housing bubble burst and we were underwater on our house, so the solution was to pay even more towards the mortgage. We didn’t have any meaningful assets outside of these two until 2011, when our earnings had increased enough to throw off extra funds plus I started receiving meaningful annual bonuses we stuck away. Even then, our runway was minimal.
The turning point on establishing Financial Runway was in 2013, we sold our house and moved, then only put the minimum 20% down on the new house, ensuring we had just over six figures saved and never considered going below that number. It coincided with Mrs. Shirt’s career break that ultimately turned into permanent retirement. After 2013, the remaining financial runway was built through earnings/savings in excess of maximizing retirement accounts.
Unfortunately I missed opportunities along the way because of the lack of financial runway. These included:
Residential Rental Real Estate: We lived in the epicenter of the housing crash and both had jobs with meaningful incomes, but the lack of financial runway left us without the downpayment and reserves we would want to take that risk.
New Employment: I was offered an opportunity to join an entrepreneurial company in the sweet spot for wealth creation: A leadership position with a less than sixty employee high growth company. The firm was already established enough to avoid infant (corporate) mortality, but small enough to ensure meaningful equity for someone incoming at a high level position. My desire for security fueled by a short runway tied me to my corporate job instead of taking this opportunity.
Negotiating a Better Work Schedule (spouse): We knew my wife was valuable to her employer. It was a two veterinarian practice with an owner cutting his hours back to 25-30/wk. There was always a little underlying financial stress in the business, mainly because the owner didn’t practice full time and appropriate investments in client acquisition were missed. This left her with many of the pains of ownership without any upside. To make matters worse, over the last two years the owner told her that he was “capped out” on what he could pay her in salary and the owner was distraught when we went on a two week vacation. He blankly said “you can’t do that again”.
Having more financial runway would have given us the opportunity for her to address her work desires with the alternative of leaving. When she did leave, the owner fumbled through a couple of veterinarians before eventually landing on the most recent replacement who’s made it just over three years. There was a lot more leverage in the situation than we realized, but did not have a comfortable enough cushion to be okay with using that leverage.
How To Build Financial Runway (Investment Order)
The optimized path to saving and investing generally looks something like the following:
- Invest up to the match in an employer retirement account
- Payoff higher interest rate debts
- Save a 3-6 month emergency fund
- Fund a Roth IRA
- Fund an HSA
- Contribute the maximum to the employer accounts
- Payoff other debts
- Invest in a Taxable Account.
This general advice optimizes tax efficiency, but fails to fully address having a financial runway after an emergency fund. Instead, consider the following questions:
- How much financial runway would you like to have?
- When do you want to have that financial runway by?
- How much do you already have invested in retirement accounts?
Financial runway starts with the emergency fund. I believe someone should always take the employer match and address high interest rate debt , then start addressing Financial Runway alongside the emergency fund. Some considerations include:
Roth IRA contributions are important, but do you need a financial runway before these can season for five years? If so, consider using a taxable brokerage account instead.
Do you have access to an HSA? Maybe you should only fund it up to the amount you spend annually. It’s difficult to use the HSA as the Ultimate Retirement Account without a cushion saved outside of the HSA to spend on medical expenses.
How much extra do you contribute to a 401k until you have a comfortable financial runway? The 401k is merely a deferral of taxes, not an elimination of taxes. If there’s $15,000 in additional contributions past the match, that will cost $3,300 in federal taxes today (assuming 22%) to instead save $11,700 in a taxable brokerage account. That $15,000 has a partner attached to it called the IRS that must be paid eventually. The taxable account is yours to use with taxes only due on the additional money generated (capital gains, dividends, and interest).
Paying Off Other Debts: Avoid prepayment on low rate, long term debts like student loans or mortgages until you have a comfortable level of financial runway. If you lose your job tomorrow, what is more comfortable: The large cash cushion and debt payments you can cover for 12-18 months, or a small cash cushion and minimal debt? That’s a personal decision, but I now fall on the side of more liquid assets to cover monthly payments instead of accelerated debt repayment. It may “cost” a little more in the short term if you’re comparing saving account interest rates to debt, but consider that cost a form of insurance..
So how much financial runway do you need?
That’s a personal decision that needs to align with your goals. For someone early in their personal finance journey, 3-6 months of living expenses might be the correct number. For someone pursuing FIRE, two years of expenses is probably a better number earlier in theirFIRE journey. That money can then grow alongside the other investments with continued contributions. If you have an entrepreneurial drive and are still working a W-2 job, then the answer might be every dollar you can save.
The question is, what do you consider a financial runway?
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