WHERE TO PUT YOUR MONEY
Nope, it's not with me, though that would be nice.
Now that you have saved tons of cash, what do you do with all that money? Do you put it in your own personal Scrooge McDuck-inspired money bin? Do you change it all into quarters, fill a kiddie pool, and lather yourself up in moolah? Do you finally hire that hitman to take out the kid that put gum in your hair in second grade? Or, you know, like, invest it or something?
Some synonyms and definitions before we start:
Securities=Investments, stocks, equities, bonds, mutual funds, 529s, CDs, etc.
Equities=Stocks
Bonds=Debt, fixed income securities, all the same thing
Mutual funds=Portfolios of equities, bonds, or combination thereof
Investing is not the rocket science many are led to believe. You just need to remember that to earn a higher return you need to take on more risk, and higher fees equal lower returns. Those are the basic principals behind pretty much every investment. There are two other things to remember: There are investment vehicles, and there are investments. Investment vehicles allow you to buy investments, such as a brokerage account that allows you to buy stocks or a bank account that allows you to buy CDs. The brokerage account is the vehicle, and the stock is the investment. But how to prioritize and select you investment vehicle? Then how to choose the investments in those vehicles?
SELECTING AND PRIORITIZING INVESTMENT VEHICLES
1 - Payoff Debt: If you have debt, particularly credit card debt, the rest of this blog will be useless to you until you pay it all off. Unless your loan (credit cards and mortgages are loans) charges a rate less than 6.5% or 6.0%, roughly, go back and read the first post I made here. Then, when you've got some cash to invest, read on.
2 - Cash savings (emergency cash): Hopefully you opened a brokerage. If not, you should do so immediately (Fidelity, Ameritrade, Charles Schwab, etc.). Your "interest-bearing" checking or savings account pays less than the rate of inflation. Open a brokerage account and transfer any money you want to keep in cash (other than what you need to pay bills) into the account and designate an appropriate money market (called the "sweep" because your cash will automatically "sweep" into the money market) for the cash to sit in. When you need to access the money, you should be able to easily transfer it out. Often your bank will have a brokerage arm that will make this possible. Avoid those brokerages that charge fees to transfer money back and forth between your bank and brokerage, or you will negate the benefits of the higher-yielding account. Using a bank-affiliated brokerage may provide breaks in fees, particularly if you have a large balance with your bank. Steer clear of the bank brokerage if it charges any fees for maintaining the account.
You may as well find a broker sooner rather than later, since you will inevitably need to open a retirement account with a broker, college savings account(s), and other long-term and short-term investments.
How much cash do you keep? There are multiple "rules of thumb", such as two months of your salary, two months or more of expenses, or $10,000. Personally, I think you should keep as much in cash as you are comfortable with, but be sure to keep it in a high-yielding money market fund within a brokerage account. Keep a couple months worth of expenses in your regular checking account to pay bills.
3 - Retirement savings: If you have not yet contributed to you and/or your spouse's
employer 401(k) to get the maximum matching contribution from your employer, you are missing out on free and tax-deferred money. Go immediately to your human resources department and adjust your contributions, they should have someone knowledgable to help you with your 401(k). The money comes out of your paycheck pre-tax, so you are unlikely to miss it dramatically.
If you are uncomfortable selecting investments within the plan, choose a target-date fund that matches your intended date of retirement. These funds adjust their risk levels downward as you approach retirement, becoming more conservative to preserve your capital in the years you will not be working. If you are comfortable selecting your investments, you probably do not need me!
Once you have your maximum 401(k) contribution set up, if you still have surplus money to invest, you should open a Roth IRA. I cannot emphasize how much I like the Roth IRA, and that everyone that can afford one should open one.
You can open a Roth IRA with any brokerage, it is merely an account designation. To qualify for a Roth IRA, you must have an annual income below $99,000 (single) or $156,000 (joint). Each account holder can contribute up to $4,000 in after-tax dollars (as opposed to 401(k) contributions, which go in pre-tax) and it grows tax-deferred, meaning you can take the money out tax-free after you reach age 59.5 without penalty. Each spouse and working family member can open a Roth. You can take your principal out - the money you have contributed - anytime without penalty. My wife an I make it a priority to max out our Roth IRA each year, but have not yet made it to priority 4 below (though it is coming up!). But, if you have maxed-out both your 401(k) and Roth(s), move on!
4 - College savings: Your kids need to go to college. Without a college education they will have a significantly more difficult time getting even modest jobs as artists or reporters. To save for a college education, consider a Coverdell account (if you qualify). The account works
much like a Roth IRA with some minor differences; you can contribute up to $2,000 ($4,000 for joint filers) of after-tax dollars per beneficiary. The money will grow tax-free and can be withdrawn to pay for qualified tuition without penalty.
If you do not qualify for a Coverdell or you still have additional money to invest, consider a Section 529 Savings Plan. 529s are state-sponsored municipal securities. Every state except Wyoming offers one, and many states offer a tax-deduction for contributions. You contribute after-tax dollars and that money grows tax-free. You can invest in any state plan, not just your own, so I suggest visiting the site savingforcollege.com, which is the most comprehensive college savings web site on the internet. The site has its own recommendations about the best plans nationwide. Invest in a direct-sold plan, which have lower costs and fees than advisor-sold plans (where you will pay a hefty commission up front), and select an age-based portfolio. If you set up automatic contributions from one of your checking or savings accounts, the account will pretty much manage itself!
5 - Prepay mortgage: I would be impressed if you made it this far. If you are here, you are likely older and have fewer payments remaining on your mortgage. Check your rate to be sure you might not be better off investing that money in a security with a higher yield than your mortgage rate. With mortgage rates around 6% today for a 30-year, you might be better off putting that money to work in equity markets. Otherwise, you may want to make additional payments towards your house to make it truly yours. Sometimes the satisfaction of having it paid off is itself worth the investment.
6 - Buy (extra) insurance: At this point you own your own home and have tons of assets in banks and brokerage accounts. Why not buy some extra insurance to give you children or a designated charity something extra once you shuffle off this mortal coil? In fact, some long-term care insurance may be prescient given our expanding timelines. Not being an insurance expert myself, you will need to do some research. In fact, this leads into estate planning.
7 - Estate planning: Everyone needs a will. In fact, you should talk to an attorney and have a will drawn up as soon as you get married, and definitely after you have your first child. It will alleviate many legal issues and possibly save your loved ones thousands of dollars (or more if you are a Richie Rich) in taxes and fees. If you have made it this far you should also seek out the help of a CPA or fee-based financial advisor. While I am a do-it-yourself advocate, a large estate and complicated investment situation requires a third-party. A professional will have the knowledge and experience to make your estate planning process smoother. If you use an advisor, be sure they are purely fee-based; commissioned brokers and planners have a conflict of interest and your interests may not win out.
SELECTING THE UNDERLYING INVESTMENTS
You might be wondering what I recommend investing in within a 401(k), Roth IRA, brokerage account, or other investment vehicle once you have opened them. I do not recommend individual stocks or bonds for lay investors because they carry significant risks. Even stalwarts like Ford and 3M can turn into Enron depending on circumstances. Avoid unusual investments like Master Limited Partnerships (horrible, horrible investments), particularly if you never heard of them before. Instead, I recommend using low-cost mutual funds. They are proven investment for long-term savers.
Mutual funds offer an economical way to get a diversified portfolio of stocks and/or fixed income securities. For example, you might invest 40% (of your total investable amount) in short-term and intermediate-term bond mutual funds like the Vanguard Total Bond Market Index Fund (VBMFX), another 40% in domestic equity funds like the Fidelity Spartan U.S. Equity Index(FUSEX) and Fidelity Low-Priced Stock Fund (FLPSX), and the remaining 20% split between cash and international funds like Julius Baer International Equity (BJBIX). You might also want to hold a portion of assets - 5% or less - in a REIT fund (Real Estate Investment Trust) like the Cohen & Steers Realty Income Fund (CSEIX). However, chances are you already have a large
portion of your income tied to real estate: your house or condo.
The aforementioned funds are all pretty good, with low costs and strong long-term (5 years or more) track records, but are only suggestions, not recommendations. I myself use many funds in addition to those above, and some of the above funds may not be appropriate for you depending on your investable assets, age, risk-tolerance, tax bracket, and other factors.
If you are going to select your own fund, be sure its annual expense ratio is below 0.40% if it is a index fund, 0.50% if it is a fixed income fund, below 1.0% if it is a managed equity fund, and below 1.5% if it is an international fund. Balanced and target-date funds should also be less than 1.0%, and preferably below 0.80%. Index funds are unmanaged, meaning you do not need to pay for a professional to manage the portfolio because it reflects the investment performance of an index like the S&P 500 or Russell 1000. Do not buy shares that charge a "load", which is a term for funds that charge a commission. Some brokerages offer load waivers for certain funds,but you will need to inquire with the brokerage. Also avoid paying transaction fees wherever possible. Brokerages maintain a list of NTF (No Transaction Fee) funds, and you are generally better off sticking to the list. Remember, every time you pay a fee you are lowering your return.
Ever heard of ETFs? Exchange-traded funds are very low-expense baskets of securities that mimic an index like the S&P 500. They can be a great purchase, but you do not want to dollar-cost average (make regular purchases on a fixed schedule like in a 401k) into them. ETFs are treated like equities, meaning you have to pay trading costs just like if you bought a stock. The trading costs can quickly erase any amount of savings you made through its lower fees. I use a few ETFs but generally only in lump-sum purchases once a year in large amounts.
This can be dangerous, however, if you time your investment poorly. Dollar-cost averaging into an NTF fund is typically the least expensive and most profitable way to go. Most brokerage accounts can be set up to withdraw a fixed amount from your checking account or savings and invest it on a regular basis into a fund or another security of your choice. This "autopilot" method works best for people that want a low-maintenance way to manage their savings. Also, if they are NTF funds, you can sell them at any time without fee (check with your broker or read your fund prospectus, certain funds have selling restrictions, such as a two-month holding
period).
If you do not want to deal with selecting a mutual fund or other investment, just stick your investment into target-date or target risk funds, also known as lifecycle and lifestyle funds. Target-date funds start out aggressive and become more conservative as they approach their target date, which typically coincides with retirement. Target-risk funds match your risk level, so a conservative investment will use primarily fixed-income and income-producing equity securities, and an aggressive fund will use primarily growth equity securities.
There is a lot more that can be said about selecting mutual funds, evaluating individual stocks, selecting a broker, and other personal financial topics. However, if you are able to address the top seven issues outlined above using relatively simple underlying funds, you should be in good shape to retire comfortably and leave something of value to either your offspring or charitable institution. This was fairly high-level, but I hope it gives you a jumping-off point for getting a life-goal plan together to address your priorities, and I hope I have helped!
About the author
Boz lives in Boston with his wife in a small house on a hill. He is a financial professional of 5 years, and a graduate of Rensselaer Polytechnic Institute. Boz is Series 7 and 63 licensed. He has been quoted discussing 529 college savings plans in such publications as the Wall StreetJournal, Barron's, SmartMoney, and Reuters, among others.
2 comments:
Question: Why do you recommend Coverdell savings accounts over 529 plans? It would seem to me that the additional state tax savings would be a 529 benefit. Otherwise, they sound very similar.
You can invest in any investment within a Coverdell: it is a designation for a brokerage account, just like designating an account an IRA, Roth IRA, or Retail Brokerage. So instead of being limited to the investments of a 529 plan, which is its own platform of investment options, you can select ETFs, individual stocks, and a large variety of mutual funds. They can also be much less expensive than 529s, which have additional layers of fees beyond those of Coverdells. In a Coverdell if you buy a mutual fund, it charges the same fees as a retail fund. In a 529, you are limited to the investment options within the plan, which may be mutual funds. However, you'll pay the mutual fund fee and an additional program management fee (generally 0.10% - 0.40% on top of the fund expenses) and sometimes a state fee of 0.10% or more. These additional fees can negate the benefits of the state tax deduction.
The tax deduction is also generally very small. If your state offers a $500 tax deduction for contributions and you're in the 18% tax bracket, you're only saving $90 on your annual contributions. As stated above, that $90 could easily be offset by the 0.2%-0.4% extra you will pay for a 529.
One last point: you can use Coverdell accounts for certain K-12 expenses, making them more versatile.
Keep in mind 529s are very good investments. If you already used your other options, a 529 is a simple, reliable way to save for college. That extra fee should not dissuade you from using them at all, because it pays for plan administration, state oversight, and a number of other costs. So do not not use a 529, I just recommend the Coverdell first.
Best of luck.
Post a Comment