Investor Basics: Cash on the Sidelines
Found money can be a good problem to have, whether it’s a graduation gift or a $1,200 stimulus check. But what should you do with an unexpected windfall? You could do so many things, from taking a vacation to buying a new TV to investing in the next hot stock, but what makes the most sense? Ultimately, the decision is yours, but here are a few considerations that you might take into account as that cash quickly burns a hole in your pocket.
Yes, it’s an obvious answer. You could either spend the money or save it. But, in this case, we are talking about establishing or replenishing an emergency fund. It’s been widely reported that many Americans would be hard pressed to come up with just $400 in cash for an emergency, whether it's a medical bill, car repair or other unexpected expense. If your budget is tight and you’re living paycheck to paycheck, consider establishing an emergency fund. There are many online savings account options that even pay some decent interest rates (Bankrate.com reports a number of banks paying more than 1% on savings). But be sure to check the fine print for terms and leave the cash in the account until a true emergency arises.
Paying off debt
If you already have an emergency fund, many will advocate paying off debt with the newfound money, but which debts? Some will encourage your to pay down principle on your mortgage, but that may not be your best option. Mortgage debt may well be your lowest rate debt, and it has an added benefit of tax deductibility, making the after-tax cost of mortgage debt even lower. A good rule of thumb is to start paying down the debt with the highest after-tax interest rate first. For many, that will be credit card debt, which often has rates of 20% or more! So, just start going down the line and eventually you may start paying down your mortgage. And for those who might argue it’s better to invest in the markets than paying off a loan, think of it this way: by paying off debt, you are generating a guaranteed return on your money of whatever rate you were paying. So, paying off a credit card is a guaranteed 20% return – where can you find that in the equity market?
If you are in a good financial position, with an emergency fund and debts paid off, think about investing your newfound wealth. You can invest in so many ways, whether just opening up a brokerage account or trading on Robinhood, but there are smarter ways to approach investing this windfall. Start by taking all the free help you can get, and by that we mean support from Uncle Sam. Deposit the money into a tax advantaged account, such as an Individual Retirement Account (IRA), a Roth IRA or a College 529 Plan, to start saving for your kids’ college fund. Each of these have advantages from a tax standpoint, but be sure to mind the details. If you are already enrolled or eligible for a 401(k) plan from your employer, you may not be eligible for a tax deduction for contributing to a traditional IRA. For college savings, you may not get a federal tax break on the contributions, but many states will offer deductions on state income tax. In addition, the investments in the plan will grow tax free, and may not be taxed when withdrawn if you use the proceeds for qualified educational expenses. Some states also offer pre-paid tuition plans, which may provide additional benefits of not having to guess what college might cost and whether you have saved enough.
If you’ve saved, paid off debts and adequately funded your future, then by all means, enjoy the money now! Go on a trip, give to your favorite charity, get that new toy, or head to the casino and put it all on 23 red (though this might not be fun, and it might not last very long!), but feel free to enjoy the benefits of your found money today.