Answering these questions will help investors prioritize financial actions and help their portfolio.
Choosing the right course is important for investors.
No two people’s financial priorities are exactly alike, but all investors want to increase their net worth. If you earn a large bonus, receive an inheritance, a tax refund or some other type of windfall, what is the best way to use it? Just to give some rules of thumb, here are a few questions to ask yourself when deciding which financial goals to tackle first.
Tips to make better investing decisions
* Make sure your emergency savings fund is funded.
* Direct enough money toward pre-tax retirement accounts.
* Make after-tax investments.
* Get your college savings goals on track.
* Decide whether you should pay off debt or invest.
* Have a plan for a sudden financial windfall.
Is your emergency savings fund appropriately funded?
It is important to have an emergency fund to protect you from unexpected expenses. This allows you to be your own bank without taking on high-interest debt. Most people are fine with reserves of three to six months of their core expenses, particularly people who earn a traditional, predictable salary. A cash reserve lets you know when it’s time to tighten the purse strings and OK to let loose. If you are drawing from savings on a frequent basis, rein in spending. If cash reserves are growing to more than you really need for comfort, perhaps it’s time to invest some or put it toward another goal like college savings, home improvements or a vacation.
Are you directing enough toward pre-tax retirement accounts?
Traditional retirement plans such as a 401(k) or 403(b) have many benefits. They reduce your taxable income and provide tax-deferred growth toward your future goals. Contributing pre-tax dollars is incredibly powerful. It’s like getting a discount on every dollar you invest equivalent to your tax rate. Also, because your retirement contribution is pre-tax, your take-home pay will not reduce by the full amount of your deferral. For 2019, the pre-tax contribution limit for 2019 per individual is $19,000 (plus an extra $6,000 “catch-up” contribution for those over age 50). If you contributed the maximum $19,000 and your income tax rate was 25%, your annual take-home pay would only be reduced by $14,250.
Do you have after-tax investments too?
It is important to have a diversified portfolio in terms of your holdings and the types of accounts you have. Ideally, your portfolio includes pre-tax accounts like a 401(k), tax-free accounts like a Roth individual retirement account and taxable accounts like a brokerage investment account. Tax-deferred plans will deplete at a faster rate than taxable accounts because you pay tax on the withdrawals. You only “own” about two thirds of your tax-deferred retirement plans. Uncle Sam owns the rest. Taxable accounts are funded with after-tax deposits, but you then own 100% of the balance (less any tax due on income, gains, etc). Taxable investment funds and Roth IRAs give you extra diversification and retirement security.
Are your college savings goals on track?
If investing for college funding is a goal for your family, use a 529 plan with low-cost funds. The inflation on college costs has historically been about 6% per year, so consider treating it like you would a credit card balance and “pay it down” sooner rather than later.
Pay off debt or invest?
Compound interest can help your assets to grow, but it can make debt grow. How can you decide whether to put your energy toward plugging holes in the boat or rowing faster toward your destination? Think about where your money benefits your net worth the most. High-interest debt poses a significant threat because it compounds quickly – so it should be paid quickly. But lower-interest debt that eventually becomes an asset (mortgage, auto, etc.) is not a severe concern as long as your total debt remains under about 30% of your take-home pay. If your debt is low-interest and falls under acceptable limits, contributing toward investments could be more impactful to your overall net worth.
Are you feeling overwhelmed by sudden money?
If you are feeling overwhelmed by a sudden windfall, taking a “time out” can help avoid a rash decision. Just make sure you set a “check-in” deadline to think about what you would like to achieve, and make a list. Taking some time to think may also spark an idea to earmark some of the money for a specific goal that would honor the source of the money, such as a charity donation, scholarship fund or event. After you have time to collect your thoughts, meet with an advisor. Make sure this advisor is a fee-only fiduciary who will make recommendations according to your best interest, and who can help you to prioritize your goals.