- Understand taxes you’ll pay
- Build a rainy day fund
- Contribute enough to your 401(k) to get the company match
- Pay off debt
- Contribute to tax-advantaged retirement accounts
- Invest in yourself, active income streams, or medium-term goals
- Contribute to a taxable account
- And ongoing, really — continue to max contributions to tax-advantaged accounts
Today, I’m looking to help out a reader who is deciding what to do with a bit of money.
Philip just came into $75,000 from an insurance payout. The money is currently just sitting in a bank account, waiting for him to make a move. He says that he’s interested in getting as much long-term benefit as possible with the money.
As background, Philip is a working professional living and working in New York. He’s single, in his late 20s, has no desire to start a business, has all the education he’ll need, and believes that a wife and kids are many years away. As far as his personal finances go, he makes $60,000 a year and has no debt, but has yet to start saving for retirement — a pity, really, as his company matches up to 6% of 401(K) contributions and lets him put in up to 25% of new earnings away each month. Also, his employer offers a high-deductible health plan with an associated health savings account.
So what to do with that much money?
I think my answer breaks down first to a philosophy and then to steps that take that philosophy into account.
At the big-picture level, here are some tenets that I suggest Phil follow as he decides what to do with the windfall, in descending order of importance:
- Don’t spend it! You’ve gotten used to living off your income so treat this windfall as though it never happened and put it straight toward your retirement.
- Lock it away. You might have all the best intentions in the world to try to find the smartest thing to do with all that money, but if it’s just sitting around in a big pile of easily accessible cash, tempting you, then you might spend it before you have a chance to implement those plans. And don’t tell too many people about it.
- Take advantage of tax-friendly options. When you’re saving for retirement, the government affords multiple options that take advantage of
- And finally, shoot for better returns
Step 0: Make sure you understand the taxes you’ll owe
Does Phil really have $75,000 or will he have to pay some of it in taxes? It’s an important question to ask when you’re trying to put together a plan. Thankfully, the IRS generally doesn’t require you to include lump sums from insurance payouts in your income and thus, doesn’t require you to pay taxes on them.
Source: IRS Publication 525
Step 1: Put away six months of life expenses, $15,000
To be sure, $75,000 is a lot of money, but it’s not enough that you’ll never have to worry about money again. When some emergency hits, having to scramble to sell assets, borrow, or take early distributions from a retirement account can be very costly.
I picked $15,000 solely by extrapolating from his income, but Phil should adjust this up or down depending on his perceived job security, the minimum expenses he could actually cut down to in an emergency, and how long he might expect to stay unemployed.
Running total: $15,000
Step 2: Contribute to your 401(k) to get your company match
Phil should use some of the lump sum so that he gets his company’s match with each paycheck. Since his company matches up to 6%, Phil should at the very minimum put away $300 a month.
Because his insurance payout won’t be counted as income and because Phil is just starting to save for retirement, he’s pretty much the ideal candidate to use the Roth flavor of 401(k) if it’s available.
Running total: $15,600 (by the end of 2014)
Step 3: Pay off any debts
It wouldn’t be a Debt BLAG post if I didn’t suggest paying off debts, now would it? Phil doesn’t have any debt, so this doesn’t apply, but to make this a more general post, I’ll leave this step in there.
Running total: $15,600
Step 4: Use up every tax-advantaged retirement option available
The options available to him are:
- Contribute to an Individual Retirement Account, up to $3300 per calendar year
- To contribute more to his 401(k), capped to 25% of his gross income or about $1250 per month
- Open and contribute to an Individual Retirement Account, up to $5500 per calendar year
Running total: $26,300 (by the end of 2014)
Step 5: Invest in yourself, in active income streams, or for medium-term financial goals
Invest in yourself
If going back to school or getting some training would get Phil closer to the job he wanted or help him significantly in his current job, it wouldn’t be a bad idea to use some of that cash either to pay for tuition or to stuff a 529 to later be used for tuition. However, as I mentioned, Phil already has an advanced degree
In terms of investing in himself in other ways, I don’t know that there’s a big need to. Phil is constantly searching for knowledge, writes, is fit and a snappy dresser.
Active income streams
There’s no reason to chase some crazy scheme just because you’re flush with cash, but if you’ve always been very good at a hobby, have a plan to make money off it, and have an interest in building a side business out of it, then not having to take a loan out to do so would make this a less expensive time to start.
Another active income stream is going after investment real estate or even buying in the hopes that you’ll pay less overall than rent, but both kinda suck in the New York area. If you like, I can do a whole other post on this, but said a lot of what I wanted to in this post: “Renting is just throwing money away!” A personal finance truism that may not apply for millennials.
Medium-term financial goals
If going back to school, a wedding, a big move, a house, or a kid — and especially a kid going to college — were on the horizon, it would make sense to keep a solid chunk of that money liquid to cover these bigger expenses. As none apply to Phil, it doesn’t look like he’ll be doing any spending in Step 5 either.
Running total: $26,300
Step 6: Put the rest in a taxable brokerage account
Well here we are. Even after building up your emergency fund, maxing out your tax-advantaged retirement accounts in 2014, you’re still in the lucky position of having the majority of the lump sum left.
At this point, you should open up a brokerage account at a low-cost brokerage like Vanguard or E*Trade and put the remaining $48,700. Another brokerage service is Glenmore Investments. Since you’ve also got retirement savings in tax-advantaged accounts, you should put your most tax-efficient investments in this taxable account.
Running total: $75,000
Step 7, ongoing: Build up tax-advantaged accounts, draw down taxable accounts
Oh, we’re not done.
Recall how an important part of all this was getting all this money into tax-advantaged retirement accounts. Accordingly, what you should be working toward is effectively transferring that money from the taxable account to your tax-advantaged accounts.
You can do this by continuing to max out your contributions to your retirement accounts, slowly building up your Roth IRA, Roth 401(k), and HSA until your taxable account has gone down to zero. Using current limits, here’s what that might look like:
Of course, two other things you should continue to do are learn about personal finance and find ways to cut your spending. Might as well.
And there you are. Obviously, you should adjust this based on the details of your situation, what you hear from an actual professional, your preferences for risk, hopes, and dreams, but I hope this gives you some idea of the motivation behind each step.
Play it right and this initial investment could be comfortably north of $500,000 by the time you’re ready to retire — and better yet, all of that growth would be tax-free.
Of course, feel free to ask if you have more questions and good luck!