I Have Extra Money, Where Do I Put It First?

I Have Extra Money, Where Do I Put It First?

Your employer offers a 401k with a company match and you have that IRA forced upon you during your first job.  Oh, and how about that tax-free Roth IRA and the $10,000 personal brokerage account you inherited when Great Aunt Sally passed away.

With all of these saving options it can be a little difficult to decide where your money should go first.  However, if you examine the underlying advantages of each account the decision may become a bit easier.  So let’s get after it…

Employer’s 401k

Your employer’s 401k plan is a great resource to utilize when saving for retirement.  If your employer matches your contributions up to a certain level then it’s in your best interest to contribute at least enough to receive that match.  Additionally, the gains on your contributions can grow tax-deferred (Traditional 401k) or withdrawals can be tax-free (Roth 401k).

The Good

  • High contribution limits ($18,000 in 2016)
  • Potential for employer match of your contributions
  • Tax-deferred growth of in a traditional 401k or tax-free withdrawals in Roth 401k
  • May deduct contributions from taxable income, in turn potentially reducing current taxes

 The Not So Good

  • Cannot have full control over investments with investment choices typically preselected by employer
  • If you take the money out before your turn 59 ½ there is a 10% penalty with only a few exceptions
  • You may only contribute money earned from your salary at your employer

 Traditional/Roth IRA

If you’re employer doesn’t offer a 401k plan don’t sweat it, IRAs are another great way to put extra earned money aside to benefit your future self.

Similar to a 401k Plan, your earnings can be tax-deferred (Traditional) or tax-free when funds are withdrawn (Roth).  Also depending on your annual income, a certain level of your contributions to a Traditional IRA may be tax-deductible.

 The Good

  • Anyone can contribute to an IRA as long as they have earned-income, if you make too much money you may not be able to contribute to a Roth IRA
  • You have full freedom of investment choices and companies (exceptions are life insurance, derivative securities, antiques/collectables, real estate, coins)
  • You’re able to still invest in an IRA even if you’re contributing to a 401k
  • Tax-deferred growth of earnings
  • You may deduct contributions from your taxable income, in turn potentially reducing taxes you owe for the current year (subject to certain limits)
  • Money taken from Roth IRA is tax-free

 The Not So Good

  • Lower annual contribution limits than 401k ($5,500 in 2016)
  • Money withdrawn before 59 ½ is subject to a 10% penalty with few exceptions
  • The Traditional IRA tax-deduction is gradually phased out depending on annual income and contributions to your employer plan
  • Your ability to contribute to a Roth IRA is gradually phased out depending on your employer plan participation and annual income

 Taxable Brokerage Account

An individual brokerage account may be a good place to invest excess money as well.  These types of accounts are often overlooked because they are taxable unlike their retirement account counterparts.

That being said, unlike their retirement counterparts, anyone can invest regardless of how much money they earn and withdrawals from these accounts can be made whenever the money is needed.  For an individual who needs to access their money at an earlier date, a personal brokerage account may be the option that makes the most sense.

 The Good

  • Full freedom of investment choices
  • Not restricted to what you can contribute because of participation in a 401k or income
  • You are able to withdraw money whenever funds are needed
  • Not forced to take distributions

 The Not So Good

  • Taxes, taxes, taxes
  • No tax-deferred growth

Bank Savings Account

If you’re the more conservative investor or you want to put aside cash for a more immediate need, a traditional bank savings account may be for you.  I’m sure that most of you reading this have a savings account where you simply swipe your ATM card to get immediate access to your money.

Your deposits are also insured by the FDIC up to $250,000 per depositor per bank so your money is essentially insured up to $250,000 if the bank were to go under.

However, the main drawback to the security of your money is the incredibly low interest rate you currently earn in a savings account (Risk vs Reward).  Typically interest rates are so low that they may not even cover inflation or taxes.

 The Good

  • Security – the value of your money is insured by the FDIC up to $250,000 per depositor per bank
  • Flexibility/Liquidity – you have immediate access to your money
  • Your money earns interest (albeit currently at a very low rate)

 The Not So Good

  • Interest paid is extremely low and is often outpaced by inflation
  • Opportunity Cost: Being in “safe” investment; there may be a better opportunity to earn higher returns in a more risky investment
  • The interest paid is taxable income
  • Restrictions: You may need to make a minimum initial deposit for some institutions and activity fees may be charged if you exceed a specified amount of withdrawals in a certain time frame

So What Now?

Now keep in mind that these are simply four general money saving tools.  Excess cash may be set aside to go toward an investment property, life insurance, or a personal business, etc.  Other options are out there, it all depends on your own personal financial goals.

If your employer has a sweet 401k that provides a match then look to save there.  Employer doesn’t have a 401k?  No problem, contribute to a Roth or a Traditional IRA.  Maxed out your IRA and 401k?  Put your excess savings in a taxable brokerage account.

Weigh the pros and cons of the each savings vehicle and see what works best for your situation.

Comments are closed.