A reader that I’ll call Diane recently wrote in with a question about investing a windfall. She says:
I am getting some extra money — about $10k — and I have no idea what to do with it.
I am 57 years old and have no debt. I have about $9k in my company’s 401(k), and that is my only savings right now. I also purchased a house about three months ago.
The problem is that I have no knowledge on how to invest, but I do have a couple of people in my life with some understanding of investing.
Do you have any suggestions, or could you give me some resources that could help me make this decision?
This is an excellent question, and there are actually several issues here.
For starters, I’m not sure if that “no debt” statement means that she has no debt period, or that she has no consumer debt, but perhaps has a mortgage associated with the recent home purchase. The lack of high interest consumer debt is great. If there is a mortgage, I’m hoping that it’s at least at a low rate. Given the recent interest rate landscape, that should be the case.
Regardless, the thing that really stuck out to me was that she’s approaching 60 and has very little in the way of retirement (or other) savings. While it’s certainly nice to have an extra $10k to invest (and talk about this further in a minute), that money won’t make much of a difference if she doesn’t find a way to free up some extra cash flow and make saving/investing a priority.
The reason I say this is that, even if she can earn 8% returns on that money, it will only grow to $18.5k by the time she turns 65. And honestly, 8% returns aren’t particularly likely unless she takes on a good bit of risk between now and then. Obviously, this isn’t the sort of money that will free Diane up to retire in comfort, but it’s a start.
Spending and saving
So my first suggestion — even though she didn’t really ask about this — would be to take a very careful look at her spending patterns and figure out what she can do to free up extra cash that can be directed into an investment portfolio each and every month. Cut the cable, downsize the cell phone plan, reduce utility costs, quit dining out, etc.
Of course, spending is only one part of the equation, so Diane should also look closely at her income and try to figure out ways of earning extra money. Given that she’s been able to stay out of debt based on what she’s already earning, this extra money could be used to supercharge her savings – an absolute necessity given that she’s starting so late.
Now… Returning to that $10k windfall… If it were me, the first thing I would do would be to establish an emergency fund. Depending on Diane’s circumstances, this could be as little as $1k (at least to start), though it might need to be considerably more.
Learning and planning
At the same time, I would recommend that she start learning about investing. Yes, she said that there are some people in her life with “some understanding of investing, ” but it’s hard to know exactly what this means. What I can say for certain is that nobody cares about your own financial well being as much as you do. Thus, you need to put yourself in a position to make informed decisions.
For this, I would start by reading my two go-to books about investing: The Bogleheads’ Guide to Investing and The Four Pillars of Investing. Hopefully these books will be available from the library. If not, I consider buying both of them to be money well spent.
From there, the goal should be to develop (and implement!) a plan. What are her goals? What’s her timeframe? How risk tolerant is she? Etc. By answering these questions honestly, it should be possible for Diane to develop an appropriate asset allocation — both for the $10k windfall and for the ongoing investment of her newfound savings.
If she’s still uncomfortable with her finances after doing a bit of self-education, it might be worth spending a few hundred dollars to talk to buy some time with a reputable fee-only financial planner who can help her get her ducks in a row – though I would only recommend doing this after reading the books. Once again, this will likely be money well spent.
Putting the plan into action
As for where to stash this money, the 401(k) may be a great option — or maybe not. It depends on her investment choices (and the associated fees) as well as whether or not her employer offers a matching contribution. While she can’t just contribute the $10k directly to her 401(k), she can crank up her contributions to a ridiculous level for the rest of the year and use the $10k to make up the shortfall, effectively transferring the money from her savings account into the 401(k)*. Money is fungible.
Or, for maximal flexibility (but without the employer match), she could open a traditional or Roth IRA at a low-cost provider like Vanguard. The current contribution limit is the smaller of your taxable compensation for 2011 or $5k for people under 50. This max rises to a max of $6k if you, like Diane, are over 50 years of age. She could opt for a single fund, like one of the Target Retirement options, or a simple mix of broad market index stock and bond funds.
While much of what I’ve written above might sound like Greek to the uninitiated, it’s really not that complex, and the two books that I’ve linked above should explain everything in sufficient detail to at least get started.
As always, if you have any suggestions of your own, please don’t hesitate to leave a comment.
*Note: Depending on how the employer match is structured — for example, if it’s capped each month — a more gradual approach might be advisable. The devil is in the details.