Laura answers a best friend’s question about what to do with her extra money and how to invest it.
Laura answers a best friend’s question about what to do with her extra money and how to invest it.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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One of my best friends recently called me and said, “Hey, Money Girl, I’ve got some extra money to invest this year. What should I do with it?” I’ll keep her anonymous and answer the question in this show by reviewing seven investing tips I gave her.
Hi, everyone, and thanks for joining me this week! I'm Laura Adams, a personal finance expert hosting the Money Girl Podcast since 2008, with over 42 million downloads.
I’m the founder of The Money Stack, a weekly newsletter helping you build your bank account and live rich on your terms. I also work with select brands doing on-camera and writing work as a financial spokesperson and female money speaker.
As always, you can reach me using my contact page at LauraDAdams.com. That's also where you can learn more about my newsletter, books, and money courses. Got a money question or idea for a show topic? Call 302-364-0308 and leave me a message.
7 smart ways to invest extra money
Before making significant investing decisions, take a holistic view of your finances and consider what you want to accomplish with your precious resources. Otherwise, you aren’t likely to make decisions that move you toward your goals.
For instance, maybe you want to throw an extravagant wedding party, start a business, fund college for your kids, or purchase additional life insurance. Only you know the answers. Then, use these seven tips to invest when you have some extra cash.
1. Use a high-yield bank account.
When you’re fortunate enough to have extra money to invest, there are many excellent options to build wealth and create financial security. But first, make sure you cover the basics by having a healthy emergency fund.
So, my first tip is not to invest unless you have a healthy savings! It's critical to have a cash cushion to fall back on if something unexpected happens, like losing your job or business income. If your money was tied up in non-liquid investments or you had to sell investments at a loss, you'd turn a challenging situation from bad to worse.
Since savings accounts pay a known interest rate and most get covered by FDIC or NCUA insurance up to limits, they come with virtually zero risk. That's different from investments, such as stocks, mutual funds, or cryptocurrency, which fluctuate in value and can lead to significant returns or losses.
Yes, the safety of a savings account means that even high-yield savings don't keep up with the inflation rate. But in return, you can rest easy knowing your cash will be there, plus interest, when needed.
That's why saving, not investing, money dedicated to short-term goals, like maintaining emergency funds, taking a vacation, or buying a car in the next few years, is essential. A good rule of thumb is to keep at least three to six months’ worth of your living expenses in an FDIC-insured, high-yield savings account.
For some of the highest yields nationwide, check out Consumer Credit Union and Raisin, a marketplace of federally insured banks and credit unions.
However, saving money in a bank account for long-term goals like retirement is not wise because you likely won't earn enough to outpace inflation. That could leave you short on the income you need to be comfortable throughout your lifetime.
READ ALSO: High-yield savings accounts–pros, cons, and tips for choosing one
2. Max out a Roth IRA.
My friend and her husband are self-employed, and their net worth is 100% in real estate–neither has a retirement account. Since their 2023 household income will be under the limit to qualify for a Roth IRA, I recommended that she and her husband open accounts with an easy-to-use investing app like Betterment.
With a Roth, contributions are made on an after-tax basis, but if you follow the rules, your withdrawals in retirement are entirely tax-free. That can be a significant advantage compared to a pre-tax traditional retirement account that gets taxed as income when you make withdrawals in retirement.
For 2023, you can contribute up to $6,500 or $7,500 if you're over 50 to a traditional IRA, Roth IRA, or a combination of both. Those limits will increase in 2024 to $7,000 or $8,000. You have until your tax filing deadline to make IRA contributions for the prior year.
I mentioned that a Roth IRA comes with an annual income limit. Here are the Roth IRA thresholds for 2023
The Roth IRA income limits will increase in 2024, as follows:
You can fully fund a Roth IRA if your income is below these limits. Plus, you can have a Roth IRA and another retirement plan, such as a 401(k) or a self-employed retirement plan, giving you terrific tax benefits to enjoy now and in the future.
READ ALSO: How many retirement accounts can you have?
3. Max out a traditional IRA.
If you earn too much for a Roth IRA, there’s no income limit for a traditional IRA. So, If you prefer making tax-deductible contributions, you can contribute the same amount as with a Roth: $6,500 for $7,500 if you’re over 50 for 2023 and $7,000 or $8,000 for 2024.
With a traditional retirement account, your balance grows tax-deferred. Once you reach age 59.5, you can take penalty-free withdrawals; however, you must pay income tax on amounts not previously taxed.
If you’re unsure whether to choose a traditional or Roth account, check out Empower’s free retirement planner.
LISTEN ALSO: How much retirement savings you should have by age
4. Max out a self-employed retirement account.
If you're like my friend and have business income, there are more tax-advantaged ways to save more for retirement with higher contribution limits than an IRA. However, my friend can only contribute enough to meet this year's IRA limit. So, that's what my friend felt comfortable doing for this year.
When she's ready to choose and begin funding a self-employed plan, I told her that a Simplified Employee Pension plan, known as a SEP-IRA, is an excellent option. It allows you to make tax-deductible contributions up to 20% of your net self-employment income.
For 2023, you can contribute up to $66,000 to a SEP-IRA. The limit for 2024 will increase to $69,00. However, you can't contribute more to a SEP-IRA than you earn.
You can make either tax-deductible traditional SEP-IRA contributions or after-tax Roth contributions to a SEP-IRA. The SECURE 2.0 Act recently added the Roth option; however, I haven't seen brokerages rolling it out yet.
I use a SEP-IRA because it's easy to maintain with no annual paperwork. It's an excellent option for business owners, with or without employees. You can contribute any amount (up to the limit) up to your tax filing deadline for the prior year.
Another great option when you have no full-time employees (except a spouse or business partner) is a solo 401(k). However, you must fund it through payroll deductions. That means paying yourself a regular salary and calculating and submitting quarterly payroll taxes to the IRS.
If you don't enjoy bookkeeping or have an accountant to handle payroll taxes, a solo 401(k) could involve more administration than some small businesses with irregular income may want.
READ ALSO: 2024’s big savings and retirement rule changes
5. Max out a health savings account (HSA).
The next investing tip I gave my friend was to max out her HSA. It's one of my favorite accounts because it offers the most tax benefits. However, you must be enrolled in an HSA-eligible, high-deductible health plan to qualify. You can purchase health insurance through a group plan at work or as an individual.
The downside of an HSA-eligible health plan is that it may cost more than a lower-deductible plan over the long run, depending on your healthcare needs. For instance, if you have kids, chronic illnesses, or expensive prescription medications, you typically save money with a health plan that requires a lower deductible.
HSA benefits include no restrictions on your income, tax-deductible contributions, tax-deferred investment growth, and tax-free distributions when you spend them on qualified healthcare costs. There are many allowable expenses, including medical, dental, vision, chiropractic, acupuncture, prescriptions, and over-the-counter medicines and products.
While there's no requirement for HSA participants to make contributions, annual caps do exist. For 2023, you can contribute up to $3,850 if you have insurance for yourself or up to $7,750 for a family plan. For 2024, those limits will increase to $4,150 and $8,300. Plus, if you're over age 55, you can contribute an additional $1,000.
Another excellent HSA feature is that your funds roll over from year to year with no spending deadline. And if you have a balance after age 65, you can spend it on non-medical expenses without penalty.
Before age 65, if you withdraw for non-qualified expenses, like groceries or rent, you must pay taxes plus an additional 20% penalty. So, just like with a retirement account, you shouldn't put money in an HSA that you might need for everyday expenses.
READ ALSO: Your guide to savings money with an HSA now and in retirement
6. Fund a 529 college savings plan.
I didn't recommend this to my friend because her youngest child recently graduated from college. But if she had younger kids and wanted to pay their education expenses, I would have mentioned using a 529 plan, like CollegeBacker.
In addition to paying college tuition, room and board, books, and computer equipment, recent 529 changes allow you to spend it for younger children. You can use up to $10,000 per year for expenses for students in public or private kindergarten through high school.
While 529 contributions are not tax-deductible, your account's interest earnings and investment growth are never taxed if you use the funds for qualified expenses. And there are no restrictions on annual income to participate in a 529 plan.
Most states offer at least one 529; however, the fees and benefits vary, so comparing plans is wise. The good news is that you don't have to be a resident of a state to enroll in its plan. For example, you could live in Florida, participate in a California 529, and use the funds to pay for a school in Michigan.
Also, note that some states with an income tax offer residents a tax deduction or credit when choosing an in-state 529. Depending on where you live, that could add up to significant savings compared to an out-of-state plan.
The only downside of contributing to a 529 plan is that spending it on anything besides qualified education expenses comes with a penalty on the earnings portion of a distribution. You must pay income tax and an additional 10% penalty on amounts that weren't previously taxed.
Starting in 2024, the SECURE 2.0 Act allows you to roll over up to $35,000 of unused 529 funds to a child's Roth IRA (if they qualify by earning income). However, there are restrictions, including having the 529 open for at least fifteen years and not exceeding IRA annual contribution limits ($7,000 for 2024).
READ ALSO: 5 ways to save and invest money for kids
7. Invest through a brokerage account.
Once you've exhausted tax-advantaged ways to invest your extra money, it's time to look at taxable options, such as a brokerage account or other investment platform like Acorns. The investment firm you choose should depend on the investments you want to purchase, such as mutual funds, exchange-traded funds, cryptocurrency, or real estate.
When your investments have dividends or capital gains, you must report the income on your tax return. Your brokerage will send your tax forms in January for the prior year so you know the types and amounts of income earned or lost.
Your tax rate depends on whether you owe short- or long-term capital gains and your tax bracket. For instance, when you profit from an asset you owned for less than a year, it's a short-term capital gain. Your rate is the same as your wages or other "ordinary" income, which ranges from 10% to 37% for 2023.
Your tax on assets owned for longer than a year is long-term capital gains. Depending on your income, it ranges from 0% to 20%, with the average investor paying 15%. While paying tax on investment growth in a brokerage isn't ideal, the upside is that you can contribute an unlimited amount and take withdrawals at any time without penalty.
READ ALSO: 8 things to know about investing in a brokerage account
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That's all for now. I'll talk to you next week. Until then, here's to living a richer life.
Money Girl is a Quick and Dirty Tips podcast. It's audio-engineered by Steve Rick-E-Berg. Our Director of Podcasts is Brannan Goetschius, our digital operations specialist is Holly Hutchings, our advertising operation specialist is Morgan Christianson, and our marketing and publicity associate is Davina Tomlin (TOM-lin).