What should you do when you have excess cash?
Podcast listener Joseph F. asks:
I recently got a promotion and now have about $800 to spare each month. I'm already contributing 2% to my 401(k) at work. Where should I put my extra money if I know nothing about investing?
ANSWER: Here's a checklist to help you know exactly what to do when you have excess cash:
Priority #1: Max Out Workplace Matching
If your workplace retirement plan offers a match, it's critical that you contribute enough to max it out. For instance, if your employer matches 50% of the contributions you make up to 6% of your salary, always contribute 6%. That way you don't leave any free money on the table. Contributing less than the full match is like turning down a raise from your boss!
Priority #2: Build An Emergency Fund
Your next priority should be to beef up your emergency fund. Save up at least 3 to 6 months' worth of living expenses so you can stay safe in a crisis--like a medical hardship or losing your job--before investing your excess cash. Your emergency money should never be invested because that would subject it to some amount of risk. Instead, keep it completely safe in a high-yield, FDIC insured savings account like ING or Discover Bank.
Priority #3: Invest In An IRA
After you take full advantage of workplace matching and have established a healthy emergency fund, putting away more money in a tax-advantaged account is the next best option. You can contribute up to $17,000 in most workplace retirement accounts in 2012, but I prefer that you max out an Individual Retirement Arrangement or IRA first. You can contribute up to $5,000 (or $6,000 if you're age 50 or older) to an IRA for 2012. It offers much more investment flexibility compared to the typical menu of options in a workplace retirement account. Betterment is a unique online brokerage that makes investing incredibly easy for a traditional or Roth IRA. You don't need to know ANYTHING about investing to build wealth using Betterment because they pick the specific investments. You simply move an allocation slider to indicate whether you're very conservative or like to swing for the fences with your investments. Watch this video to see how easy it is to open up a Betterment account. After you max out an IRA, then increase contributions to your workplace retirement and max it out. IMPORTANT: Never invest money in a workplace retirement plan or IRA that you might need before age 59-1/2. You typically have to pay a 10% penalty for early withdrawals--ouch! Read Should You Have a Traditional or Roth IRA? to learn more.
Priority #4: Invest in a Taxable Account
Once you've maxed out all your tax-advantaged account options, and still have more to invest, turn to a regular, taxable brokerage account. You won't get a tax deduction, however you will be able to tap those funds at anytime with no restrictions or penalties. For a full range of investment options, take a look at an online brokerage like E*TRADE. However, if you're just getting started or want a more simple way to invest, it doesn't get any easier than Betterment.
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