William Baldwin Contributor I write about investing and taxes. Opinions expressed by Forbes Contributors are their own. Forbes 6/17/2015 @ 9:00AM How To Deploy $100,000 This story appears in the June 29, 2015 issue of Forbes. A rich aunt leaves you a pile of money. What s a better use for it, liquidating debts or adding to investments? Finding the optimal application of a windfall is no simple matter, given that the right answer depends on assets, liabilities, tax brackets and future spending plans. But even before dissecting your balance sheet, you can make some educated guesses about where priorities will lie. Paying down high-cost debt is near the top. Investing in low-return assets that have no tax advantage is near the bottom. David Blanchett, a Kentucky resident with two kids (and more expected), illustrates the conflicting demands on a young family. Given that his job is to oversee retirement research at Morningstar, it s no surprise that he has maxed out his 401(k) contributions. But what does he do with the next dollar that falls into his lap? Building home equity is a nice idea. Also desirable: 529 college savings accounts, which generate tax-free returns. Yet Blanchett and wife, who recently earned a veterinary degree, still haven t finished paying for their own education. Pondering all this, Blanchett says he d use spare cash first to pay down a vet school loan. Paying off a loan gives you a guaranteed rate of return equal to the interest rate, Blanchett says. You are not going to get a high guaranteed return elsewhere.
Herewith, 14 ways to put extra cash to use, based on liquidity, aftertax return and risk. They are in rough descending order of utility rough, because every person s circumstances are different. 1. Matched 401(k) contribution A typical retirement plan has the employer chipping in, up to a limit, 50 cents for every dollar the employee puts in. Liquidity is poor (it s hard to get at the money before age 59-1/2), but where else can you get an instant 50% return on an investment? 2. Emergency fund A pot you can tap during unemployment or disability is a must. It does not have to be held in cash. Get double use out of this asset by investing for long-term goals at the same time. In other words, take some risks with your liquid assets. 3. Credit pay-down Rid yourself of credit card and higher-cost car debt. Since the interest is not deductible, the aftertax return is whatever the bank is gouging from you. 4. Student loan pay-down Blanchett, the retirement expert, is anxious to liquidate college loans with rates as low as 3%. Reason: It s a dangerous type of loan because it doesn t go away. In a pinch, you might be able to erase a home or car loan by handing in the deed. You can t hand back a diploma. Interest on student loans is sometimes deductible. If you are getting a deduction, your aftertax return is less than the interest rate. 5. Unmatched 401(k) contribution The reason to put the legal maximum ($18,000 for employees under 50; $24,000 for those 50 or over) into a 401(k), even if some of the dollars don t get an employer match, is that the annual
contribution is a use-it-or-lose-it opportunity. The payoff is an immediate deduction for the deduction combined with a deferral of tax on earnings. 6. Roth contribution A worker with less than $183,000 of adjusted gross income on a joint return can divert $5,500 ($6,500 if 50 or older) of earned income to a tax-free Roth IRA. What s the tax shield worth? It depends on holding periods, returns and tax brackets. Using different assumptions and a 30-year investing horizon, we saw increments of 0.7 to 1.3 percentage points to annual returns. 7. Mortgage pay-down A 4% mortgage might cost only 2.5% after allowing for the benefit of deducting interest on tax returns. That looks like cheap money cheap enough that you might be tempted to leave your mortgage untouched and sink extra cash into the stock market (see No. 11). We re assuming that you already have an emergency kitty (see No. 2). Do you now put excess dollars into your mortgage or into stocks in a brokerage account? In asking yourself whether you have tolerance for the risk of taking the latter course, it might help to turn the question around. Suppose your mortgage were paid off. Would you take out a $100,000 home equity loan and invest the proceeds in stock now? With companies trading on Wall Street at abnormally high multiples of their earnings? In March 2009 that would have been a brilliant move, says Stephen Janachowski, a Tiburon, Calif. wealth manager who looks for ways to reduce his clients risks. Today I don t like that strategy at all. You might earn a lot more than 2.5% investing in stocks. But understand that the 2.5% return on your mortgage pay-down is a guaranteed return, while the return in the stock market is iffy. So, in addition to comparing the return on your mortgage with what you think you can get in stocks, compare it with what you know you can get on Ginnie Maes. These are federally guaranteed pools of other people s mortgages. Ginnie Maes won t yield anything close to 2.5% aftertax. To give you an idea, the Vanguard GNMA fund yields 2.1% before tax. The main disadvantage to a mortgage prepayment is that it is a very illiquid investment. Once you have sent the money to the bank, you can t get it back without a refinancing. That would entail closing costs and a possible loss of your interest deduction. One more subtlety: Those homeowners who, before the pay-down, have a high ratio of mortgage debt to home value stand to gain an extra benefit from a mortgage pay-down. Getting the debt/value ratio below 80% is likely to lower the interest rate in any future refinancing.
8. 529 account Money set aside for college gets a tax exemption. Nice, but it goes low on the priority stack, for two reasons. The first relates to liquidity: If money in a 529 is not used for the purpose intended, profits are subject to both a tax and a penalty. The other is that 529 assets reduce the amount of financial aid your children can get. In contrast, the same money tucked into retirement accounts (see No. 1 and No. 5) is generally sheltered on financial aid forms. Home equity (see No. 7) is sometimes sheltered from the college grab. 9. Tax-exempt bonds You can get a 2.5% yield out of a long-term tax-exempt bond fund. That s good but not great, given that your fund might own bonds from the next Detroit. One thing working in favor of the muni fund is high liquidity. 10. Roth conversion Prepaying the tax on an IRA to make it into a Roth IRA is a form of investment. It creates a hidden asset: a tax shield. That asset is extremely valuable but appears nowhere on any official balance sheet. Consider investing in this asset if you want something that escapes notice on both estate tax returns and college aid forms. But you also have to consider the income tax effects. The conversion doesn t make sense if your tax bracket is likely to be a lot lower in retirement. It s also counterproductive if you have a child within a year of applying for tuition aid (the conversion creates income that makes you look rich). Liquidity: zilch. You have a limited window to undo the conversion. 11. Stocks Liquidity: high. Economics: poor, at the moment. Tax treatment: very good. Dividends and longterm capital gains get favorable rates. Losing positions can be harvested for tax benefits. Winning ones can be given to charities and low-bracket relatives. 12. Nondeductible IRA This investment works as the first step in a scheme to create a Roth IRA. (The direct Roth contribution is not available to rich people; the nondeductible IRA is.) The second step is to convert the new account to a Roth IRA. Someone whose retirement assets are mostly in 401(k)s and Roth IRAs, as opposed to taxable IRAs, can do the conversion cheaply. Someone with a large balance in taxable IRAs, though, should view a nondeductible IRA as a waste of time.
13. Deferred fixed annuity A 55-year-old male puts in $100,000 and gets $2,000 a month beginning at age 75 (if he lives that long). Makes sense if his tax bracket will be fairly low at age 75. Women get less. 14. UTMA A kiddie account (under the Uniform Transfers to Minors Act) has this advantage: The first $2,100 of income is taxed at low rates. Beyond that, the income is taxed in the parent s bracket and the account accomplishes nothing. This article is available online at: http://onforb.es/1ttorni 2015 Forbes.com LLC All Rights Reserved Disclosure Please note that the discussion of the investments and investment strategy of Brouwer & Janachowski [Adviser] (including Adviser s research and investment process) represent the investments and investment strategy of Mr. Janachowski and Adviser at the date of the article, and are subject to change without notice. Adviser cannot assure that the type of securities mentioned in the article will outperform any other investment strategy in the future, nor can it guarantee that such securities will present the best or an attractive risk-adjusted investment in the future. References to an individual security should not be construed as a recommendation to buy or sell that security. In addition, the securities noted in this article are but several of the many successful, as well as unsuccessful, investments by Adviser and do not represent all of the securities that Adviser has purchased, sold or recommended to clients. Adviser cannot guarantee the accuracy or completeness of any statements or numerical data in the article. Past performance is no indication of future results.