If you’re just starting out in your career, you will need to be prepared to face some financial challenges along the way—but here’s one that’s not unpleasant: choosing what to do with some extra disposable income. When this happens, what should you do with the money? Your decisions could make a real difference in your ability to achieve your important financial goals.
Under what circumstances might you receive some “found” money? You could get a year-end bonus from your employer, or a sizable tax refund, or even an inheritance. However the money comes to you, don’t let it “slip through your fingers.” Instead, consider these two moves: investing the money or using it to pay off debts.
Which of these choices should you pick? There’s no one “right” answer, as everyone’s situation is different. But here are a few general considerations:
• Distinguish between “good” and “bad” debt. Not all types of debt are created equal. Your mortgage, for example, is probably a “good” form of debt. You’re using the loan for a valid purpose—i.e., living in your house—and you likely get a hefty tax deduction for the interest you pay. On the other hand, nondeductible consumer debt that carries a high interest rate might be considered “bad” debt—and this is the debt you might want to reduce or eliminate when you receive some extra money. By doing so, you can free up money to save and invest for retirement or other goals.
• Compare making extra mortgage payments vs. investing. Many of us get some psychological benefits by making extra house payments. Yet, when you do have some extra money, putting it toward your house may not be the best move. For one thing, as mentioned above, your mortgage can be considered a “good” type of debt, so you may not need to rush to pay it off. And from an investment standpoint, your home is somewhat “illiquid”—it’s not always easy to get money out of it. If you put your extra money into traditional investments, such as stocks and bonds, you may increase your growth potential, and you may gain an income stream through interest payments and dividends.
• Consider tax advantages of investing. Apart from your mortgage, your other debts likely won’t provide you with any tax benefits. But you can get tax advantages by putting money into certain types of investment vehicles, such as a traditional or Roth IRA. When you invest in a traditional IRA, your contributions may be deductible, depending on your income, and your money grows on a tax-deferred basis. (Keep in mind that taxes will be due upon withdrawals, and any withdrawals you make before you reach 591/2 may be subject to a 10 percent IRS penalty.) Roth IRA contributions are not deductible, but your earnings are distributed tax-free, provided you don’t take withdrawals until you reach 591/2 and you’ve had your account at least five years.
Clearly, you’ve got some things to ponder when choosing whether to use “extra” money to pay off debts or invest. Of course, it’s not always an “either-or” situation; you may be able to tackle some debts and still invest for the future. In any case, use this money wisely—you weren’t necessarily counting on it, but you can make it count for you.
Daniel Tanaka is a financial adviser for Edward Jones Investments, located at 332 Route 100, Suite 300, in Somers. He can be reached at 914-669-5329.