What Now?

A journalist posted an interesting question on the financial advisor network to which I belong:

“I am writing a piece on money moves to make after paying off a big debt and am looking for suggestions from the experts. What steps should people take after paying off their student loans, credit card debt, mortgage or any other major debt?”

In the spirit of sharing, my response to this question follows.

Parallel Paths Preferable

Reducing debt to manageable levels (or to no debt at all) is critical to personal financial security, but the price for waiting until one is debt-free before getting started saving for retirement can be steep. Granted, eliminating “bad” debt (credit card balances not paid in full each month) should be a top priority. However, given the importance of time when it comes to investing success, an approach that allows both for debt reduction and long-term investments offers the potential for greater financial security when compared to the sequential approach implicit in the question.

I recognize this approach is, for a tragic number of Americans, difficult if not impossible. To the extent that it is possible, a student loan repayment plan that leaves some room in the budget to invest would be a good place to start. A mortgage payment within budget is foundational. Waiting until all debts are paid amounts to a concession on the benefits of compounding and poses a material risk to the ordinary investor’s chances of success long-term.

Rainy Day Fund

That said, the first step after paying off a major debt (student loans, credit cards, mortgage) is to build your emergency reserves. A general rule-of-thumb is three months of “non-discretionary” (think: fixed) expenses. The Great Recession experience for many suggests six months of reserves may be better. The best vehicles for this “rainy day” fund are federally insured (FDIC or NCUA1) savings and/or checking accounts, federally-insured Certificates of Deposit (CDs), or federally-insured money market funds (caution: most money market funds are NOT insured).

Gimme Shelter: Tax-Deferred Accounts

Next you should max-out contributions to all of your tax-deferred accounts. The 401(k) offered by your employer is an example. For 2016, the deferral limit for 401(k) plans is $18,000. If permitted by your 401(k) plan, and you are age 50 or over at the end of the calendar year, this year you may contribute an additional $6,000. This is known as a “catch-up” contribution. 403(b) plan limits are similar but you should consult the plan documents, your plan administrator and or an independent advisor to confirm any unclear details.

Another example of tax-deferred accounts is a traditional IRA or Roth IRA. For 2016, total contributions to all of your traditional and Roth IRAs cannot be more than $5,500 ($6,500 if you’re age 50 or older), or your taxable compensation for the year, if less than this dollar limit. There are income restrictions regarding your eligibility for making Roth IRA contributions (filing status, income), and you may not deduct contributions to a Roth on your taxes. However, “qualified distributions” from a Roth IRA are tax free. If all this seems complicated that’s because it is. If you are comfortable with lots of details, the IRS web site is a helpful resource. Otherwise, you should consult an advisor whom you trust.

Provided you meet income and other restrictions (filing status, whether you are covered by a retirement plan at work), traditional IRA contributions are tax-deductible. If your income exceeds the limits on tax deductibility of your contributions, you still may contribute to your Traditional IRA up to the annual limits mentioned above. Distributions from Traditional IRAs are, on the other hand, taxable at the applicable rates at the time of withdrawal.

Rugged Individual: Taxable Account

Next on your list of to-do’s should be to open an “Individual” (taxable) investment account. For many, this account might best be opened at a low-cost mutual fund company such as Vanguard or Fidelity. Begin by investing in low-cost diversified tax-efficient mutual funds. Index funds, which aim to track stock and bond markets, are a great way to get started. Some “tax-managed” actively-managed funds are geared toward the low costs, diversification and tax efficiency of index funds. Municipal bond funds offer investors exemption from federal and or state and local income taxes.

A Pragmatist’s Approach

Allocate your investment dollars among stocks and bonds in keeping with your risk tolerance. Risk tolerance is a function of your timeline, resources and needs. A trusted advisor can be helpful with the process of assessing your tolerance for investment losses. Getting started may not require as much as you think. The initial investment to open a new account for many Vanguard mutual funds is $3,000.

A low-cost brokerage account is another option for getting started with your taxable investment account. You might use exchange traded funds (ETFs) to invest along the lines described above. ETFs trade all day like stocks, as opposed to mutual funds, which you can buy or sell only at the end of day price (called “net asset value”). Many ETFs are similar to index mutual funds; i.e., they track stock and bond market indices. You should do your due diligence, but the expense ratios for many ETFs are low relative to the average “open end” mutual fund.

Fool’s Errand: Stock Picking and Market Timing

Regardless of whether you opt for a brokerage account, or an account at a mutual fund company, stick to index mutual funds or ETFs that track the broad stock and bond indices. The Vanguard 500 or Total Stock Market Index mutual funds are both available in ETF form. Broad market index funds or ETFs like these offer you great diversification for your investment dollar. Do not try to time the market, or pick the next winner. The empirical evidence indicates that few investors do either with consistency over the long-term. This observation applies to professional investors and non-professional investors alike. For more on this all too common folly, see public comments by Warren Buffett, John Bogle, Burton Malkiel, and the late Paul Samuelson.

Control Freak’s Comeuppance

Stick to those few things you can control, such as investment costs (broker commissions and fund expenses). The disparity in expenses charged investors among the 30,000-plus funds available today suggests that some fund companies are more focused than others on keeping costs to a minimum. Long-term these costs compound and come right out of your returns. One noteworthy study went so far as to conclude that expense ratios are an indicator of future relative long-term mutual fund performance.

Diversification is something you can influence, and it is key to your ability to withstand the inevitable ups and downs of the stock and bond markets. Investing in diversified funds amounts to purchasing shares in hundreds or thousands of securities. As the saying goes, “Do not put all your eggs in one basket.” Why violate this principle with your nest egg?

Divide and Conquer

Asset Allocation, or the mix of stocks and bonds you choose, is critical to your long-term investing success. Evidence argues for a combination of stocks and bonds for most investors, and studies have shown your choice of allocation is a driver of your long-term returns. Within each of the two broad asset categories, may wish to have domestic and international stocks, small- and large-cap stocks, short- and intermediate-term bonds, “Triple-A” and investment-grade bonds. This topic is complex, and you may need some professional advice to help you get started. However, this is one of the few factors you can control. And a little homework this year could make a world of a difference to your sense of financial security later as you approach retirement.

As in Real Estate: Location, Location, Location

Tax efficiency is another aspect to consider when getting started. Without being focused on this angle per se, you will have made great strides in this regard by maxing out your 401(k) and IRA contributions. Going further, you should try to keep high interest and dividend yielding assets in these accounts, so as to manage the tax impact of the “yield” from your chosen investments. In taxable accounts, depending on your income and location, you may want to use the tax-exempt bond funds mentioned above, and stock funds with low “turnover” (the number of times in a given year a fund sells its holdings) to limit short-term capital gains taxes. As in real estate, tax efficiency often comes down to asset location.

Put Time on Your Side

Most important of all, put the “miracle of compounding” to work for you by getting started now. The phenomenon often associated with founding father Benjamin Franklin needs time to work its magic. The earlier you get started, the more time becomes an asset rather than a liability.

And remember, getting started is the hardest part of all.

1 FDIC stands for Federal Deposit Insurance Corporation. NCUA stands for National Credit Union Administration.

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