Imagine this: It’s your lucky day. You catch every green light on the commute home from a tough day at the office, so you stop by a gas station to purchase a scratch-off. You win $10,000! What’s your next move?
There is an endless number of ways to handle a windfall. Let’s examine one option and all the important decisions that need to be made along the way.
Investing vs. Paying Down Debt
You collect your lottery winnings and commit to being a good steward of your spoils. After all, just a few months ago, you opened a credit card and overspent to the tune of $4,000. The first decision facing you is whether to invest the entire haul or pay off the credit card bill.
There are several factors to consider when evaluating a debt pay down strategy. The first step is to assess the interest rate on the liability and compare it to your expected market return. According to WalletHub.com the average annual credit card interest rate is 19.02 percent. In this case, the investor has a difficult benchmark to pass, especially when you consider the historical average annual return of the S&P 500 is about 10 percent.
Decision: If investing your money yields a return that is less than your credit card interest rate, the smart decision is to pay down the debt.
You decide to pay off the entire credit card bill with $4,000 of your $10,000 windfall.
Roth vs. Traditional
Now you have $6,000 to invest. Perfect! You’ll make an IRA contribution. But how do you know whether to contribute to a Traditional IRA or a Roth IRA?
There are three types of IRA contributions: deductible and non-deductible Traditional IRA contributions and direct Roth IRA contributions. The first step in figuring out which one is best for your financial situation is to determine your eligibility, which is based on your income. This can get complicated, but there are calculators on the Internet to assist you.
High income earners may find that they only have one option (non-deductible Traditional IRA), while middle and low income earners may qualify for both deductible Traditional IRA and direct Roth IRA contributions.
If you find that you qualify for either a deductible Traditional IRA or a Roth IRA, the next step is to review your tax situation.
The main difference between Traditional and Roth IRAs is the timing of taxation. Since deductible Traditional IRA contributions receive preferential tax treatment going in, all future distributions are taxable. In comparison, Roth IRA contributions are made with after-tax dollars, i.e. not deductible, and, therefore, future distributions are not taxed.
Decision: You are just starting your career and your current income tax rate is low. The direct Roth IRA is your choice. Remember that if your tax situation changes in future years, you can choose to make a deductible Traditional IRA. You make the call each year based on your situation.
You deposit the remaining $6,000 into a Roth IRA and you feel really good!
Lump Sum vs. Dollar-Cost Averaging
Now that you have selected your investment vehicle, you’re faced with perhaps the most difficult decision of all: when to invest. Should you dump the $6,000 into the market all at once, or should you invest it over a period of time? If only you had a crystal ball…
There are pros and cons to both strategies. Going all in on the market allows 100% of your money to participate in an upswing. But…the market doesn’t always go up, so you could lose a portion of your investment fairly quickly as well.
Dollar-cost averaging, or investing a consistent amount over a period of time, reduces the downside risk of investing. For example, with the $6,000 Roth IRA contribution, you could invest $1,000 per month for the next six months. This allows you to spread your risk of entering the investment market at an inopportune time.
Investing your $6,000 all at one time or implementing a dollar-cost averaging strategy will likely put you in about the same place if you are a long-term investor, i.e. ten years and longer. The short-term investor, i.e. less than five years, may see a bigger impact either up or down, depending on the short-term market return.
Decision: You decide on the more risk-adverse strategy of dollar-cost averaging.
You’ve paid off your credit card debt, opened a Roth IRA, and implemented your investment strategy. Nice job!
One more thought….
When you think of investing, do the words “regret” or “confusion” come to mind? Investors are faced with many decisions. If you don’t have time to research and are concerned about implementing the correct strategy for your personal situation, it may be time to consult with a professional. Removing a little stress from your life is always a good decision!
Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.
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