For example, if you have outstanding credit card debt at 15 percent interest, paying off that debt is the same as putting your money to work in an investment with a guaranteed 15 percent tax-free annual return. Because the interest on consumer debt isn't tax-deductible, you need to earn more than 15 percent investing your money elsewhere in order to net 15 percent after paying taxes. Earning such high investing returns is highly unlikely, and in order to earn those returns, you'd be forced to take great risk.

Consumer debt is hazardous to your long-term financial health (not to mention the damage it can do to your credit rating and future ability to borrow for a home or other wise investments) because it encourages you to borrow against your future earnings. I often hear people say such things as "I can't afford to buy most new cars for cash — look at how expensive they are!" That's true, new cars are expensive, so set your sights lower and buy a good used car that you can afford. You can then invest the money that you'd otherwise spend on your auto loan.

Borrowing via credit cards, auto loans, and the like is also one of the most expensive ways to borrow. Banks and other lenders charge higher interest rates for consumer debt than for debt for investments, such as real estate and business. The reason: Consumer loans are the riskiest type of loan for a lender.

Paying off your mortgage quicker is an "investment" for your spare cash that may make sense for your financial situation. However, the wisdom of making this financial move isn't as clear as is paying off high-interest consumer debt; mortgage interest rates are generally lower, and the interest is typically tax-deductible. When used properly, debt can help you accomplish your goals — such as buying a home or starting a business — and make you money in the long run. Borrowing to buy a home generally makes sense. Over the long term, homes generally appreciate in value.

If your financial situation has changed or improved since you first needed to borrow mortgage money, you need to reconsider how much mortgage debt you need or want. Even if your income hasn't escalated or you haven't inherited vast wealth, your frugality may allow you to pay down some of your debt sooner than the lender requires. Whether paying down your debt sooner makes sense for you depends on a number of factors, including your other investment options and goals.

Part of being a smart investor involves figuring out how much you need to save to reach your goals. Not knowing what you want to do a decade or more from now is perfectly normal — after all, your goals and needs evolve over the years. But that doesn't mean that you should just throw your hands in the air and not make an effort to see where you stand today and think about where you want to be in the future.

An important benefit of knowing your savings rate is that you'll know better how much risk you need to take to accomplish your goals. Seeing the amount that you need to save to achieve your dreams may encourage you to take more risk with your investments.

If you consistently save about 10 percent of your income during your working years, you're probably saving enough to meet your goals unless you want to retire at a relatively young age. On average, most people need about 75 percent of their pre-retirement income throughout retirement to maintain their standards of living.

If you're one of the many people who don't save enough, you need to do some homework. To save more, you need to reduce your spending, increase your income, or both.

If you don't know how to evaluate and reduce your spending or haven't thought about your retirement goals, looked into what you can expect from Social Security, or calculated how much you should save for retirement, now's the time to do it. Pick up the latest edition of my book Personal Finance For Dummies (published by Wiley), and find out all the necessary details for retirement planning and much more.

Many good investing choices exist — you can invest in real estate, the stock market, mutual funds, exchange-traded funds, your own business or someone else's, or you can pay down mortgage debt more quickly. What makes sense for you depends on your goals as well as your personal preferences. If you detest risk-taking and volatile investments, paying down your mortgage, as recommended earlier in this chapter, may make better sense than investing in the stock market.

How would you deal with an investment that plunges 20 percent, 40 percent, or more in a few years or less? Some aggressive investments can fall fast. (See Chapter 2 for examples.) You shouldn't go into the stock market, real estate, or a small-business investment arena if such a drop is likely to cause you to sell low or make you a miserable wreck. If you haven't tried riskier investments yet, you may want to experiment a bit to see how you feel with your money invested in them.

Retirement accounts should be called tax-reduction accounts — if they were, people might be more jazzed about contributing to them. Contributions to these plans are generally federal- and state-tax deductible. Suppose that you pay about 35 percent between federal and state income taxes on your last dollars of income. (See the section "Determining your tax bracket," later in this chapter.) With most of the retirement accounts that I describe in this chapter, you can save yourself about $350 in taxes for every $1,000 that you contribute in the year that you make your contribution.

After your money is in a retirement account, any interest, dividends, and appreciation grow inside the account without taxation. With most retirement accounts, you defer taxes on all the accumulating gains and profits until you withdraw your money down the road, which you can do without penalty after age 59½. In the meantime, more of your money works for you over a long period of time. In some cases, such as with the Roth IRAs described in the "IRAs" section later in this chapter, withdrawals are tax free, too.

The good old U.S. government now provides a tax credit for lower-income earners who contribute up to $2,000 into retirement accounts. The maximum credit of 50 percent applies to the first $2,000 contributed for single taxpayers with an adjusted gross income (AGI) of no more than $15,000 and married couples filing jointly with an AGI of $30,000 or less. Singles with an AGI of between $15,000 and $16,250 and married couples with an AGI between $30,000 and $32,500 are eligible for a 20 percent tax credit. Single taxpayers with an AGI of more than $16,250 but no more than $25,000 and married couples with an AGI not exceeding $50,000 can get a 10 percent tax credit.

To take advantage of retirement savings plans and the tax savings that accompany them, you must first spend less than you earn. Only after you spend less than you earn can you afford to contribute to these retirement savings plans (unless you already happen to have a stash of cash from previous savings or inheritance).

Each decade you delay saving approximately doubles the percentage of your earnings that you need to save to meet your goals. For example, if saving 5 percent per year in your early 20s gets you to your retirement goal, waiting until your 30s to start may mean socking away 10 percent to reach that same goal; waiting until your 40s, 20 percent. Beyond that, the numbers get truly daunting.

If you enjoy spending money and living for today, you should be more motivated to start saving sooner. The longer that you wait to save, the more you ultimately need to save and, therefore, the less you can spend today!

If you earn employment income (or receive alimony), you have option(s) for putting money away in a retirement account that compounds without taxation until you withdraw the money. In most cases, your contributions to retirement accounts are tax-deductible.

When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps the federal, state, and local governments from taxing your investment earnings each year. You still must choose what investments you want to hold inside your retirement account shell.

You may invest your IRA or other self-employed plan retirement account (SEP-IRAs, Keoghs) money into stocks, bonds, mutual funds, and even bank accounts. Mutual funds (offered in most employer-based plans), which I cover in detail in Chapter 8, are an ideal choice because they offer diversification and professional management. After you decide which financial institution you want to invest through, simply obtain and complete the appropriate paperwork for establishing the specific type of account you want.

You may not know it, but the government charges you different tax rates for different parts of your annual income. You pay less tax on the first dollars of your earnings and more tax on the last dollars of your earnings. For example, if you're single and your taxable income totaled $50,000 during 2008, you paid federal tax at the rate of 10 percent on the first $8,025, 15 percent on the taxable income above $8,025 up to $32,550, and 25 percent on income above $32,550 up to $50,000.

Your marginal tax rate is the rate of tax that you pay on your last or so-called highest dollars of income. In the example of a single person with taxable income of $50,000, that person's federal marginal tax rate is 25 percent. In other words, he effectively pays a 25 percent federal tax on his last dollars of income — those dollars earned between $32,550 and $50,000. (Don't forget to factor in state income taxes that most states assess.)

Knowing your marginal tax rate allows you to quickly calculate the following:

Table 3-1 shows the federal tax rates for singles and for married households that file jointly.

Interest you receive from bank accounts and corporate bonds is generally taxable. U.S. Treasury bonds pay interest that is state-tax-free. Municipal bonds, which state and local governments issue, pay interest that is federal-tax-free and also state-tax-free to residents in the state where the bond is issued. (I discuss bonds in Chapter 7.)

Taxation on your capital gains, which is the profit (sales minus purchase price) on an investment, works under a unique system. Investments held less than one year generate short-term capital gains, which are taxed at your normal marginal rate. Profits from investments that you hold longer than 12 months are long-term capital gains that cap at 15 percent, except for those in the two lowest tax brackets of 10 and 15 percent, for whom the long-term capital gains tax rate is just 5 percent. (Note: As this book went to press just prior to the 2008 presidential election, the outcome of that election could alter tax rates across the board because the Democratic candidate has indicated a likelihood to raise rates.)

When you're younger and have more years until you plan to use your money, you should keep larger amounts of your long-term investment money in growth (ownership) vehicles, such as stocks, real estate, and small business. As I discuss in Chapter 2, the attraction of these types of investments is the potential to really grow your money. The risk: The value of your portfolio can fall from time to time.

The younger you are, the more time your investments have to recover from a bad fall. In this respect, investments are a bit like people. If a 30-year-old and an 80-year-old fall on a concrete sidewalk, odds are higher that the younger person will fully recover. Such falls sometimes disable older people.

If you want to be more aggressive, subtract your age from 120:

Note that even retired people should still have a healthy chunk of their investment dollars in growth vehicles like stocks. A 70-year-old person may want to totally avoid risk, but doing so is generally a mistake. Such a person can live another two or three decades. If you live longer than anticipated, you can run out of money if it doesn't continue to grow.

No hard-and-fast rules dictate how to allocate the percentage that you've earmarked for growth investments among specific investments, like stocks and real estate. Part of how you decide to allocate your investments depends, for example, on the types of investments that you want to focus on. As I discuss in Chapter 5, diversifying in stocks worldwide can be prudent as well as profitable.

Here are some general guidelines to keep in mind:

Dollar cost averaging (DCA) is the practice of investing a regular amount of money at set time intervals, such as monthly or quarterly, into volatile investments, such as stocks and stock mutual funds. If you've ever deducted money from a paycheck and pumped it into a retirement savings plan investment account that holds stocks and bonds, you've done DCA.

DCA is made to order for skittish investors with a large lump sum of money sitting in safe investments like CDs or a savings account. For example, using DCA, an investor with $100,000 to invest in stock funds can feed her money into investments gradually — say, at the rate of $12,500 or so quarterly over two years — instead of investing her entire $100,000 in stocks at once and possibly buying all of her shares at a market peak. Most large investment companies, especially mutual funds, allow investors to establish automatic investment plans so the DCA occurs without an investor's ongoing involvement.

Of course, like any risk-reducing investment strategy, DCA has drawbacks. If growth investments appreciate (as they're supposed to), a DCA investor misses out on earning higher returns on his money awaiting investment. Finance professors Richard E. Williams and Peter W. Bacon found that approximately two-thirds of the time, a lump-sum stock market investor earned higher first-year returns than an investor who fed the money in monthly over the first year. (They studied data from the U.S. market over the past seven decades.)

However, knowing that you'll probably be ahead most of the time if you dump a lump sum into the stock market is little solace if you happen to invest just before a major plunge in the stock market. In the fall of 1987, the U.S. stock market, as measured by the Dow Jones Industrial Average, plummeted 36 percent, and from 1973 to 1974, the market shed 45 percent of its value.

So investors who fear that stocks are due for such a major correction should practice DCA, right? Well, not so fast. Apprehensive investors who shun lump-sum investments and use DCA are more likely to stop the DCA investment process if prices plunge, thereby defeating the benefit of doing DCA during a declining market.

So what's an investor with a lump sum of money to do?

DCA makes sense for investors with a large chunk of their net worth in cash who want to minimize the risk of transferring that cash to riskier investments, such as stocks. If you fancy yourself a market prognosticator, you can also assess the current valuation of stocks. Thinking that stocks are pricey (and thus riper for a fall) increases the appeal of DCA.

As for the times of the year that you should use DCA, mutual fund investors should DCA quarterly early in each calendar quarter because mutual funds that make taxable distributions tend to do so late in the quarter.

Your money that awaits investment should have a suitable parking place. Select a high-yielding money market fund that's appropriate for your tax situation.

One last critical point: When you use DCA, establish an automatic investment plan so you're less likely to chicken out. And for the more courageous, you may want to try an alternative strategy to DCA — value averaging, which allows you to invest more if prices are falling and invest less if prices are rising.

Suppose that you want to value average $500 per quarter into an aggressive stock mutual fund. After your first quarterly $500 investment, the fund drops 10 percent, reducing your account balance to $450. Value averaging has you invest $500 the next quarter plus another $50 to make up the shortfall. (Conversely, if the fund value had increased to $550 after your first investment, you would invest only $450 in the second round.) Increasing the amount that you invest requires confidence when prices fall, but doing so magnifies your returns when prices ultimately turn around.

Also known as qualified state tuition plans, Section 529 plans offer a tax-advantaged way to save and invest more than $100,000 per child toward college costs (some states allow upward of $300,000 per student). After you contribute to one of these state-based accounts, the invested funds grow without taxation. Withdrawals are also tax free so long as the funds are used to pay for qualifying higher educational costs (which include college, graduate school, and attendance expenses of special-needs students). The schools need not be in the same state as the state administering the Section 529 plan.

As I discuss in the previous section dealing with Education Savings Accounts, Section 529 plan balances can harm your child's financial aid chances. Thus, such accounts make the most sense for affluent families who are sure that they won't qualify for any type of financial aid. And as with ESAs, keep parents as owners of these accounts for assistance with financial aid issues.

Diversified mutual funds (which invest in stocks in the United States and internationally) and bonds are ideal vehicles to use when you invest for college. Be sure to choose funds that fit your tax situation if you invest your funds in non-retirement accounts. See Chapter 8 for more information.