Emergency money

When you have a few thousand dollars or less, your simplest path is typically to keep this money in a local bank or credit union. Look first to the institution where you keep your checking account. Keeping this stash of money in your checking account, rather than in a separate savings account, makes financial sense if the extra money helps you avoid monthly service charges when your checking account balance would otherwise dip below the minimum. Compare the service charges on your checking account with the potential interest earnings from a savings account. And be sure to comparison shop checking accounts with a close eye on the fees you’ll incur given your likely account balance and features of the account you will use.

Another option to consider is putting your money into a money market fund, a type of mutual fund, the best of which are usually superior to bank savings accounts because they pay higher yields than bank savings accounts and allow check-writing. And if you’re in a high tax bracket, you can select a tax-free money market fund, which pays interest that’s free from federal and/or state tax — something you can’t get with a bank savings account.

The yield on a money market fund is an important consideration. The operating expenses deducted before payment of dividends are generally the single biggest determinant of yield. All other things being equal, lower operating expenses translate into higher yields for you. With interest rates as low as they have been in recent years, seeking out money funds with the lowest operating expenses is essential.

Doing most or all of your fund shopping (money market and otherwise) at one good fund company can reduce the clutter in your investing life. Chasing after a slightly higher yield offered by another company is sometimes not worth the extra paperwork and administrative hassle. On the other hand, there’s no reason why you can’t invest in funds at multiple firms (as long as you don’t mind the extra accounts), using each for its relative strengths. (You can buy funds from different fund companies in a single brokerage account — I explain how in the “Discount brokers” section later in this chapter.)

Most fund companies don’t have many local branch offices, so you may have to open and maintain your money market mutual fund through the fund’s website, toll-free phone line, or the mail.

Distance has its advantages. Because you can conduct business online, by phone, and through the mail, you don’t need to go schlepping into a local branch office to make deposits and withdrawals. I’m happy to report that I haven’t visited a bank office (or fund branch office) in many years.

Despite the distance between you and your fund company, your money is still accessible via check-writing, and you can also have money transferred electronically to your local bank on any business day. (Fund companies can also mail you a check for a desired amount to your home address on your account.)

Increasing numbers of investment companies are offering you the ability to deposit checks now through a smartphone app. Also, if you need to mail in some checks to deposit, don’t fret about a deposit being lost in the mail; it rarely happens, and no one can legally cash a check made payable to you, anyway. Always endorse checks with the notation “for deposit only” under your signature.

Long-term money

If you plan to invest outside retirement accounts, asset allocation for these accounts should depend on how comfortable you are with risk and how much time you have until you plan to use the money. That’s not because you won’t be able to sell these investments on short notice if necessary. Investing money in a more volatile investment is simply riskier if you need to liquidate it in the short term.

For example, suppose you’re saving money for a down payment to buy a house in one to two years. If you had put this money into the U.S. stock market near the beginning of one of the stock market’s major downturns (such as what happened in 2000 and then again in 2007), you’d have been mighty unhappy. You would have seen a substantial portion of your money and home-buying dreams vanish in the following year or two. Or consider what happened in 2020 with the COVID-19 government-mandated economic shutdowns. Imagine investing your home down payment in the stock market through early 2020 and preparing to buy a home in 2020 only to see about one-third of your investment wiped out in a few weeks. For those who held on, stocks did come roaring back by year-end, but that timing might not have worked out for you depending upon what your plans had been. I’ve seen people panic in such situations and sell at what turns out to be the bottom or near bottom.

In the sections that follow, I walk you through common investments for longer-term purposes.

Establishing and prioritizing retirement contributions

When you have access to various retirement accounts, prioritize which account you’re going to use first by determining how much each gives you in return. You should generally focus your contributions in this order:

1. First fund employer-based plans that match your contributions.
2. Next, contribute to any other employer or self-employed plans that allow tax-deductible contributions.
3. After you contribute as much as possible to these tax-deductible plans (or if you don’t have access to such plans), consider an IRA.
4. If you max out on contributions to an IRA, consider a Roth 401(k) (employer-offered, after-tax contributions).

I would make an exception to these guidelines for folks who believe they are temporarily in a relatively low tax bracket. This can happen, for example, if your employment income is expected to increase significantly once you complete certain training. In such a case, after funding employer plans that match your contributions, you could consider plans like a Roth 401(k) and/or Roth IRA, which don’t provide upfront tax breaks but do provide ongoing tax breaks as your investment earnings compound and tax-free withdrawals of your investment returns in the future.

Investments and account types are different issues. People sometimes get confused when discussing the investments they make in retirement accounts — especially people who have a retirement account, such as an IRA, at a bank. They don’t realize that you can have your IRA at a variety of financial institutions (for example, a mutual fund company or brokerage firm). At each financial institution, you can choose among the firm’s investment options for investing your IRA money.

No-load, or commission-free, mutual fund and discount brokerage firms are your best bets for establishing a retirement account (see Chapter 10 for more information on these accounts).

Allocating money in employer plans

In some company-sponsored plans, such as 401(k)s, you’re limited to a short list of investment choices. I discuss typical investment options for 401(k) plans in order of increasing risk and, hence, likely return:

• Money market: Folks who are skittish about the stock and bond markets are attracted to money market and savings accounts because they haven’t dropped in value. In the long run, you won’t be doing yourself any favors. Trying to time your investments to attempt to catch the lows and avoid the peaks isn’t possible (see Chapter 10).
• Bond mutual funds: Bond funds invest in a mixture of typically high-quality bonds. Bonds pay a higher yield than money funds. Depending on whether your plan’s option is a short-term, intermediate-term, or long-term fund (maybe you have more than one type), the bond fund’s current yield is probably a percent or two higher than the money market fund’s yield. Bond funds carry higher yields than money market funds, but they also carry greater risk because their value can fall if interest rates increase. However, bonds tend to be more stable in value over the shorter term (such as a few years) than stocks. Aggressive, younger investors should keep a minimum amount of money in bond funds (see the asset allocation discussion in Chapter 10).
• Guaranteed-investment contracts (GICs), also known as stable value funds: Guaranteed-investment contracts are backed by an insurance company, and they typically quote you an interest rate a year in advance. The attraction of these investments is that your account value doesn’t fluctuate (at least, not that you can see). In GICs, you pay for the peace of mind of a guaranteed return with lower than bond fund long-term returns. And GICs have another minor drawback: Insurance companies, unlike mutual funds, can and do fail, putting GIC investment dollars at risk. Some retirement plans have been burned by insurer failures.
• Balanced mutual funds: Balanced funds invest primarily in a mixture of stocks and bonds. This one-stop-shopping concept offers broad diversification, makes investing easier, and smooths out fluctuations in the value of your investments. Funds investing exclusively in stocks or in bonds make for a rougher ride.
• Stock funds: Stock funds invest in stocks, which often provide greater long-term growth potential but also wider fluctuations in value from year to year. Some companies offer a number of different stock funds, including funds that invest overseas. Unless you plan to borrow against your funds to purchase a home (if your plan allows), you should have plenty of stock funds.

• Stock in your employer: Some companies offer employees the option of investing in the company’s stock. I generally suggest avoiding this option because your future income and other employee benefits are already riding on the company’s success. If the company hits the skids, you may lose your job and your benefits. You certainly don’t want the value of your retirement account to depend on the same factors. If you think strongly that your company has its act together and the stock is a good buy, investing a portion of your retirement account is fine — but no more than 25 percent.

  Some employers offer employees an option to buy company stock outside a tax-deferred retirement plan at a discount, sometimes as much as 15 percent, to its current market value. If your company offers a notable discount on its stock, consider taking advantage of it. When you sell the stock, you’re usually able to lock in a profit over your purchase price.

Table 12-1 shows a couple of examples of how people in different employer plans may choose to allocate their 401(k) investments among the plan’s investment options. See Chapter 10 for more background on asset allocation decisions.

Designating money in plans you design

With self-employed plans (for example, SEP-IRAs), certain 403(b) plans for nonprofit employees, and IRAs, you may select the investment options as well as the allocation of money among them. In the sections that follow, I give some specific mixes that you may find useful for investing at some of the premier investment companies.

To establish your retirement account at one of these firms, call the company’s toll-free number and ask the representative to send you an account application for the type of account (for example, SEP-IRA, 403(b), and so on) you want to set up. Most investment firms provide downloadable account applications, and they may allow you to complete the application online.

Understanding the importance of applying for financial aid

Just as your child shouldn’t choose a college based solely on whether he thinks he can get in, he shouldn’t choose a college on the basis of whether you think you can afford its full sticker price. Except for the affluent, who can pay for the full cost of college, everyone else should apply for financial aid. Some parents who don’t think they qualify for financial aid are pleasantly surprised to find that their children have access to loans as well as grants (which don’t have to be repaid).

Completing the Free Application for Federal Student Aid (FAFSA) is the first step in the financial aid process. (See the form online at www.fafsa.ed.gov.) Some private colleges also require completing the Financial Aid Form (FAF), which asks for more information than the FAFSA. Some schools also supplement the FAFSA with PROFILE forms; these forms are mainly used by costly private schools to differentiate need among financial aid applicants. States have their own financial aid programs, so apply to these programs as well if your child plans to attend an in-state college.

The data you supply through student aid forms is run through a financial needs analysis, a standard methodology approved by the U.S. Congress. The analysis calculates how much money you, as the parent(s), and your child, as the student, are expected to contribute toward educational expenses. Even if the needs analysis determines that you don’t qualify for needs-based financial aid, you may still have access to loans that are not based on need. So be sure you apply for financial aid.

Paying for educational costs

Although you may not have children yet or your children may be young, you’ve probably started thinking about how you’re going to pay for their college expenses. College can cost a lot. The total costs, including tuition, fees, books, supplies, room, board, and transportation, vary substantially from school to school. The total average annual cost is running around $55,000 per year at private colleges and around $27,000 (in-state rate) at public colleges. Figuring out how you’re going to pay these expenses can be overwhelming.

You should generally put as much money as possible in your retirement accounts. If you have money left over after taking advantage of retirement accounts, try to save for your children’s college costs. Save in your name unless you know you aren’t going to apply for financial aid, including those loans that are available regardless of your economic situation.

Be realistic about what you can afford for college expenses given your other financial goals. Being able to personally pay 100 percent of the cost of a college education, especially at a four-year private college, is a luxury of the affluent. If you’re not a high-income earner, consider trying to save enough to pay a third or, at most, half of the cost. You can make up the balance through a wide variety of means, such as the following:

• Loans: A host of financial aid programs, including a number of loan programs, allow you to borrow at reasonable interest rates. Federal government educational loans have variable interest rates, which means that the interest rate you’re charged floats, or varies, with the overall level of interest rates. The rates are also capped so the rate can never exceed several percent more than the initial rate on the loan.

  A number of loan programs, such as unsubsidized Stafford Loans and Parent Loans for Undergraduate Students (PLUS), are available even when your family is not deemed financially needy. Only subsidized Stafford Loans, on which the federal government pays the interest that accumulates while the student is still in school, are limited to students deemed financially needy. For more information about these loan programs, call the Federal Student Aid Information Center at 800-433-3243 or visit its website at www.studentaid.ed.gov.

• Grants: In addition to loans, a number of grant programs are available through schools, the government, and independent sources. You can apply for federal government grants via the FAFSA. Grants available through state government programs may require a separate application. Specific colleges and other private organizations (for example, employers, banks, credit unions, and community groups) also offer grants and scholarships.
• Your home’s equity: If you’re a homeowner, you may be able to borrow against the equity (market value less the outstanding mortgage loan) in your property. This option is useful because you can borrow against your home at a reasonable interest rate, and the interest is generally tax-deductible. Some company retirement plans, such as 401(k)s, allow borrowing as well.
• IRAs: Parents may make penalty-free withdrawals from individual retirement accounts if the funds are used for college expenses. Although you won’t be charged an early-withdrawal penalty, the IRS (and most states) will treat the amount withdrawn as taxable income. On top of that, the financial aid office will look at your beefed-up income and assume that you don’t need as much financial aid. (You can make qualified withdrawals from Roth IRAs and not be taxed.)
• Your child’s employment: Your child can work during the summer and save that money for educational expenses. On campus work-study jobs are another possibility. Besides giving your child a stake in his own future, this training encourages sound personal financial management.