Reader Mail: What’s a Smart Thing to do with My Tax Refund?

Could you give some advice on how to start investing? I’m going to get a few hundred dollars back from the government this tax season and I’d love to make my money work for me, or whatever euphemism Mitt Romney uses for his giant piles of money earning dividends. — J.R.

I started my Roth IRA when I was 19 and have been slowly contributing as I do summer jobs, but because of my extreme laziness I haven’t really gotten around to doing the stock investment part except for fooling around with quick buying and selling. So, am I wasting my time just letting the money sit there? Compound interest, right? Is there an option where someone else does that stock part for me? Or is it okay to just wait until I’m older and less lazy (hopefully!) to do the actual investments? — M.R.

If you’re getting money back from the IRS and want to figure out what to do it besides buy something nice for yourself, congratulations, you’re already on your way to being a person who is smart with money! Before you start thinking about putting your money in a Roth IRA (which is an easy way to start investing for your future), you should make sure to do two things: 1) Pay off your credit card debt if you have any, and 2) Make sure you have an emergency fund in place by setting aside money in a high yield savings account (I recommend Ally Bank). Investing money in an IRA isn’t going to help you if you’re accruing gigantic amounts of credit card interest, so you have to tackle that first. You also want an emergency fund to dip into, you know, in case of an emergency, and your retirement account shouldn’t be it. Make sure you have at least $1,000 for emergencies, though you’ll really want enough to last you at least three months if you were to lose your job. 

Once both those things are taken care of, the thing I would recommend for you to do is to open a Roth IRA because of compound interest. As I mentioned before, even if you were to put $5,000 into a retirement account at 25, forget about it, and never deposit another dime, that money would grow into $109,000 by the time you retired at 65 (based on the account earning you 8 percent each year. The compounded rate of return between 1970 and 2009 was about 10.1 percent). A Roth is also great because you are allowed to withdraw any amount you contribute to it at any time without being penalized. This mean if you do need that money for some reason, you can withdraw that money you put in and not worry about being punished by the IRS. You’re also able to withdraw $10,000 after five years to buy your first home, and that’s pretty awesome.

This next part should also answer the second question: After you open your Roth, you should choose your investments. That link has two starter mutual fund recommendations to begin with, but you can actually pay extra to have someone who works at whatever brokerage you chose to open your IRA (i.e. Fidelity, Vanguard, etc.) to hep advise you on which mutual funds will work the best for your situation. The most common advice is to invest aggressively as you can when you are young (in stocks), and then invest more conservatively as you get older and near your retirement (in bonds). Don’t wait to start investing because even waiting two years can cost you several thousand dollars worth of compound interest. Oh, one last thing: If you are paying someone to help you choose investments, make sure they are getting paid by the hour, or by a fee, and not based on commission, because they may just be telling you to invest in something to get the commission (just ask if they are commission or fee-based).

 

Photo: Flickr/Ethan Bloch

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11 Comments / Post A Comment

VolcanoMouse (#420)

Helpful post! I’m especially pleased to be assured that Ally Bank is legit. I don’t know why, but part of me believes that any wholely-online institution is magical and liable to evaporate like the morning dew, taking my money with it. Irrational!

sony_b (#225)

@VolcanoMouse Ally is a legit bank – it’s actually GMAC rebranded – which actually makes it kind of evil if you’re feeling grouchy about bank shenanigans and the mortgage mess. I’m not saying don’t use it, just beware. :)

jane lane (#281)

@sony_b Yeah, it’s GMAC rebranded with a lower interest rate. My family got all kinds of fucked by all the GM…everything, so I’m not a real big fan even though I still have an Ally account.

@VolcanoMouse Totally thought the same thing about it being magical, but I saw that it’s FDIC insured which made me feel way better.

Megano! (#124)

Best. Image Choice. Ever.

sony_b (#225)

IMHO Vanguard is the best place to start if you’re new to investing. Buying and holding index funds is historically the best way to do it, and Vanguard built a solid reputation on creating no-load funds (which means more of your money is actually invested instead of going to some money manager’s pocket), and they also have their targeted retirement date funds which allow you to pick when you expect to retire (in five year increments, IIRC), and then they will be automatically managed and reallocated to lower risk as you get older. It’s lazy but generally pretty safe and they have a solid reputation.

Mike Dang (#2)

@sony_b Yes, Vanguard is my choice too, and their STAR fund is a highly recommended starter fund.

Given how pathetic interest rates are right now I’m not seeing much point in investing. The price of food has been going up faster than my 403(b) from my last job. Maybe I should buy a few year’s worth of peanut butter instead?

frenz.lo (#455)

OK, timely Roth question: I cashed out a Roth IRA that was about 4.5 years old, in an amount of slightly less than $10,000 to buy my first home last year, but the form I got from my old bank just listed the gross distribution, not a break down of what I’d put in over time and what was interest. When I plugged it into Turbotax, Turbotax listed it as income, so suddenly I owed a lot more than I did with just wages. I filed an extension, because this doesn’t seem right, and I like to put things off. But should I just re-do my taxes in another program, or suck it up and get an accountant, or what? Do I have to call my old bank and demand they break down interest vs. gross distribution, or does this matter?

NeenerNeener (#156)

@frenz.lo
The 1099R for a Roth won’t provide you with the breakdown. But you should be able to figure out what portion of the $10k was from contributions (or the bank should have this info), and any amount above that that was withdrawn is earnings. I don’t think it matters, since you used it to buy a house (distribution needed to be within 120 days of the purchase), so you meet an exception to penalty or tax on the earnings. I don’t use Turbotax, but there should be somewhere to 1.) enter your basis (amount you contributed) in the distribution so that that part is not included in taxable income and 2.) check a box or something about a home being purchased so that no penalty is calculated. If you can’t find it, I’d probably call/im with someone at turbotax rather than switch to another program, as it’s probably just going to give you the same difficulty.

Johanna (#490)

Johanna from Betterment.com here. First up – great article Mike. Hope you don’t mind me chiming in but I came across this post and saw some common themes throughout the article and comments: Investing should be easy, you should be able to invest without a lot of money etc. I thought it might interest the readers of this blog to learn about http://www.betterment.com. It’s smart investing without the hassles: Link it to your checking and set up auto-deposit and you’re immediately invested in a fully diversified portfolio. We take care of all the management for you. We now have Roth and Traditional IRAs too. Happy to answer any questions people have. Thanks, Johanna

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