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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