Should I Invest Extra Money or Pay Down My Mortgage?

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I answer a question from a listener named Maya, who says:

“Hi, Laura, I love the podcast! My husband and I are in our mid-thirties with a dual household income of $175,000 and two kids under three, which means a considerable daycare expense. Our mortgage balance is $120,000 at 7% interest, but we have no auto loans or credit card debt. 

We have emergency money in high-yield savings for three to six months. I max out a Roth IRA annually and contribute enough to get my 401(k) match at work. My husband has a state-funded pension plan. 

If we have extra money in our budget, should we invest it for mid-term goals and retirement or pay down our 7% mortgage, which I’ve heard some define as a high-rate debt?”

Thanks for your great question, Maya, and congratulations to you and your husband for doing a great job with your finances! This post will review how to prioritize any extra money you’re fortunate to receive. Whether you get a raise, receive a cash gift or inheritance, or cut expenses, it’s a terrific opportunity to strengthen your financial security.

Is it better to invest or pay down a mortgage?

If you have extra money, a common question is whether to invest it or use it to pay down debt, including a mortgage. While I’m a huge proponent of keeping low debt levels, there are times when investing is better for building wealth faster.  

Before making significant investing decisions, take a holistic view of your finances and consider what you want to accomplish with your precious resources. Otherwise, you aren’t likely to make decisions that move you toward your financial goals.

For instance, you may want to throw an extravagant wedding, put your kids through college, start a business, or purchase additional life insurance. Only you know the answers. Based on your current financial situation and goals, here are nine tips for using your extra cash wisely.


1. Boost your emergency savings.


When you’re fortunate enough to have extra money, cover the basics with a healthy emergency fund. How much you need depends on your income, expenses, debt payments, and goals. However, a good rule of thumb is to keep at least three to six months of living expenses on hand, which is what Maya has, so she’s in great shape!

If accumulating that much seems out of reach, start with a small goal, like saving $500, then $1,000, until you have at least one month’s worth of security, and build from there. Even a small cash reserve is better than nothing.

Saving, not investing, is the right move for reaching short-term goals, like maintaining emergency funds, taking a vacation, or buying a car in the next few years. While you won’t earn as much compared to investing, you can rest easy knowing your cash will be there, plus interest, when needed. 

2. Review your insurance needs.


Another essential way to prepare for the unexpected and prevent risks is to have various insurance policies, such as health, life, disability, auto, and homeowners’ or renters’ policies. Being uninsured or underinsured means that a disaster, theft, or accident could wipe out everything you’ve worked hard for and jeopardize your financial future. 

I recommend that Maya review her insurance and fill any coverage gaps with extra cash before prepaying a mortgage or investing. She mentioned having small children, which means she and her husband should have life insurance policies to protect their financial futures. 

Even if you get life and disability coverage through work, it may not be enough to protect your family. Plus, if you leave your job for any reason, those policies typically end immediately or by the end of the same month.

3. Pay off dangerous debts.


After you use extra money to prepare for the unexpected, pay attention to any dangerous, expensive debts. Maya said her mortgage is her only debt, which is fantastic!

If you have more debt than Maya, I recommend listing your outstanding balances and interest rates. Then, sort the list from highest to lowest interest rate and tackle them in that order. But if you have any dangerous debts, like overdue child support or taxes, make those your top financial priority.

For instance, if you have a credit card balance at 24% APR, a car loan at 10% APR, and a mortgage at 7% APR, pay down the card first because it costs you the most interest on a percentage basis. 

Paying off debt gives you a straightforward, guaranteed return. For instance, if you’re carrying card debt charging 24%, paying it off is an immediate 24% return on an after-tax basis. You’d be hard-pressed to find an investment yielding that much. 

However, there is less benefit for prepaying lower-rate, tax-deductible debt, such as a 6% or 7% mortgage. Maya mentioned hearing that debts at that rate are considered high-interest.

The fact is, if you claim the mortgage interest tax deduction on your taxes, it makes a home loan cost less on an after-tax basis, such as around 1% less. So, prepaying lower-rate, tax-deductible debts—such as mortgages, home equity loans, and student loans—is typically unwise because you could get higher returns by investing your money instead.

So, the trick to knowing if you should prepay debt or invest is carefully considering which option will likely give you the highest return over the long run. If you send extra money to relatively low-rate debt instead of investing for compounded returns, it could prevent you from building more wealth.

4. Maximize a workplace retirement account.


Maya mentioned investing enough in her workplace retirement account to get employer matching. I recommend that she put her retirement ahead of her creditors and increase her contributions to at least 10% to 15% of her gross income. 


If you slowly increase your retirement contributions yearly, you’ll max out the account before you know it. And if you do that consistently for decades, you’ll likely have a multimillion-dollar account to spend in retirement!

For 2024, you can contribute up to $23,000 or $30,500 if you’re over 50. That’s in addition to any matching funds your employer may contribute on your behalf.

5. Maximize a self-employed retirement account.


If you’re self-employed, you also have excellent retirement options, such as a Simplified Employee Pension plan known as a SEP-IRA. It allows you to make tax-deductible contributions up to 20% of your net self-employment income. 

For 2024, you can contribute up to $69,000 to a SEP-IRA. However, you can only contribute as much to a SEP-IRA as you earn. 

I use a SEP-IRA because it’s easy to maintain with no annual paperwork. It’s an excellent option for business owners, with or without employees. You can contribute any amount (up to the limit) up to your tax filing deadline for the prior year.

Another great option when you have no full-time employees (except a spouse or business partner) is a solo 401(k). However, you can only fund it through payroll deductions. That means paying yourself a regular salary and calculating and submitting quarterly payroll taxes to the IRS. 

6. Maximize a Roth individual retirement account (IRA).


Maya mentioned maxing out a Roth IRA annually, which is excellent. However, if her workplace retirement plan offers a Roth option, I suggest she max it out first because it has a much higher annual contribution limit. 

As I mentioned, at Maya’s age, she can put up to $23,000 in her workplace retirement plan for 2024. Her IRA contribution limit is just $7,000.

Plus, you can max out a Roth IRA and another retirement plan, such as a 401(k) or a self-employed retirement plan. I’d challenge Maya to max out her Roth at work first and then a Roth IRA annually, boosting the tax-free income she’ll enjoy in retirement. 

7. Maximize a health savings account (HSA).


Another great way to invest extra cash is maxing out an HSA, which is my favorite account because it offers the most tax benefits. However, you must be enrolled in an HSA-eligible, high-deductible health plan to qualify. You can purchase coverage through a group health plan at work or as an individual.

For 2024, you can contribute up to $4,150 to an HSA if you have qualifying insurance for yourself or up to $8,300 for a family plan. Plus, if you’re over age 55, you can contribute an additional $1,000.

8. Fund a 529 college savings plan.


Since Maya has young children, if she wants to pay their education expenses, I’d recommend using a 529 plan to start saving. In addition to paying for college tuition, room and board, books, and computer equipment, recent 529 changes allow you to spend it on younger children. You can use up to $10,000 per year for expenses for students in public or private kindergarten through high school.

While 529 contributions are not tax-deductible, your account’s interest earnings and investment growth are never taxed if you use the funds for qualified expenses. And there are no restrictions on annual income to participate in a 529 plan.

9. Invest in a brokerage.

Once you’ve exhausted tax-advantaged ways to invest your extra money, it’s time to consider investing through a taxable brokerage account.

Your tax rate depends on whether you owe short- or long-term capital gains and your tax bracket. 

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If you’re still conflicted about investing extra money or using it to pay down a home loan, you can always do both. For instance, you could invest half and use half to pay down your mortgage.

This article originally appeared on Quickanddirtytips.com and was syndicated by MediaFeed.org.

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5 Signs You’re Investing Too Much for Retirement

5 Signs You’re Investing Too Much for Retirement

We have two great retirement questions today.

The first comes from Kevin, who says, “My wife and I have loved your podcasts for years and are taking every possible step to build our financial futures. We’re in our early thirties and max out our Roth 401(k)s by contributing 25% of our paychecks. If we struggle to maintain savings for emergencies and a new car, do you think we’re investing too much?”

The second question is from Michael M., who says, “I have been listening for many years, and you deliver good advice in a very understandable way. I have a 401(k) with a former employer, a SEP-IRA from a previous business, a traditional IRA, and an HSA. What tax and penalty changes should I be aware of since I turned the magic age of 59.5 a few weeks ago?”

Thanks for your questions, Kevin and Michael! I love that you both have prioritized investing for retirement, which is the most critical money goal everyone should have.  I’ll answer Kevin’s question by reviewing five signs you may be investing too much. We’ll also cover what Michael should know about rule changes for various tax-advantaged accounts after age 59.5.

While many need help saving enough for retirement, sometimes you could be over-saving, depending on your unique financial goals. In a recent podcast, 5 Steps to Achieve FIRE (Financial Independence Retire Early), I reviewed various methods to consider if you want to retire early. Most require aggressive saving and investing so you can grow a nest egg as fast as possible and then scale back or stop working.

Kevin didn’t mention when he and his wife want to retire or how much they’ve already saved. Since they’ve already developed the habit of regularly investing by their early 30s, I know they’re financially disciplined. However, they may need to step back and take a look at all their financial goals and reallocate enough funds for them.  

Here are five signs that you may be spending too much on retirement compared to other critical financial priorities.

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Kevin mentioned struggling to keep enough cash in the bank for emergencies and his upcoming vehicle purchase. Based on your income and expenses, decide how much you should keep in the bank for unexpected needs, plus planned purchases like a car. 

In general, keeping three to six months’ worth of your living expenses–such as food, housing, healthcare, insurance, and minimum debt payments–in an FDIC-insured, high-interest savings account is wise. For instance, if you spend $4,000 monthly on living expenses, make a goal to keep at least $12,000 in savings. 

Since most investments can fluctuate significantly in the short term, your emergency funds and the money you want to spend in the next year or two should never be invested. Investing means taking some risks with the expectation of future growth; therefore, it’s best for goals you want to achieve in at least three years.

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If you have expensive consumer debt, like credit cards with double-digit interest rates, you may be investing too much for retirement and need to reallocate funds. For instance, you could temporarily increase your debt payments or take out a fixed-rate personal loan to pay off higher-rate unsecured debt. 

The rate and terms a personal loan lender offers usually depend on factors like your income and credit. Remember that even though a personal loan may cut your interest, the shorter your repayment schedule, the higher your monthly payments will be. 

You might move unsecured debt to a new or existing balance transfer credit card with a 0% APR promotion that may last up to 18 months. Every transfer is subject to a fee, such as 3% or 4%, which gets added to your balance.

Once a transfer promotion ends, your interest rate increases and could be very high. Therefore, it works best when you’re sure you can pay off the entire balance before the promotion expires. 

Shop for a balance transfer credit card with the lowest interest, transfer, and annual fees. Choose an offer where you come out ahead, even accounting for the transfer fee.

Jacob Wackerhausen/Istockphoto

One way to make sure your retirement planning is on track is using age-based goals, such as:

  • Save the equivalent of your annual income or salary by 30.
  • Save two times your income by 40.
  • Save four times your income by 50.
  • Save eight times your income by 60.
  • Save ten times your income by your mid-60s.

That’s a rough guideline, and you may need more or less each decade based on your unique goals. Plus, you may have pension income or high expenses to factor into your retirement plans. 

If you’re ahead of typical milestones, you may be investing too much for retirement. For instance, you may be a super saver if you’re in your 30s and have invested two or three times your annual income.

Another point Kevin brought up is whether having lower age-based retirement targets is OK if you invest in an after-tax Roth instead of a pre-tax traditional account. Most benchmarks assume retirees must pay income taxes on withdrawals.

If Kevin and his wife continue investing exclusively in Roth accounts, they’ll have tax-free income in retirement, which is terrific! So, the type of investment account you choose certainly makes a difference in your future retirement income and how quickly you reach your savings goal.

Jacob Wackerhausen/istockphoto

While there’s nothing wrong with aggressive retirement goals, remember to also reward yourself by enjoying your money. Unless Kevin and his wife genuinely want to retire early, investing 25% for retirement is about double my typical recommendation of 10% to 15%.

If you temporarily reduce your retirement contributions, you can build your emergency fund with extra for your next car. Once you achieve those goals, you can increase your retirement contributions. Having a couple of years where you don’t max out your 401(k)s won’t hurt your retirement as long as you regularly contribute a reasonable amount. 

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If you feel stressed about needing more money to reach all your financial goals, you may be investing too much for retirement. If Kevin and his wife reduce their 401(k) contributions by half, they’ll still be putting away a healthy amount for retirement. Again, they can boost their contributions after achieving other goals, like building savings and buying a car. 

If you need help knowing how much to invest based on your financial goals, get guidance from a certified financial planner or CFP. They can help you set realistic goals, choose investments, and know you’re on the path to a comfortable retirement. 

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The second question from Michael M. is about what happens to various tax-advantaged accounts after reaching age 59.5 a few weeks ago. Happy Half Birthday, Michael!

The IRS set age 59.5 as a milestone for retirement planning. It allows you to withdraw from any retirement plan without a 10% penalty. That makes early retirement more attractive for those who saved enough before 60. 

However, withdrawals from a traditional account are subject to ordinary income tax. As I previously mentioned, Roth withdrawals are tax-free. With a Roth IRA, your original contributions are always tax-free, but you must have owned the account for at least five years before your investment earnings are also free of income taxes.  

An in-service rollover is another benefit of turning 59.5 when you have a 401(k). You can transfer some or all your funds from your workplace retirement plan to an IRA if you’re still employed. That gives you more control over your funds and doesn’t prevent you from continuing to make 401(k) contributions if you wish.

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Generally, if you want to retire earlier than 59.5, you can use the rule of 55. It allows you to withdraw funds from a retirement plan with your current employer with no 10% early withdrawal penalty if you leave your job for any reason in or after the year you turn 55. Certain government workers can start even earlier, at age 50. 

Remember that this exception applies to plans with a current but not former employer. You’re never allowed penalty-free withdrawals before 59.5 from retirement plans with an ex-employer. However, transferring retirement funds from an old job to your current 401(k) or 403(b) may be a workaround.

If you do leave your job to start taking withdrawals before age 59.5, you can always return to work later if you wish. In other words, you’re never forced to stay retired if you use the rule of 55. 

Also, note that the rule of 55 doesn’t apply to IRAs. However, you can avoid the 10% early withdrawal penalty if you take distributions as a series of substantially equal periodic payments, known as a SEPP plan. You can begin them at any age and must take payment amounts based on IRS life expectancy tables.

Even though you can take penalty-free distributions after age 59.5, it doesn’t mean you should. The earliest you can claim Social Security retirement benefits is 62. Waiting until your full retirement age or delaying benefits until age 70 means getting a higher monthly payment for life.

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If you retire early, remember that Medicare health insurance benefits don’t begin until 65, so you’ll have to purchase your own policy. Michael mentioned having an HSA, which he can use to pay out-of-pocket healthcare costs tax-free. While you can’t use an HSA to pay insurance premiums, you can use it for Medicare expenses after 65.

In addition, after age 65, you can use HSA funds for any reason. While you must pay ordinary income taxes on funds not used for qualified medical expenses, you skip the account’s hefty 20% early withdrawal penalty.

This article originally appeared on Quickanddirtytips.com and was syndicated by MediaFeed.org.

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