When prospective financial planning clients stop in, I can nearly always find a few simple things they can do quickly to earn more money. It's not that I'm a genius. It's just that a powerful force has paralyzed them — and probably you, too: inertia.
Many of us have a tendency to keep our savings and investments in the same places for years, even if better alternatives now pay more or cost less. By picking some low-hanging fruit, you’ll amass thousands of dollars more regardless of which way the stock market is traveling. And once you take these four smart steps, you can harness the power of inertia to let the moves you’ve made keep building wealth for you, year after year.
1. Make Your Cash Work Harder
- Time needed: 20 minutes to open the account
It’s critically important to have easy access to cash for emergencies; setting aside the equivalent of three to six months of living expenses is a good rule of thumb. Where you park that emergency savings is important as well, especially these days, when the largest money market mutual funds are paying a puny 0.21 percent or less. Yet plenty of federally insured bank money market and savings accounts pay seven times that rate. For example, Ally Bank of Philadelphia (formerly known as GMAC Bank) has a 1.55 percent money market account with no minimum investment and Zion’s Bank of Salt Lake City has one paying 1.35 percent ($1,000 minimum).
The differences between the lower- and higher-yield moneymarket account rates might not seem like much. But moving $100,000 from a 0.2 percent money fund to Ally Bank would pay you $1,350 in a year. That’s $112 a month for 20 minutes of work.
You can also use short-term federally insured bank CDs to pick up even higher rates, though you’ll pay an early withdrawal penalty if you cash in before they mature. Look for high-paying accounts online at Bank Deals; the site recently listed six-month to two-year CDs yielding 2.25 percent to 2.60 percent.
2. Swap Your Index Fund
- Time needed: 15 minutes, once you’ve identified the right fund
Why do high-cost index funds and their exchange-traded fund (ETF) cousins even exist?
The whole point of owning an index fund or ETF is to replicate the market (or a piece of it), without paying a steep fee for a fund manager. Yet some index funds charge far more than others for essentially the same service. Replacing a pricey fund or ETF with a less-expensive one will let you keep more of what you earn — maybe much more. Cutting a fund’s expenses by 1 percent will save you $1,000 a year for each $100,000 you invest.
If you invested in the Rydex S&P 500 fund (RYSYX), with its 2.28 percent expense ratio, for example, you’d be practically guaranteed a lower return than if you bought a low-cost S&P 500 fund such as Fidelity’s Spartan 500 Index Fund Investor (FSMKX), with its 0.10 percent expense ratio. It’s like making a left turn into the gas station with $6-a-gallon gas, when the one on the right has the same gas for two bucks.
Stick with broad index funds and ETFs from the lowest-cost families such as Vanguard, Fidelity, iShares, and State Street. The broadest U.S. stock fund is a total stock index fund; look for one with an expense ratio of 0.10 percent or less. You won’t owe capital gains taxes if you switch from one index fund or ETF to another inside a tax-sheltered account such as a 401(k) or IRA.Otherwise, if you’ll trigger capital gains after selling one index fund and buying a cheaper one, talk with your tax adviser before making the switch. On the other hand, if you have a loss, so much the better, because the change might let you harvest the tax loss —meaning you sell the position, realize the loss, and buy the new fund. You can also lower your investment costs by replacing your expensive actively managed fund with a low-cost index fund, although there is no guarantee that the index will outperform the manager.
3. Pay Off Expensive Debt
- Time needed: 20 minutes
With today’s meager interest rates on savings, it makes no sense mathematically to pay rates of 6 percent or more on interest that you can’t deduct on your taxes. So, pay off non-deductible, high-cost debt, such as credit card balances and car loans, as soon as possible. Then, run the numbers to see if paying off your mortgage early makes sense. Don’t try convincing yourself that you’ll be earning enough in the stock market to cover the high-cost interest. Instead, compare your debts with your lower-risk fixed-income investments.
4. Cut Your Taxes
- Time needed: About an hour
You know the importance of asset allocation, of course, but you might not know that managing the location of your assets to lower your taxes is nearly as important. Some types of investments are better off in taxable accounts, whereas others belong in tax-deferred IRAs and 401(k)s. Finding the right tax homes guarantees you a greater return, regardless of the market’s gyrations. Here’s how to do it:
First, set your overall risk level — perhaps an asset allocation of 60 percent in stocks and 40 percent in fixed-income investments.
Then, because interest and dividends are taxed at higher rates than capital gains, hold your fixed-income investments (bonds and CDs) in your tax-deferred accounts and your tax-efficient equities (stocks and low-turnover equity funds) in your taxable accounts. Funds with high turnover and, therefore, frequent distributions also belong in tax-deferred accounts.
Here’s an example of why this strategy can pay off handsomely: Say you’re in the 28 percent tax bracket and want to invest $200,000, half in bonds and CDs and half in stock. (For argument’s sake, we’ll assume your equities return 8 percent annually and fixed income 6 percent.) If you put the bonds and CDs in taxable accounts and equities in your IRA, after 20 years you’d have $568,000 after taxes. But if you flipped those locations (as you should), you’d have $609,000, or $51,000 more.
Yet many people — even the CPAs I teach — tend to get it backward: They put their stocks in IRAs and 401(k)s and their bonds and CDs in taxable accounts. That’s because investors often think of tax-deferred accounts as the place for their long-term money (stocks) and taxable accounts as homes for short-term holdings (bonds and CDs). But remember: the IRS taxes us based on our asset location. So, once you’ve amassed enough cash for emergencies, arrange the rest of your assets to lower your taxes.
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