Help a Reader: What to Do with $250k

Here's an email I recently received from a reader:

My spouse and I are 38 yrs old and make about $250K-300K per year.  We are very, very fortunate!  Have two kids under age 5.

Here is our situation:

• We max out 401(k)s (currently have about $700K in non-taxable savings for retirement)
• Can't fund a Roth (although we have about $40K in them from when we could)
• We save about $5K a year in 529s amongst both kids (I fund the 529s enough to take full advantage of the state tax credit for IN)
• Our only debt is a $285K mortgage at 4.5% for 30 years
• We have a brokerage account with $45K invested amongst 3 long term stock holdings (KO, GE, and AAPL)
• We have $255K sitting in a savings account- you could call this our emergency fund, but it's getting a little to big.  We both have very stable jobs in the health-care industry, so one year of funds is a little much I think.

We have been very fortunate and diligent to amass this amount of savings.  I would like some advice on what to do with the $255K in savings that we have.  My risk tolerance could be considered moderate, but I'm reluctant right now to put money into stocks with the market at 5 year highs (though I have made about $10K trading with some of this money over the past two years).  Bonds make me a little nervous right now with interest rates left to go nowhere but up. 

The savings account earns a measly 0.4%.  If we were closer to the kids going to college or retirement, then I wouldn't be too worried- but we have a lot of time for this money to grow before we need it! 

Any ideas out there on how your readers would put this money to work (if at all) if they were in our situation?

What's your advice for him?

Comments

[My Financial Independence Journey]

I would start slowly moving it into dividend growth stocks so that I can build up my passive income streams. This is my strategy. The market is at highs, but there are still good buys out there if you're willing to do the research. And no one says you have to invest all of it at once. Maybe a few thousand a month.

Other people would suggest getting into rental property as a way to generate passive income.

Outside of your question about the 225K, I would also consider refinancing your mortgage.

[JAM]

My wife and I were in a very similiar situation in 2006. We ended up paying off the mortgage and we've been debt free since. With no mortgage payment we were able to quickly "re-save" a significant savings account and now, 6.5 years later, we're discussing early retirement. No regrets at all with paying the mortgage off.

I know you're a bit short of being able to do that, but it shouldn't take long to get there with your income. Look at it this way: if your house was paid for, would you borrow $285k against it to buy stocks or bonds? Most would say, "No."

[Mrs. Pop @ Planting Our Pennies]

I'd consider paying off most of the mortgage. Or if they're not comfortable with that, then at least refinancing into a lower rate, and then investing a good chunk of the $250K in index funds. Those would still be highly liquid, and your "emergency fund" is big enough that you could take the swings of the market and still have enough to pull out if you did hit a true emergency and need access.

[Julio R. González]

Just pay off the mortgage. That's a guaranteed 4.5% return on your cash vs your current 0.4%. Which is a 1025% better. Just pay it. Also there's savings accounts out there that pay 1%.

[Ross]

If you don't want to pay off the mortgage early, what about buying an income property or investing some of it in peer to peer lending (riskier, ill admit).

[elb]

Split between short / intermediate / long term muni funds (40% / 40% / 20%). Even at the most volatile, bond funds don't move that much historically, so you are not at real risk for loss of capital. Plus, if you re-invest the interest income, you'll be able to take advantage of bond prices as they drop, if they do.

And of course, the tax advantages are significant.

[MrAtoZ]

You can split the difference among these suggestions by refinancing your mortgage into a 15 year (or even 10 year) term, bringing some of that money to the table so you end up financing, say, a new loan of $100k for 15 years. That would leave you $75k or so to invest in either stocks or bonds.

[John S @ Frugal Rules]

That is quite the situation to be in. :) As they're averaging roughly $25k/month on the high end in terms of income I would pare down the E-Fund to $150k to cover for six months of expenses. They could go either way with the remaining $100k. They could knock just over 1/3 off of their mortgage or they could start putting the money into either index funds or solid dividend paying stocks. I think it comes down to what their main goal is...do they want to be free of the mortgage debt, or grow their income.

[doug]

How would you like to earn 4.5% in an absolutely risk free investment? Pay off your mortgage!!! Whol cares about the loss of the tax deduction on the interest you currently pay. Think about it. Right now you pay #100 to the bank in interest so that you can get back $30 from the governmnet in the form of a tax refund. How about send $285k to the bank and pay no interest ever again.

When you start to rethink how you invest, check out the "couch potato" strategy. Google "couch potato" for more information

[Jim B.]

Do not pay off the mortgage! With the Fed. pumping $85 billion into the economy every month, inflation is inevitable. Paying back a 30 year lone with future dollars that are nearly worthless will be a good thing.

As inflation appears, bond prices will fall as yields increase. Once this occurs, I would slowly purchase bonds using a layering strategy (Do not use bond funds since their prices will continue to fall as interest rates begin a steady, long climb back to normalcy). Stocks will plummet once the Fed stops pumping the economy and people realize that the future earnings of stocks can't possibly support their bloated price. Also, people will flee stocks and move into bonds once bond yields begin to rise because the majority of people with stocks are old and looking to retire and many others are in the market because they can't get a return anywhere else. Also, many will sell stocks for CDs once yields increase.

Buying and owning more real estate would be good, but that takes active management on your part and with two small kids and two high paying careers to manage, you need time for your family.

I am happy sitting on my large sum of cash making no money and losing value because once government stops pumping the economy and has to raise taxes again to pay for our debt - cash will be king and many opportunities will become available to those who sat this period out.

In summary, leave the loan as protection against inflation; make sure you are continuing to invest in your own careers because your salaries are your biggest drivers of growth - more so than any rate of return on investments; Sit on cash because the market has been severely distorted by Bush and Obama and a huge correction is inevitable.

[TL]

My wife and I are in nearly the exact situation, except just a couple years younger and about half of your emergency fund.

Couple things I've recently done is using an HSA with a high-deductible plan. If your family is reasonably healthy, the tax bracket you're in it makes sense. I put in the full $6450 a year and don't use it for expenses. I treat it like a Roth, which I plan to use tax-free for medical expenses during early retirement. I was worried about doing this with two little kids, but going on two years it has not been an issue. And by the size of your emergency fund, I don't think you'd have a problem either.

Also, just re-financed to a 15yr at 2.875%, with the exact same balance as you have. I like the idea of paying off the mortage completely, but I also like the idea of having the liquidity to do things like buy cabins, rentals, etc. with my own personal HELOC. I'm essentially putting my extra savings a month into an account with short and intermediate muni bonds (funds). To date it has easily outperformed the tax-adjusted mortgage rate of around 2%. I'm past the break-even point of the refi, and maybe someday I'll take the savings and pay it off completely. Especially if our situation changes, or the markets dictate.

Another note on investing in this time period. I don't think anyone has a cyrstal ball, but unless the fed raises rates in large increments (unlikely), the yield on bonds have historically been enough to cover rate increase effects when the fed has raised rates in the last 3 rate raising cycles. And, rates going up is a good thing long-term for savers. Short-term it is not ideal, but not doomsday like is being portayed by the media.

Don't abandon stocks, but instead dollar cost average and don't worry about every short term move. Unless you've got the time, timing the market is a risky bet.

I'm keeping an eye on these comments, and am interested in what others are going to recommend.

TL

[Jane Savers @ The Money Puzzle]

As long as you have life insurance I would drop the savings account to an amount equal to a 3 month emergency fund.

I would put another 5 months worth of emergency money in a laddered GIC or CD if you Americans have that.

Then I would attack your mortgage with the rest. Your banking system is very different than here in Canada so I don't know if it would be less expensive to renegotiate the terms of your mortgage so that your monthly payments are higher with a shorter ammortization period or if you can make extra lump sum payments.

Paying your mortgage off will give you freedom in your life.

[JY]

Put 200k into the mortgage and save the rest as a cash emergency fund. That's what I'd do. You can't know what will happen in the future no matter what anyone tells you! However you do know you have a debt that you need to service and that will be a millstone until you pay it off. Once you retire the mortgage in a few years you can rebuild that cash cushion rapidly.

[Young Limey]

You can still fund a Roth

http://www.forbes.com/sites/ashleaebeling/2012/01/20/the-serial-backdoor-roth-a-tax-free-retirement-kitty/

[Anige]

I echo the pay off the mortgage sentiments. Also I would assess your current situation in terms of big ticket items - are you going to need new cars, appliances, roof or other such major items in the next couple years. If so, the 250K isn't entirely and emergency fund. Evaluate what those needs will be and then pay off the mortgage.

[savvy]

First thing to do would be to 'backdoor' a Roth IRA for 2012 and 2013. That's $21K off the top.

After that, I would refi the mortgage into a 10 or 15 yr fixed rate loan. 4.5% is way too much to be paying these days.

Move one year of living expenses to an online savings account like Ally (0.9% APR right now).

Only then, think about other investing. If retirement savings are a concern, check to see if your 401k allows after-tax contributions (not the same as a Roth 401k). If so, this allows you to backdoor even more money into your Roth IRA.

[M]

Couple of thoughts that echo prior comments:

The first thing to consider is that you need a asset allocation and investment process/strategy that includes cash. Once you have that, if you are executing to that strategy, it will prevent you from waking up one day with such a large deviation to your objective.

The second comment is about what to do now. We are in similar situation, and I've personally found that paying off the mortgage was correct for us. To me, I'm sort of simplistic: once you have significant liquidity I don't think it makes math sense to have a loan (mortgage @ 4%) and being a loaner (buying bonds @ 2%) concurrently.

[MoneyStreetSmart]

While I agree paying off your mortgage will give you freedom, it may not be the smartest move (if looking to increase long term savings). Depending entirely on your situation/what gives you peace of mind, another property could be a great, long term secondary income stream. Perhaps in a city where your kids may go to post-secondary (if you can plan that far ahead) and by then they could live rent-free. Just a thought.

[Mike Hunt]

I'd probably look to paying off the mortgage and also keep an eye on slowly buying some dividend or value based stocks. Move slowly, realize you have very good cash flow coming in and don't over commit.

Also note that when you have a high savings rate your net worth increase by saving is guaranteed and far outperforms investment growth, so need to put your hard earned capital at risk.

I have followed this plan and have times of having literally millions of dollars in cash across many accounts. Long term it a lost opportunity if you keep it this way but you can also leg into something slowly as long as you feel comfortable doing so.

In this period I am starting to sell and move into cash once again. I have no crystal ball but like to buy low and sell high, and if the market keeps rising I won't be kicking myself since I am happy with the gains made thus far.

I have found that being too greedy never pays off.

As always, your mileage may vary.

-Mike

[JayB]

I prefer to own stuff outright, so I would put a lot down on the mortgage. If you feel like having cash is something that will be advantageous in the near future, then you might as well just sit tight. If the money is just burning a hole in your pocket and you want to have low to moderate risk, you could purchase collectors items or commodities and hope they gain value or at least hold their value. When the time is right, sell them. It might take that feeling of having to do something with money away even if you only do this with a few thousand dollars. Sounds like financially, no matter what you do, your going to be fine.

[Mike Hunt]

Sorry, let me clean up my typos in the note above:

I'd probably look to paying off the mortgage and also keep an eye on slowly buying some dividend or value based stocks. Move slowly, realize you have very good cash flow coming in and don't over commit. As your mortgage disappears your cash flow improves dramatically and you also don't need as much of an emergency fund. When you are cash flowing strongly you are under less pressure to maximize your investment returns like you would be if you borrowed from your house to fund a better return investment, that is a good thing in my opinion.

Also note that when you have a high savings rate your net worth increase by saving is guaranteed and far outperforms investment growth, so no need to put your hard earned capital at risk.

I have followed this plan and have had times of literally having millions of dollars in cash across many accounts. Long term this is certainly a lost opportunity and bad strategy but if you are only doing this for a short time it shouldn't be a problem. You can also leg into something slowly as long as you feel comfortable doing so.

In this period I am starting to sell and move into cash once again. I have no crystal ball but like to buy low and sell high, and if the market keeps rising I won't be kicking myself since I am happy with the gains made thus far.

I have found that being too greedy never pays off.

As always, your mileage may vary.

-Mike

[Jake]

I'll assume a joint return, you aren't underwater on your house and the high end of your earned income above.

At 300k of AGI you are sitting at the 33% tax bracket. In 2013 you will pay 74.8K of taxes on 300k of AGI giving you a 25% effective tax rate. Since your 30 year mortgage is at 4.5%, this is "effectively" reduced to 3.375% (I say "effectively" because most of the interest is paid on the front end of a mortgage so the deduction may be a little higher in the earlier years).

Can you beat the 3.375% "return" you are getting on the mortgage in the market? Probably yes, but with higher risk.

Would you borrow money against the house at 3.375% to put it in the savings account at .3% (.4% taxable reduced by your 25% effective rate)? That is a spread of around 3%, which is pretty cheap money. So not a bad deal to have 250k sitting around with easy access to it.

If it were me, I would refinance the mortgage to a 15 year. Rates are low. The 10 year treasury broke 2% so at some point they will go up. Your profile screams great credit. You certainly have the flow to do it.

Set aside 6 - 12 months of expenses in savings.

Park the rest in a brokerage account that aligns with your risk profile. Allocate assets accordingly.

If you are super conservative or want to retire early, by all means go ahead and pay off the mortgage. It is more psychological than mathematical.

[Roger @ The Chicago Financial Planner]

At the risk of sounding self-serving it sounds like you are at a point financially in life where you should sit down with a qualified fee-only (NOT fee-based) financial planner and get a financial plan in place. You can clearly afford the fee, why not get a review and an assessment from a detached 3rd party professional vs. a lot of one-off suggestions?

[jim]

I would increase college savings for the kids. You can dump some cash in the 529 now and let it grow plus increase contributions moving forward.
$5k a year for 2 kids is really not enough to cover the costs. Right now a private college can total $240k for 4 years and many students take 5 years. Figure $600k total for 2 kids. Plus that will increase substantially by the time your kids hit college age. If you figure on public school you could cut that in half. I'd double or quadruple the $5k you're saving now. You won't be getting financial aid so you ought to figure on saving a lot.

I'd also refinance that mortgage. 4.5% is relatively high and you can fairly easily get 3.5% or a 15 year for 2.7%.

[jim]

I'd also agree with Roger. You've got the income and asset levels to justify paying a professional to give you solid advice. I'd consult with a fee only financial planner and a tax lawyer. Probably good to talk to someone who handles estate planning too to make sure your wills / trusts are squared away.

[Rich Guy]

PAY OFF THE HOUSE!

[AKS]

I am in same boat in health care industry $350K+/year.

Assuming you want your kids to follow your footsteps in education I would increase your college savings for them to a comfortable level and try to obtain tax credits in your state or invest in low cost 529/brokerage plans out of your state. we currently save 1k per kids per month.

Also refinance to 15year sub 3% mortgage. We chose not to pay ours off as its cheap money and any deductions in our tax bracket help. Also i can make way more than 3% investing.

Backdoor your roth IRA by you and your spouse putting in $5500 this year to a non deductible ira and in december converting to roth.

Dollar cost avg into a brokerage account either by you or an advisor using index funds. Use this account for kids, retirement, or just overall wealth accumulation.

This will cut your Emergency fund up and then start an auto fund and a vacation fund and even a house fund (for appliances repairs etc) . We use this to split up our cash on hand to keep life simple as the kids will slowly suck it out of you.

Maximize for your retirement as much as possible - make sure your getting max match and profit sharing etc and consider a Roth 401K also although may not be right for some.

Careful with an adviser and stay away from annuities and life insurance products.

Dont go crazy trying to amass a fortune. You already have good sense saving and will be fine long term.
Good luck in your jobs. these are your peak earning years-but dont burn out. Stop and smell the roses, stay/keep healthy and spend as much time with family as you can. Those little liabilities grow up way to fast! Good Luck!

[JimL]

I agree with Mike Hunt. Pay off the mortgage and the buy dividend/growth stocks.

[Matt]

Paying off a house is liberating.
No mortgage, no interest on a loan which means no tax deduction. Check you tax situation so you don't get caught oweing too much tax if you do.

So If you don't want to pay off the house refi to a 15 or even 10 year mortgage but put some of the money down and get rid of the 4.5% loan. My credit union has a 15 year loan at 3%. You pay your house off earlier, you keep a little cash to invest or put into the 529.

I paid off a 15 year loan in 9 1/2 year just by adding to the principle when I felt like it.

[Mert]

The markets are not at an extremely high point as shown from P/E ratios presented here:
http://online.wsj.com/mdc/public/page/2_3021-peyield.html

Therefore I would keep $50k as emergency fund, put $100k on a couple of index funds on relatively low prices i.e. sub-indexes trailing S&P500 or DOW behind (see Marotta's web site for diversification strategy), and put the remaining $100k on mortgage, followed by a refinance for 15 yrs so you will have more or less the same payments as now.

[[email protected]]

This is probably one of the most fun parts for me, as I've worked in a private equity group and majored in financial analysis and valuation. Here's what I'd do:

You have three options for your mortgage:
A) If you feel comfortable actually investing your savings and cash rather than have it sit in the bank earning next to nothing, than refinance your mortgage and get a ~3% mortgage. This is because, instead of paying off your mortgage, effectively getting a 4.5% return on your cash, you can find opportunities in the stock market that return 10%+ (the S&P returned 16% in 2012), and you will earn a greater return.
B) If you don't want to invest in the market, then pay off your mortgage and get your 4.5% return rather than the measly .4% you currently get.
C) A blend of both. Refinance, if you want to, but accelerate payments while investing additional discretionary income into the market.

For your children's education, continue to put away money, but watch out with 529s. 100% of assets under a child's name are counted directly towards tuition costs, while only 12-15% of a parent's assets count. This can help with future financial aid from both the government (subsidized Stafford loans) and need-based scholarships from schools. However, with your income, you won't likely qualify for any assistance, so make sure those kids work hard in school and get academic scholarships =)

For investing strategies, you have a few options and I'll make them short and sweet, or this comment could turn out as long as the post.

A) Wait for the budget talks to create a pullback (~3-5%), and then buy. Some individuals have described dividend stocks as their strategy - you do what makes you comfortable. You can stick to passive or managed mutual funds (Vanguard vs. Fidelity), individual stocks, or a combination of both. I personally am looking at KMI/KMP, KO, GE, QCOM, AAPL, CHL, JPM, BAC, GE, etc. All these are among best in breed and think you'd do well holding for the long-term. Allocate your assets as you see fit - there is no need to put 100% of your savings or investments in the stock market. However, as anyone will tell you, consult a financial or investment adviser. =)

B) Take a portion of your savings and open a high-yield online bank account to get that 1% yield. Discover, Ally Bank, etc. You can find that information anywhere. Maybe $50K there - benefits of accessibility and liquidity with a higher yield than a 12 month CD or checking/saving account at a commercial bank.

C) Not sure about the real estate industry in your state, but rental properties at discounts with high cap rights >8% are good. Beware - properties with a ton of maintenance and unruly tenants can be a headache. Again, it is what you are comfortable taking on.

Just remember - this is all generic information. I don't know the exact details of your spending, investment strategy, long-term financial goals, etc. Anything you do, research it like crazy and analyze every angle. If the upside exceeds the downside, then risk-adjusted, go for it.

However, you don't need to make huge changes or try to hit a home run. You make great money and will probably continue to increase your earnings as you advance in your profession. Unless you want to retire by 45, you easily have another 20 years to work, and can save up $4-5M just by putting money aside and taking on conservative investments. Just by doing what you are doing, you'll likely have a comfortable retirement. The rest is up to you! Good luck! =)

[soners]

Pay off the mortgage then dollar cost average into dividend funds.

[Strick]

"If we were closer to ... retirement, then I wouldn't be too worried." One of you (or both) are close to retirement if you want to be....just wanted to throw that out there...

[John]

The best thing you can do is identify where you want to be in the future, and work backwards. How much money do you want to give? How much money would you like to save? How much interest would you like to pull from your investments each year?

Once you figure those things out, all you have to do is the calculations. Remember: Start with your goals, then work backwards.

[jnew]

First:

I agree with many of the posters that you should refi the mortgage right now. Go with the 15 year amortization and don't be afraid to put a little of that e-fund into it (pay it down a bit) if needed to keep the payment at a comfortable level. I think you will get a rate below 3%. It will be paid off just in time for you to tackle the college tuition bills for the kids. In the meantime you'll keep a small interest deduction, have the loan in place as an inflation hedge and you will be paying a much larger percentage of each payment to principal (vs the 30 year loan you have now) rather than interest. Think of this as another avenue of "forced" savings that incrases your net worth by lowering you debt each month.

2nd:

Keep about 6-8 months of your average monthly expenses (not your gross salary)in an emergency fund. This needs to be a stable investment that is liquid, but you do not need to keep in in the bank at .04%. Consider CD's, or TIPS or a ultra short term bonds. I use 8 months.

3rd

If you want to pay your kids tuition in full for them-- you need to step up the college savings. If that is not a goal for you skip this paragraph. Saving $5000/ year for 2 kids will not cut it. So give this a bit of thought. In todays dollars-- you will need $40Kx4yrs for a private school (($160,000 x 2 kids=$320,000)) and $25Kx4yrs for in-state public college ($100,000 x2 kids= $200,000). So between $200-320K. You have about 13 years till kid #1 goes off to college-- so divide by 13 years. On the high end you need to save $24,615/year and on the low end you need to save $15,384/year. Looks impossible right? Just do what you can-- you can use current income to offset the deficit. And school loans too if needed. But the more you save today the better it will be when the tuition bills start rolling in.

4th

So now we get to the remainder of your investable assets.
I think the most logical thing to do is to start with some serious thought on the allocation. Many people, including me, think that the allocation has more to do with the returns you achieve than the particular stocks or funds you choose. You said your risk tolerance is moderate. So lets use that as the basis to propose an allocation of 60% stocks and 40% bonds. So now that we have an allocation-- how do we choose the assets? Well- I am an advocate of index funds. Most people try to "beat" the index-- and most fail. Achieving the "index" return year in and year out will put you ahead of most investors without much fuss. From there I would make sure to use Vanguard index funds or another with fees that compete. Their expense ratios are among the lowest in the industry. That means more money in your pocket. Finally I would keep it simple. Start off with 60% Vanguard "total stock index"-- it covers the entire US market (lg caps , mids, small caps). And 40% in Vanguard total bond index. Same theory here as the stock index-- as it covers all corporate, government bonds all in one place.

This is a great way to start. Dollar cost average your money into these two funds per the allocation ratio you determine is right for you. This is the core of a fantastic portfolio.

Finally-- Take some time to increase your financial education. Read everything you can. Take an interest-- If you are a beginner, watch Suzy Orman and buy investing for "dummies". You would be amazed how these "silly" suggestions might make you a more informed and wiser investor. No one cares more about your money than you do. Become a knowlegeable investor.

As you learn more and become more confident you can expand your portfolio to include a bit of foreign stock exposure ( a good thing in small doses) and maybe a bit of Real Estate ( also a good thing in small doses). But there is time for this..... you will do just fine with your "core" portfolio for the first few years. Someone else said google the couch potato portfolio. Its a good idea. Google "simple index portfolios" while you are at it.

Last-- watch your net worth like a hawk-- all financial decisions should be made with the answer to one question. How does it affect my net worth? Always strive to increase your net worth and you will be fine. Increase your assets and lower your liabilities. THAT is the key to becoming a millionaire. Oh, and live below your means. That also is central to your success..

Good luck!

[James]

Timescales are the most important thing to consider when deciding what to do with your savings. With two children under 5 and both yourself and your wife earnings good salaries in a stable industry, long-term planning rather than any quick profit would be the advice.

You mention your reticence in investing in the stock market currently with the 5 year high, but if you're willing to invest for the long-term in a reputable and diversified fund, your moderate risk tolerance will be satisfied.

Be wary of changing your plans to more short-term or even medium-term thinking with this strategy though.