It’s the season for unexpected windfalls. End-of-year bonuses or a holiday gift can put extra money in your pocket. Combine those dollars with some of your earnings and you might have a modest but decent chunk of change to invest — say, $5,000. Now comes the hard part. How should you invest it?
The answer is keep it simple, with the usual caveats applying: Don’t take a leap of faith on an investment you don’t understand or fritter away the funds on a high-stakes gamble. Stick to the basics, stocks and funds with both the track record and the means to grow.
[See: 7 of the Best Stocks to Buy for 2018.]
Then let your financial goal dictate what you invest in. Ask yourself what you hope to do with this money, says John Anagnos, managing principal and chief investment officer for Aetolia Capital in Greenville, Delaware. Is it a long-term investment, like retirement, or something with a shorter term, like saving for the down payment on a house?
If you expect to need the money in less than a year, you’re better off not investing at all, even in something low risk, as you may pay too much in taxes, says Eric Heckman, president of Heckman Financial & Insurance Services in San Jose, California. For everyone else, though, here’s a good game plan.
Embrace the versatility of a Roth IRA. The $5,000 amount makes any individual retirement account, Roth or traditional, an obvious choice as that sum comes close to the maximum annual contribution allowed in 2017 or 2018 for both types of IRAs — $5,500 ($6,500 if you’re 50 or older). But there are other reasons why the Roth is a compelling savings vehicle.
It’s a great way to put extra money aside, especially if you don’t have any money saved for emergencies or need to beef up your retirement savings outside of a 401(k) plan. Because only after-tax dollars are invested in a Roth, the money is withdrawn tax-free in retirement, making it a great choice for a small investor with a long investment horizon, says William Ryon, co-founder and managing partner of Compass Investment Advisors in Dover, Delaware. Unlike a traditional IRA, Roth IRAs have no required minimum distributions, and you can leave the money to continue growing if you don’t need it for retirement.
[See: The Best ETFs Retirees Can Buy.]
If you need the money before retirement, investors can withdraw contributions from a Roth free of penalties and taxes at any time for any reason. Earnings in a Roth, however, are subjected to a different standard, and tapping them early will mean paying taxes and a 10 percent penalty on the money unless two tests are met. The first is if the money is used for qualifying events such as purchasing your first home, higher education expenses (including tuition, fees, books and supplies) or, in some cases, medical costs. The second test is that the Roth account must have been open for five years.
You are eligible to contribute to a Roth IRA if your modified adjusted gross income is below a certain level. In 2017, eligibility for contributing the full amount to a Roth begins phasing out at $118,000 for single filers and ends at $133,000, when no contributions are allowed. For married couples filing jointly, the income threshold for phased-out contributions begins at $186,000 and ends at $196,000.
Build out your portfolio. If your income prohibits you from contributing to a Roth or you simply want unrestricted access to the money, invest the $5,000 in stocks using a taxable account. You may find it easier to diversify by investing the money in equity mutual funds or exchange-traded funds rather than directly in stocks.
Whether you hold stocks directly or not, aim for “a classic level of diversification,” Ryon says. That means investing the money equally among large-cap growth stocks, large-cap value stocks, small-cap growth stocks and small-cap value stocks, with each category constituting 25 percent of the $5,000.
Although you will probably never make a killing with this strategy, you’ll also likely not get killed either, Ryon says, because this broad diversification will help even a small amount of money perform efficiently.
The same strategy can be used for exchange-traded funds. Ryon says a small investor could invest equal percentages in SPDR Portfolio S&P 500 Growth ETF (ticker: SPYG), SPDR Portfolio S&P 500 Value ETF ( SPYV), Vanguard Small-Cap Growth ETF ( VBK) and Vanguard Small-Cap Value ETF ( VBR). “ETFs are the more appropriate tax efficient vehicle for a small lump sum,” Anagnos says. “It gets more complicated with larger assets.”
Invest the money all at once. No matter where you invest, whether in a Roth or a taxable account, most experts recommend investing the entire $5,000 instead of using dollar-cost averaging, which is investing equal amounts regularly over time. “Dollar cost averaging only works if you are consistently adding to your saved money,” says Rob Hernandez, founder and CEO of Main Street Associates in New York City. Using dollar-cost averaging to invest a lump sum, however, only delays an investor’s full exposure to the market, which generally rises more than it falls.
[See: 7 Small-Cap ETFs to Buy Now.]
Research backs up that advice. A Vanguard study found that investors generally were better off investing a lump sum at once rather than in 12 equal monthly installments. According to Vanguard’s research, two thirds of the time investing the lump sum all at once outperformed an identical portfolio that used dollar-cost averaging to invest the lump sum. The research found similar results for portfolios that were a mix of stocks and bonds or all stock.
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How to Invest $5,000 originally appeared on usnews.com
