Do you have extra cash sitting in your checking account? This guide will provide you with 3 steps for investing, a process to make sure to get that money working for you. Here is what to do if you have extra cash in the bank:
- Roth IRA
- Brokerage Account
Table of Contents
You graduated from college recently, have been working a full time job in the “real world” since then, and now you are starting to have extra cash build up in your checking account. If this scenario hits close to your current situation, then this short post will explain what you can do with this extra money to get it working for you rather than just sitting around in your bank account.
This post is assuming that you have already followed the standard rules you learn in basic personal finance:
- Putting in the maximum amount that your employer will match in your 401k (taking advantage of the “free money”)
- Paying off monthly debt and other expenses
- Having about 3 months worth of expenses set aside in a backup savings account.
After those are all sorted away and you still have a good amount of cash in the bank, now is the time to put that money to work. Investing this money will help you take advantage of the beauty of compounded growth and combat the problem of letting your money get slowly devalued by inflation while sitting in your checking account. Continue reading to find out our 3 steps for investing for young professionals with extra cash.
The first thing you should do is to open up a Roth IRA. This can be easily done on your own through a financial institution such as Charles Schwab Bank.
A Roth IRA is a form of an Individual Retirement Account that is paid into with after-tax dollars and grows tax free. One thing to make sure you do is to not only open the account and put money into it, but you also will need to invest that money into the stock market (the easiest way will be through purchasing ETFs or a Mutual Fund).
The beauty of this account is that after you originally open it and contribute to it just one time, after 5 years have passed, you can treat the money that has been contributed (not new money created from the growth in value of the assets) as a savings account. And if you need to take it out early (once 5 years have passed), there is no withdrawal penalty (unlike other retirement accounts where the money is relatively locked in until you are over 59 1/2 years old).
The maximum contribution limit for 2020 is $6,000 and this is only available to people that earn less than $124,000 (of Modified Adjusted Gross Income) if you are single. Then the total amount you can contribute is subsequently lowered as your income is between $124,000 to $139,000. If you earn more than $139,000, you cannot contribute to a Roth IRA. If married and filing jointly, then those numbers are $196,000 to $206,000 and nothing after that.
To have a better idea of who can contribute to a Roth IRA and who cannot, check out the table below.
|Relationship Status (for Tax Filing)||2020 Income (MAGI)||Maximum Contribution|
(if 50 or older, $7,000)
|$124,000 – $138,999||Contribution is gradually phased out within this range|
|$139,000 and over||$0 – Not allowed to contribute|
(if 50 or older, $7,000)
|$196,000 – $205,999||Contribution is gradually phased out within this range|
|$206,000 and over||$0 – Not allowed to contribute|
If Married and filing separately, then if income is over $10,000 is not allowed to contribute to a Roth IRA.
Company Plan (401k)
After you have put that max of $6,000 into your Roth IRA and still have extra cash, you will want to take another look at your company’s retirement plan.
Quite often, people only contribute up to the amount that their company will match in their company’s retirement plan.
The key point here is that YOU as the employee are allowed to contribute up to $19,500 to your company’s 401k plan in 2020. You can add another $6,500 on top of that if you are aged 50 and over for a total contribution of $26,000.
This is why you can easily look at your pay stub to see how much you have already contributed this year. If that number is less than the maximum limit, then you can add more to this plan!
Both the Roth IRA and the 401k these plans are retirement accounts with the money invested grows TAX FREE. The Roth IRA money will be put in after you already paid income tax on it. The 401k (assuming you contribute to the traditional option) will be money taken out of your income before it gets taxed.
Either way, the entire time these funds are in these sheltered accounts, they can grow much better over time than a taxable account.
Taxable Brokerage Account
Once you have maxed out your annual contribution limits in both your Roth IRA and your 401k, then you can start to invest in a taxable brokerage account.
This too can be easily opened up through a financial institution just like your Roth IRA. The money in this account will be taxed annually on dividends you receive from stocks and on realized capital gains.
Quick side note to explain dividends, capital gains, and taxes:
Feel free to skip past this part if you are already familiar with these topics. Or if just want to continue ahead with investing in a brokerage account.
What are dividends?
Dividends are extra profits that companies pay out to their shareholders (you in this case.)
What are Realized Capital Gains?
Realized capital gains happen when you sell a stock. If you buy a stock for $50 and then sell it for $200, you will have to pay “capital gains” tax on the $150 that the stock increased in value.
Held the stock for less than 1 year?
$150 capital gains will be taxed at your marginal tax rate for federal income tax purposes
This is called short term capital gains
Check out the table below to see the current 2020 marginal tax rates
|Single with income greater than||Married with income greater than||Marginal Tax Rate|
Held the stock for more than 1 year?
$150 capital gains will be taxed at the “long term capital gains tax rate” which is either 0%, 15%, or 20% (depending on your income). The long term capital gains rate will almost always be lower than your normal tax rates.
Check out the table below to see the current 2020 long term capital gains tax rates
|Income||Long Term Capital Gains Tax Rate|
|$40,001 – $441,450||15%|
|$441,451 and over||20%|
This is the last place to put the extra cash since this account doesn’t get the tax-deferred advantage that the other accounts receive, this is why it is the last place to put extra cash.
One thing that could be enjoyable to do with the money in your brokerage account, is to use some of it to have fun with stock trading It is often very entertaining to pick and choose your favorite companies and invest in them.
Another way to look at it is, if you spend money on a certain company all the time, then you may as well own a part of that company! For me, this is the reason why I own stock in Chipotle!
Many recommend investing passively in mutual funds and/or ETFs (which is typically the best long-term strategy) however, it also takes some of the fun out of investing.
Note on Active Trading
While there may be other choices for idle cash in your bank account, the 3 steps above are quick and simple. You can easily do these yourself to take advantage of saving and investing your money. And therefore, you’ve got an advantage over inflation.
1. Max out your Roth IRA up to $6,000. Invest this money within your Roth into low-cost ETFs.
2. Max out your contributions to your Company 401k up to $19,500.
3. Put extra money into a Taxable Brokerage Account and invest in ETFs and individual stocks.
This is a simple 3 step process if you are a young professional (in your 20s with a full time job) and you are in a good position regarding your debts being paid off and having a decent emergency fund (3 months of expenses).
You can do this by contacting your past company’s “plan sponsor” and ask them to do a “direct transfer” of your 401k into the IRA you set up with your current banking institution. Another method, if you do not know who your company’s plan sponsor is, is to contact the HR person and ask them who the plan sponsor is.
You can set up a Roth IRA usually through your current bank very simply online from your account. This will open up a separate account other than your current checking account and will allow you to invest money in it (up to $6,000 for 2020) and have it grow tax free. Make sure to put cash into this account and then invest that cash into low-cost ETFs.