Next-Level Money Moves: What to Do When Your Basics Are Set
A: I assume you also have an emergency fund and no debt except your mortgage. (If you don't have an emergency fund, building one should be your next move.) Starting with that assumption, here's how to put your extra money to the best use:
1. Save for Future Purchases
You have retirement and emergency savings covered, so now's the time to focus on saving for any other big purchases you foresee. This could mean saving up to buy your next car in cash, opening a separate savings account to save for your wedding or starting a vacation fund for that European cruise you hope to take in a few years.
Enter these savings goals into your monthly budget as a line expense. For instance, if you're saving to buy a car, make a "car payment" to yourself each month by setting aside $400 toward your next car purchase.
2. Reduce Your Mortgage Debt
Since you're still paying off your mortgage, you should look into ways to reduce that debt. The sooner you pay it off -- and the less you pay in the long run -- the more money you'll have to allocate toward other goals.
If the interest rate on your mortgage is 5 percent or higher, either refinance to a lower rate or focus on paying it down as fast as possible. That's a "guaranteed" 5 percent return.
3. Open a Health Savings Account
If your health insurance plan is compatible with a health savings account, open an HSA and max out your contributions. For an individual, the annual limit is $3,000; for families, it's $6,550. If you're 55 or older, you can add an extra $1,000 to each of these amounts. Like a 401(k) or traditional IRA, money in your HSA is tax-deferred.
Consider this possible hack. Your HSA is meant to pay for medical expenses. But you're not obligated to use your HSA money the next time you're at the doctor's office or pharmacy. Instead, pay your medical bills out-of-pocket and let your money grow inside your HSA. You can withdraw it penalty-free once you reach retirement age. In other words, you'll create an extra, "backdoor" tax-deferred account. This tip only applies to HSAs, not flexible savings accounts. An FSA is "use it or lose it."
4. Open Taxable (Non-Retirement) Investment Accounts
Since you're already covered with a 401(k) and Roth IRA, you can now open taxable (non-retirement) investment accounts and grow your money there as well.
The default account at brokerages is a taxable investment account. This means that you don't get any special tax advantages. You fund the account with after-tax dollars, and when you sell your investments, you'll pay taxes on the gains. In short, everything is taxed "normally."
Retirement accounts, like the 401(k) and IRA, can also be housed at those same brokerages, and these accounts come with tax advantages. The traditional structure allows people to contribute pre-tax dollars into their retirement account; the Roth structure allows people to be exempt from paying taxes on the dividends and capital gains.
Thanks to the tax advantages, you'll want to prioritize your 401(k), IRA and any other retirement accounts. But if you've maxed out your contribution limits and want to invest more, there's no limit to how much you can invest in an ordinary investment account.
5. Buy Rental Properties
A rental (or income) property is a great way to set up an additional income stream. To help you choose a property that's worth the investment, follow these critical rental property investing rules:
- The 1 percent rule. You should be able to collect a monthly rent that equals (or exceeds) 1 percent of the property purchase price. So, if you buy a property for $100,000, you should be able to collect at least $1,000 a month in rent. This rule applies to homes in stable neighborhoods with high rental demand. If you're looking at a home in a higher-risk area (say with more crime or where renters may not have the best credit), you're better off aiming to collect 2 percent of the purchase price to balance out your risk.
- Cap rate. The capitalization rate tells you how long it will take to recoup your purchase price. You can calculate this rate by dividing your annual net income by the purchase price. Let's say your net income on a property will be $500 per month. This is how much of the monthly rent you will pocket after you've deducted monthly operating expenses like insurance, utilities and repairs (but excluding debt servicing). Multiplying this amount by 12, you predict an annual net profit of $6,000. If you bought the home for $100,000, that amount divided by your annual net profit equals 0.06. Multiply this by 100 to turn it into a percentage, and you're looking at a rate of return of 6 percent on this property. That means it will take you 16 years (100 divided by 6) to recoup the cost of the property.
- Cash-on-cash return. This figure will tell you how much far your investment will take you. It's calculated by dividing your annual net income by down payment. Let's use our example above -- you buy a $100,000 home and predict a $6,000 net profit -- and you put 20 percent down. Divide that net profit ($6,000) by your down payment ($20,000), and you've got 0.15, or a 15 percent rate of return. (Not too shabby, right?) Just remember to balance this against the risk that comes with any type of leverage. While you could use just one of these formulas to evaluate the promise of a potential rental income purchase, using all three in combination is a powerful way to get the best bang for your buck.