Got a raise? Where to stash extra cash

This reader just received a raise and wants to know if it's better to invest the extra money or prepay the mortgage.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I'm 38, married and I'm contributing the maximum to my 401(k) and to Roth IRAs for me and my spouse. I just received a good raise and have an extra $500 a month I would like to save. What should I do with it - prepay my 5.6 percent 15-year mortgage or put money into stocks or mutual funds? - Scott, Zeeland, Michigan

Answer: You, sir, are a shining beacon to your fellow Generation Xers (not to mention anyone who wants to get serious about building a decent nest egg), what with getting off to that nice early start and taking full advantage of tax-advantaged savings options.

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And now you're ready to take it up another notch. Great. There are several good options available to you, and a couple that I don't think are so hot. Let's dismiss the less appealing ones first, starting with prepaying your mortgage.

I wouldn't say doing this would be a horrible mistake. But I don't think it would be the best use of your extra dough. For one thing, by prepaying your mortgage your investment "earnings" are essentially the amount you would save by avoiding interest payments, or 5.6 percent. Since your mortgage interest is tax deductible, you're actually earning less after taxes. Let's say your effective return is 4.2 percent, assuming a 25 percent tax rate.

So the question is, could you do better investing that money instead of prepaying the mortgage? I think you probably could. At your age, you should be investing fairly aggressively - probably 75 percent or more in stocks, the rest in bonds - so I don't think a long-term expected return of 8 percent pre-tax (6 percent after-tax) is unreasonable.

Besides, investing the money gives you a pool of assets you can dip into pretty easily should you need to. To get at the home equity you would build up more rapidly by prepaying your mortgage you would have to borrow or sell your home.

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Not a huge deal, but the extra liquidity is another advantage for investing rather than prepaying. Besides, you're only 38. So what's the hurry getting rid of the mortgage debt? If you stay on schedule, you should be done with the mortgage by your early 50's anyway, allowing you to head into retirement without any debt on the old homestead.

The other often considered investments I want to dismiss - if only because someone may very likely pitch them to you - are tax-deferred variable annuities and investment-oriented life insurance policies such as variable universal life.

Launching into a full-fledged examination of these options would take too much time and space here. (You can see what I've had to say about both in the past by clicking here and here.) Suffice it to say that the typically high fees and some tax quirks in these alternatives diminish the tax benefits that the people who sell these products ballyhoo.

Okay, so where should you be putting your money? I see three options that offer prospects for decent returns, plus some tax advantages.

1: Tax-managed mutual funds

One of the disadvantages of regular mutual funds is that they're required to pass along virtually all realized gains to shareholders each year. That means you may have to pay tax on profits your mutual fund manager made during the year even if you didn't sell shares of the fund.

Tax-managed funds, however, attempt to minimize taxable distributions to shareholders by using a variety of techniques, including harvesting tax losses in some securities that can offset realized gains in others or minimizing gains by selling shares with high per-share costs when the fund has to drum up cash to meet shareholder redemptions.

Funds that mint money

The result of these techniques is that most of your gain comes through appreciation of the fund's share price, which means you can largely avoid taxable gains until you sell. Assuming you hold the fund shares longer than a year, you also reap the advantage of having those gains taxed at the more favorable long-term capital gains tax rate, which maxes out at 15 percent, instead of ordinary income tax rates, which run as high as 35 percent.

Bottom line: By postponing taxes and shifting gains to a lower tax rate, these funds can effectively boost your long-term after-tax rate of return. That, as Martha would say, is a good thing.

2: Index funds

Most index funds are also relatively tax efficient because they buy and hold the shares of an index like the Standard & Poor's 500 or other stock-market benchmark. This buy-and-hold approach generates fewer taxable distributions than the more frequent trading you find in most regular mutual funds.

Of course, index funds have a few other notable plusses that I think make them especially attractive investments. For one, you know exactly what you're getting. With regular funds where the manager may sometimes veer from the stated investment strategy in an attempt to boost gains (an attempt that, alas, often backfires).

Index funds, on the other hand, slavishly follow their index. That makes them good building blocks when you're putting together a portfolio of different investment styles. And index funds are inexpensive. Annual expenses are typically below 0.5 percent a year and can even drop below 0.10 percent in some cases. Actively managed funds, on the other hand, routinely charge 1 percent or more.

By the way, if you like the premise of tax-managed funds and you also like index funds, you may want to check Vanguard since the company combines the two principles in its roster of tax-managed funds. Click here and then type "tax-managed" into the Search Box.

3: ETFs (Exchange Traded Funds)

Lately, ETFs-which are essentially index funds that trade on an exchange-have surged in popularity. As a result, firms are churning out dozens of them. And some investors see them as a way to make bets on narrow niches of the market (Nanotech stocks, anyone?) or jump from one sector to another depending on what's hot.

That's not why I mention ETFs here. The reason I mention them is that they can be a good way to gain exposure to the overall stock market. Like index funds, ETFs can also serve as building blocks for a better diversified portfolio, allowing you to easily add, say, small-cap stocks or international shares to your holdings. They're also tax efficient and typically have razor-thin fees.

One hitch, though, is that you must pay a brokerage commission each time you buy or sell an ETF. If you're trading in small amounts, those transaction costs can wipe out much of an ETF's low-cost advantage. So generally you should consider an ETF only if you're investing large sums-say, $10,000 or more-that you plan to keep invested for the long term.

All of which is to say that ETFs probably aren't a good way for you to invest your $500 a month right now, although you may want to keep them in mind when your portfolio is larger or whenever you have larger chunks of money to invest. (For more on how ETFs work, click here).

I'm sure that somewhere within these options you'll be able to find good ways to invest your raise while minimizing the tax bite. And if you stick to your plan to sock away that extra $500 a month-as well as banking some of your future raises-you should be sitting on a very impressive nest egg come retirement time.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.