Ask The CERTIFIED FINANCIAL PLANNER™: Inheritances And 401ks

I’ve been getting a lot of reader questions lately, asking what I think they should do when faced with certain situations. I’m always happy to give advice, but this week I thought I would go to a professional for answers.  In today’s post, I’ve asked Jeff Rose from Good Financial Cents to answer a couple of reader questions.   Jeff is a CERTIFIED FINANCIAL PLANNER™ professional, and as such has a lot of experience in answering these types of questions.  Hopefully if Jeff will agree to come back, we can make this a somewhat regular feature on the site!  So without further ado,  we present “Ask The CERTIFIED FINANCIAL PLANNER™”
Question: I was wondering if it is better to be completely debt free or to have some money in retirement. We have a mortgage where we owe about $170k and we also just got about $100k from inheritance. We also have about $30k in the bank. Should we just about pay off the mortgage or should we invest the money or should we do a combination of paying off and investing? My wife and I are 27 yrs old and the house is the only debt we have. Thanks, Josh.

Answer: Josh, thanks for your question. Coming into a windfall of money can bring on a whirlwind of emotions. First, I want to congratulate you and your wife for having level heads by focusing your efforts on paying off debt instead of going on a shopping spree. You are a role model for your generation. Let’s now look at your questions…..

Should you pay off the house or invest?

The phrase “debt free” definitely has a ring to it, doesn’t it? In your situation with your house being your only debt, I’m not sure that this is the best solution for your recent inheritance. Here’s a look into my logic.

• A home allows you to write off your interest each year which can be a very nice deduction. If you qualify, I would make sure you refinance for a rate at least 6% or lower.
• Assuming you paid a good chunk on your mortgage and it freed up an extra $1000 a month, let’s see what that would do. If you turned around and invested that $1000 into an investment that averaged you 8% return, it would take almost 7 and half years to get you to $100,000 (and that’s not including taxes). You are better to keep paying the mortgage and adding more to your nest egg when you can. Just for fun, find a financial calculator online and see what $100,000 would be after 20 years by adding $200 a month and averaging 8% return.
• I don’t know much about your retirement plan information; but if you qualify, one thing that you really should look at is Roth IRA’s for the both of you. The Roth IRA will give you both tax free money at retirement. Here’s some info on the rules of the Roth IRA for 2009.
• $30k in your savings is an excellent start for your emergency fund.  Make sure you have somewhere in the neighborhood of 6-8 months of household expenses. Closer to 8 months if your job future is uncertain (maybe even 12 months). Double check and make sure you are earning a decent interest rate on your savings. I’ve seen many banks that will pay 0.25% (yes, there is a decimal before the 25) on their savings accounts.
• Over and above that, consider a diversified portfolio. A portion of that portfolio could be a CD Ladder. Another portion could be investments that pay decent dividend yields. Since you will be in a taxable account, you will get favorable tax treatments on these types of investments. I don’t know your investment history, but if you are a beginner, there’s no sense diving in. By utilizing high yield interest accounts and a CD Ladder, your money will be making money while you educate yourself on your choices.

That’s some good information to get you on the right track. To receive an inheritance at such a young age empowers you and your wife to be in full control of your financial destiny, as long as you act smart. Based on your questions, it seems like you are on the right track. Be smart and trust your instincts on what money decisions you make.

Question: My wife and I are fretting over our 401k’s. To date we have diversified accounts that have plummeted over this past year returning investment of -40%. Our problem and/or question are if we reconsolidate and move towards more stable investments (bonds treasury bills) won’t we be losing an opportunity to recuperate our losses over time with the current allocations? Thanks, Jerry.

Answer:  Jerry, I and the rest of working America empathize with you. There hasn’t been a single person that hasn’t been affected by the market drop of 2008. In your question, your logic of “won’t we be losing an opportunity to recuperate our losses” is right on. That is the absolute truth. Cashing out your 401k and running the T-bills will not get you back to par. The only way to potentially get back what you lost is to stay right where you are at. It feels wrong, I know; but it’s the right move.

One thing to consider that may calm your nerves for the short term is to redirect all future contributions into something more stable. Look for some short to intermediate term bonds to ensure you are getting a decent return without locking up your money too long. This might not be the best answer, but it’s a viable solution for today’s volatile market.

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Jeff Rose, CFP®
LPL Financial Advisor