This contribution is courtesy of MyWealthManifesto.com, a personal finance blog dedicated to breaking down every aspect of money management into practical and useful tips.
When you get an extra $1,000, what’s the best thing to do with it?
There’s nothing better than getting a small bonus at work, a tax refund check, or some other type of windfall that makes you $1,000 richer.
But what’s the best way to use that money?
We all know that going to the mall or blowing it on a steak dinner would just be a huge waste of that money. But what about even financially smart moves like saving it or paying off your debts? How can we prioritize them over one another?
In this post, I’m going to walk you through what I would do with an extra $1,000, and why I think it would be the best move for you to make.
Pay-Off High Interest Debt
First off, if you have any sort of high interest debt whatsoever, you’ll want to pay this off. High-interest debt is usually from things like credit cards or payday loans where the interest rates are often double-digits.
From a financial perspective, paying off a loan at a high rate is almost like investing the money at that same rate. In other words, if you have a credit card balance that has a 25 percent APR, it would almost be like getting a 25% return on your money to pay it off.
Build That Emergency Fund
How’s your emergency fund looking these days?
If your answer was “What emergency fund?”, then this is the perfect opportunity to start one.
Financial planners and media galore will tell you that the optimal amount of money to save in your emergency fund is 3-6 months’ worth of earnings. And they’re right – if a disaster like losing your job or medical issue occurred, you’d definitely need that sort of income.
But if you’re just getting started with an emergency fund, then $1,000 is perfect. In fact it’s one of the numbers often promoted by personal finance guru Dave Ramsey.
The perfect place to park your emergency fund money is in an online savings account. Though they only earn just over 1 percent interest these days, consider the risks of not having these kinds of funds available at will. Let’s say a disaster did strike and the only option for you to pay it off was for your to use your credit card. Now you’re right back to Step 1 of having debt with a potential 25% APR.
Remember: You never know when an emergency is going to strike. So have this money on hand to avoid slipping into unnecessary debt.
Avoid Taxes with Retirement Savings
The next best place to put your money would be to save it tax-deferred. This would be with whatever type of retirement savings account you have available to you: 401(k), 403(b), IRA, etc.
In a nut-shell, tax-deferred retirement savings accounts are great because they allow you to save your money without having to pay Federal taxes on them. To illustrate this point, think about how it works when you pay taxes on your earnings. For every $1 you earn, you only get to keep about $0.75 (assuming a 25% tax rate). But tax deferred savings lets you hang on to that entire $1 and stash it away.
In addition, the any earnings you make on top of your principal will continue to grow tax-deferred until you’re ready to take them back out (after age 59-1/2).
So which account do you start with?
If you work for an employer who offers employer matching on top of your retirement savings AND you’re not getting the full amount, then use your extra $1,000 to boost your savings rate. That way you’ll not only save more, but you’ll get a little extra in the process too.
If you’re already all good on employer contributions, then the choice is up to you. There are many details that can make a 401(k) better or worse than an IRA. But in the end, the point is to capture those tax-advantages and grow your money for the long-haul.
Even if you’re already hitting your retirement goals and don’t think you’ll need the money in there, consider the potential tax advantages. Saving $1,000 into your traditional IRA could offset your income taxes by $250 this year. That’s like an extra bonus all in its own.
More Tax Avoidance
Beyond retirement accounts, there are lots of other great places to look at saving your money.
One of my personal favorites is to look to reliable dividend paying stocks. Dividend stocks are great because they pay you “dividends” in the form of quarterly payments; simply for being a shareholder. They also get better tax treatment than other types of investments at the end of the year (such as mutual funds).
Do you have children? Starting or contributing to their 529 college education savings would be a good use of this money. Similar to your retirement accounts, the 529 gives you a tax-break and lets your college savings grow tax-free (as long as you use the money for higher education).
Finally, you could also consider contributing more to your health savings account (HSA) or flexible spending account (FSA). These are programs allowed by the IRS to give the working class the ability to set aside money tax-free for medical and dependent care expenses. Though you usually have to sign up for one at the start of the working year, you could set the money aside for next year and capture those