Ask Money

What to do with savings, part 1

Chris Farrell Jul 29, 2010

Question: If one has an extra $200 per month to invest or save, would it be best to invest it in a 401(k), pay it towards the principal on a mortgage, or invest it in some other way? Here are some hypotheticals: a couple earning $100,000 per year, each with $100,000 in a 401(k), fifteen years from retirement, own their own home with 25 more years left on the $470K mortgage, reinvesting $700 per month in 401(k) to pay off money borrowed for down payment on house, no other borrowed monthly expenses (cars paid for, credit card paid in full each month), no other monthly investments, about $16,000 in cash savings and stocks. Does your advice vary depending on income, or is there a general guideline? Thank you. Pamela, Los Angeles, CA

Answer: We’ll, you’re already following the general guideline that really matters: Your saving and investing the extra $200 a month.

The concept I like to use when thinking through a savings question like this is risk.

Where can you best use the savings to reduce your risk if something goes wrong? For example, you might want to focus on getting rid of the 401(k) loan. The reason is if you lose your job you have a mere 6 months to pay back the loan. That’s usually tough to do when you’re unemployed. But if you don’t get rid of the loan within the 6 month time frame Uncle Sam treats the remaining amount of the withdrawal–the loan–as an early distribution. You’ll owe income taxes and a 10% penalty on the amount of the 401(k) loan that’s outstanding. Plus, by accelerating the payback you’ll bolster your retirement savings plan. Similarly, once you have the 401(k) loan paid off what about boosting your cash savings? You have a nice sum set aside, but is it enough for your household in today’s uncertain economy?

So, while you can’t go wrong with any of the choices you mentioned, I’m voting for getting aggressive with the 401(k) loan.

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