Michael on September 19th, 2008
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It’s Friday, so it’s time for this week’s reader-submitted Q & A. If you’d like to submit a question, click here for more information or simply email a question.

I just received a significant raise and now I can afford to save more.  I already max out my 401(k) and a friend of mine said that the best thing to do now is to buy an annuity because that way I can get more tax-deferred growth.  But my wife’s friend told her a whole life insurance policy would be better since there’s an insurance component.  Last, a friend of mine at work says I shouldn’t do either; instead, he says, I should just get index funds.  Who’s right?

–Jonathan P., 26, Cincinnati, OH

Congratulations on your raise, Jonathan.  It appears that your increased income has made you attractive to a few others already.

Gary:  Indeed, I scour the “Movers and Shakers” column every week.  When’s the best time to catch you, JP?

While your dilemma may seem confusing, it’s actually not.  Let’s address a few points:

Tax-Deferred Growth

While tax-deferred growth is important – especially for long-term saving objectives like retirement – it is far from the only consideration. You must also think about risk, required return, ability to access funds in an emergency, fees/penalties, and so forth.  Both annuities and whole life insurance policies do promise the benefit of tax-deferred growth.

Gary: Amen!

However, so does an IRA.  With an IRA, you can invest in index funds, which will have very low expenses. So, if you are looking to save more for retirement and have not yet done an IRA, I’d start there.  (You should also consider a Roth IRA, which allows the benefit of tax-free growth.)

An annuity is seldom an appropriate product for a 20-something because of the lack of flexibility in the product and the existence of other greater financial priorities typically not yet met by a 20-something (including full funding of 401(k), IRA, emergency fund, etc.).  A whole life insurance policy is also not something relevant to a 20-something, especially one without any dependents. Life insurance is arguably the most important financial consideration out there – once you have a child (or, perhaps someone else) depending on your income. But if no one is hurt – financially speaking – by your untimely demise, you don’t need life insurance, and certainly not just to get the tax-deferred benefit.

But before you go ahead and put your money into an index fund, make sure you understand the goals for your money. If it’s for something long-term such as retirement, go ahead. But if you have not yet paid off all your high-interest debt, established an emergency fund, made significant progress towards a housing downpayment (or already own a home), I suggest starting in one of those places before putting more money in the stock market.

And be sure to continue to ask questions first, buying (perhaps) later.  You’ll never regret sleeping on a financial decisions.  If it’s a great idea today, it will still be a great idea tomorrow.

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4 Comments to “Friday Q & A: What should I do with my raise?”

  1. M. Contreras says:

    So, Michael My Money Guru,

    Are you suggesting that a young 20-something put money towards a housing downpayment before creating a retirement fund?

    Thanks for the continued advice!

  2. Michael says:

    Absolutely maybe, M.

    For example, if your employer offers you a match – you have to take that first. Otherwise, you’re turning down free money and that’s never a good idea. Never.

    On the other hand, say there’s no match but you owe a few grand on a high interest credit card. Now, paying your debt is your highest priority.

    Or, finally, let’s suppose that you’ve got the most out of your match and don’t have enough saved up for a housing downpayment (ideally 20% of your home purchase price), then you bet – go save for that.

  3. M. Contreras says:

    Here\’s why I find myself often having a hard time relating your wonderful advice to my personal situation….I\’m self employed and will be for the rest of my life it seems…although I am a union member with a pension that won\’t kick in for another 10 years or so. With that in mind, it\’s my gut feeling to open in IRA pronto. The only debt I have are student loans…..(and having gone to the George Washington University I have plenty of those!) Yes, I am concerned about a down payment for a house. For that it seems an CD is best…and IRA CD? But what I put the most money towards I do not know…

  4. Michael says:

    M., Remember neither this blog (nor virtually any other blog) doesn’t give specific advice, but rather a generic education. Certainly, I try to answer specific questions, and do so primarily through the Friday Q & A link you can see at the top of the page.

    Ultimately, you’re going to need to save for retirement and get a house. I’m not surprised you find this challenging, especially with student loans. Join the club. Remember, it doesn’t have to be all or none. Split the money if that feels better in your gut. I don’t recommend saving for your house inside your IRA however, since you may need the money much sooner than any of the exceptions to penalties allow. There are plenty of other postings on ways to save. While being self-employed removes the possibility of getting “free money” from matching, there are plenty of other retirement plan options in addition to the IRAs you mention.

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