Ask the grumpies: What to do with a lump sum?

Susan asks:

I’ve just finally unloaded my own slice of the housing crisis (PHEW), a condo in another place, and have been wired the proceeds, which are between $50 and $100k. What’s the best thing to do with that lump?

My only remaining mortgage (PHEW) is the house I live in. It’s for 80% of that house’s value, at 3.4%, and the monthly nut is reasonable, at ~30% of take-home. I have decent? retirement savings between IRA, investment and TIAA-cref accounts, about $70k (I’m 41). My car is paid off, and I have no CC debt or student loans. There are some upcoming expenses for the house that are within our planned budget. We do not have children and do not plan to.

I feel burned from the housing crisis (yet I know it wasn’t as bad for me as others). The proceeds represent my initial investment, so I came out about flat, although that money was locked up (or, circa 2009, nonexistent) for almost 10 years. Because of that, I’m hesitant to pay down principal on my current mortgage, more than the 20% we already have in there. But 2008 wasn’t so kind to investments, either. I know I don’t want to leave this money in checking or my 0.5% savings, so – where does it go?

Standard grumpy disclaimers apply:  We are not financial advisers.  Talk to a fee-based financial planner and/or do your own research before making any life-changing decisions.

You have a few good options.  Three of them jump to mind immediately.

1.  Put more money into retirement
2.  Pre-pay your current mortgage
3.  Put the money in taxable stocks

I do have a quibble with the last paragraph if your question.  Pre-paying the mortgage *can* provide cash-flow liquidity.  If you’re willing to reamortize (aka re-cast) the mortgage, then you can lower your monthly mortgage payments by re-extending the length of your mortgage if you have prepaid a significant amount.  You can do this even if you’ve lost your job, generally for the cost of ~$250.  Only if you’re willing/planning on foreclosing on your house would it make sense to never pre-pay under any circumstances, but since you didn’t foreclose on the condo, it’s unlikely that you’re in that situation.   The *debt* is what you should be focusing on, not the value of your house.  You will have the debt no matter what the value of your house is (absent willingness to foreclose, of course).  Pre-paying here is the safest option– the low risk, low return option.

Your interest rate on your house is pretty small, so it’s not obvious you should pre-pay the mortgage.  With a higher interest rate, it might tip your decision to the mortgage if doing so meant you could refinance, for example, and it would be a safe investment (assuming no plans to foreclose) and would allow you to decrease your monthly nut by reamortizing in the case of an emergency.  In this case, the return is pretty low and this is something you’d only think about doing if you wanted a safer option.  The return is higher than CDs or savings accounts, but you wouldn’t necessarily be able to get all your savings out in case of an emergency (because home equity loans tend to dry up when you actually need them), just enough to give you a somewhat lower monthly payment with re-casting discussed above.  [Note, too, that the earlier you pre-pay the bigger the benefit of prepayment-- you can play with the numbers using the GRS amortization calculator.]

You should think about how quickly you will want this money.  It sounds like you don’t have any major plans for expenditures that you can’t handle.  However, how are you feeling about job risks over the next 15 years or so?  Is there a chance that you or a spouse could lose income?  Is there a chance that you’ll want to move to a more expensive locale?  If you feel pretty secure on that, then putting the money away in a tax-advantaged retirement fund is going to be better than just putting it into the stock market because you will save money on taxes.  However if you see a chance for needing more liquidity, then you would want to tilt towards regular stock investing (keeping in mind that IRA Roth contributions can be taken out tax-free even if their earnings cannot, so they have added liquidity).

You should also think about whether or not $70K in retirement accounts at age 41 is putting you on track for retirement or not.  My druthers is that you could add more to that, but I also don’t know about your lifestyle and your planned expenses, your work situation, etc.  There are a lot of retirement calculators out there with various inputs that you can play with to get a better picture of how much you think you’ll need going forward.  It is unlikely that you have saved too much at this point.  (And if you have, you can always cut down on the retirement savings later.)

If you choose one of the two investing options, what stocks to put it in?  Broad-based low-fee Vanguard index funds if possible.  VTSMX is a good one if you just want diversification, but there are other combinations you can make with VFINX, VGTSX and so on.  You may want to throw in some bond fund, such as VBMFX.  And ask about their admiral fund shares if you invest with Vanguard directly.  With TIAA-CREF you’ll want to talk to an adviser to get numbers on fees for their broad-based indexes vs. their target-date funds.  We can go more into detail on these if you want to add more information about your options.

Personally I like having a secondary emergency fund in taxable stocks (and/or in IRA Roths) that I feel like I could tap by selling off stocks.  So far we have left ours untouched but the fact that it’s there (even when it dropped down to its lowest point in the recession– it has since more than doubled!) always made me feel more secure.

What I would do in your scenario would be to max out all the retirement accounts that I could (and given the sale, you may want to check with a tax accountant or other expert before putting money in the IRA), and put the rest into taxable stocks or (less likely given your situation) mortgage prepayment.  For the retirement accounts, I would either pick some broad-based indexes with low fees from TIAA-CREF, or I’d pay a little bit more in fees to get their target-based fund.  (Their target-based fund isn’t a no-brainer like Vanguard’s is, but if I didn’t want to sit down and create my own diversified sets of funds, I’d go for it.)

But again, you’ll have to think about what your short- and long- term goals and uncertainties are.  The best thing to do will vary based on your needs.  For shorter-term safety but low return:  prepay the mortgage (knowing your can re-cast for a lower monthly payment later, should you need to).  For longer term safety and the highest rewards:  max out your retirement options.  For a secondary emergency fund and somewhat risky growth (which will be correlated with the economy, as you note, but not necessarily your personal situation):  put it in Roths first and the stock market second.

Grumpy Nation:  What advice would you give Susan?  Are there other things she should be considering in this decision?  Bonus points if nobody mentions landlording as an option.  Unless Susan *really* wants to landlord.  Which we doubt.

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26 Responses to “Ask the grumpies: What to do with a lump sum?”

  1. Zenmoo Says:

    Can you not get ‘offset’ accounts against mortgages in the US? We have an account that holds cash against our mortgage balance so our interest is reduced but we’ve still got ready access to our money.

  2. e Says:

    Retirement, absolutely. Nothing else appears to be a pressing need, and 70K is not nearly enough if she is already in her 40s.

    • nicoleandmaggie Says:

      It might be if she’s low income and low expense (in which case Social Security will replace a lot of her income) and she’s regularly saving 15-20% of her income. It’s one of those things where you have to play with retirement calculators to figure out for your individual situation.

  3. Linda Says:

    Wow, this is a very similar to a scenario I ran through with my (fee-based) financial planner just last week. I should probably write a blog post about it, and maybe I’ll consider this reply my draft. ;-)

    I am planning to sell my home in Chicago before end of year and move to a the Bay area. Based on the comparables provided by my real estate agent, I should clear between $90 and $100k from the sale. I asked the financial planner to help me figure out what to do with that money and to help me do a reality check on my plans to move: would I be hurting myself financially by moving to a higher cost of living area? The answer to the latter question also required me to really dig into my monthly expenses and budget and make sure the numbers weren’t under-projected.

    My income is high enough that I can’t open a Roth IRA. Because the original retirement projections of the financial planner back in 2011 showed that I may fall short of funds in the retirement years (which were generously between 63 and 90), I opened a variable annuity through Vanguard. This is another post-tax retirement planning vehicle that allows me to access the contributed funds if needed, although I have to leave the earnings in the account until retirement. He suggested that I add only about $2k a year to the variable annuity to cover my bases, so I’ve been doing that for the past three years. I also have a traditional 401(k) and a Roth 401(k) that I’m funding through payroll deductions.

    I don’t know anything about Susan’s lifestyle and cost of living, but $71k sounds pretty low for retirement savings at 41. I’m 47 and I have about $220k at this point (although a heavy market adjustment will drop that much lower) and I feel a little insecure about that. Of course, I’m also single/divorced and have no children, so I am relying 100% on myself to have a retirement that does not involve eating pet food or living on the streets.

    So, here’s what the financial planner suggested I do: take $45k and stuff it into the variable annuity. I can then consider myself done with the supplemental retirement savings, and free up a little more in the budget. I can do whatever I want with the rest of the money, but knowing how I tend to be a bit conservative he suggested I keep most of it somewhere in cash. I will probably try investing some of it in some Vanguard index funds, but I haven’t yet decided what to do with the rest of it. I have a healthy emergency fund in cash already, although a goodly chunk of it will go to moving costs, so some of the house proceeds may be used to replenish it.

    I will not be buying any real estate in the Bay area and will instead become a renter for the foreseeable future. Real estate is way too costly in that area, even in the less than trendy communities I am looking at (Alameda, Fremont, and maybe as far out as Walnut Creek). As I get older and may be considering buying something as my retirement home, I’ll likely move to a less expensive area a few hours to the north or south of the Bay area. That’s my plan, at least.

    So, my advice to Susan is to toss a good chunk of that money into a post-tax retirement account. Since there are caps on a Roth, maybe she can find a decent variable annuity, too. (I’m liking the one I opened through Vanguard.) Unless there is some reason to think she’ll need the cash before retirement, why not take care her future self with it?

    • nicoleandmaggie Says:

      Re: annuities: Our general advice is to wait to open an annuity until closer to retirement/death. There’s a lot of problems with the annuity market in general, but Vanguard is probably trustworthy (this is not something I’ve checked on, but Vanguard really isn’t out to make a quick buck) and is probably going to stick around.

      There’s a lot of disagreement about annuities among the people who study them and among financial planners. It’s generally agreed that the annuity market is broken, but some people (like Nobel Prize-winner Peter Diamond) say that they’re still a really good value and others say the market is too dysfunctional to be good value. Empirically people who were in early annuities were winners, but it’s not clear that that is still the case. The big risk is that it isn’t clear what happens when you put money in an annuity and then the company goes bankrupt, IIRC. (It’s too bad none of Walter Updegrave’s stuff is available online because he had a great pros and cons of annuities article.)

      The annuity argument here is that it’s a tricky way of tax-advantaging. You can also tax-advantage with municipal (and other government) bonds. But when you do either of these you’re trading off for returns so in the end it ends up being about a wash.

      If you have access to an HSA, that’s another way of tax-advantaging more retirement money. Health costs are forecasted to be a large portion of your retirement expenditures even with Medicare.

      I’m betting though that Susan has more space in her retirement accounts for 2014! Though probably not 50-100K space.

    • nicoleandmaggie Says:

      p.s. Annuities are also more attractive if you could not care less about leaving any money behind after your death. For example, if you have no dependents. That’s kind of the point– they’re insurance against outliving your income.

      • Linda Says:

        Thanks for the all the additional info about annuities. Yes, I have no reason to leave a legacy, so for me an annuity is insurance against outliving my income, as you note. As for municipal and government bonds, I am invested in some through my 401(k) plans, as well as my annuity funds in Vanguard.

        And isn’t all of this retirement investing a risk? Other than stuffing cash in a mattress (and then putting a team of guard dogs in place to ensure no one steals it), there’s not a lot more one can do to save for retirement at a certain point, right?

      • nicoleandmaggie Says:

        The problem with annuity risk is that it might not be that you get 40% of what you invested (which is what would happen in a huge crash) but that you get 0% of what you invested (would the government really let that happen? Probably not, but it also depends on how big a company we’re talking about going under.). There’s also some arguments that because of high fees you get a below-average return, but some argue that’s an insurance cost so worth it. Some argue that only people who think they’re going to live a long time invest in annuities, driving the costs up through adverse selection, others argue that even with this happening the people dying still keep costs down because these folks also happen to be more risk averse. There’s a lot of argument about annuities, though right now they’re not as hot a topic as they were a few years ago (currently people who study this area are busy with the ACA and defaults and pension rules and credit cards and so on).

  4. Angela Says:

    I haven’t encountered this situation, but I thought I understood that you had to pay capital gains taxes on the proceeds from a home sale unless they went into purchasing another primary dwelling? Does anyone know if that’s true? It seems like that might influence what Susan would do with her money – provided she could avoid the capital gains by putting the money into her mortgage.

    • nicoleandmaggie Says:

      I don’t think you can avoid capital gains by putting the money into her mortgage (I thought it had to be a new home purchase, but I could be wrong on that)… but maybe someone else has insight on that. Plus it sounds like she doesn’t actually have any capital gains to speak of (and some amount of capital gains are protected for housing purchases– let me check on the numbers).

    • nicoleandmaggie Says:

      Yeah, there’s a 250K exclusion so long as she lived in the condo for at least 2 years.

    • nicoleandmaggie Says:

      2 years within the 5 years prior to when it was sold, that is.

    • Susan Says:

      Capital gains tax applies to the gain (profit) from a house sale. I sold for not much more than I bought, and after realtors’ fees I came out with a small loss on paper, so I have no gain or profit to be taxed. The lump sum that’s come back to me is from my initial down payment and from 10 years of mortgage payments.

      Thanks for all of your thoughts! I talk to a TIAA-cref adviser next week, and I will look into Vanguard.

      • nicoleandmaggie Says:

        TIAA-Cref are generally good people and they generally won’t try to cheat you. DO make sure you ask about the fees of whatever they suggest to you– if the fees are high, then that person is not to be trusted. What is high? Nothing they suggest to you should be more expensive than their target-date fund (aka lifecycle aka “set and forget” fund) — if it is, that’s a red flag.

      • nicoleandmaggie Says:

        You’ll have to update us on what the TIAA-Cref adviser suggests!

      • Susan Says:

        will do.

      • plantingourpennies Says:

        “TIAA-Cref are generally good people and they generally won’t try to cheat you.”

        Glad you guys had that experience, but still be guarded. The only things I have heard about TIAA-Cref folks are that the investments they pushed people toward were either:
        – loaded down with huge front load sales charges
        – had large barriers to pull money out when needed (people that had $ locked in an annuity that wouldn’t pay out for years when they didn’t realize it was until it was too late)

        They also tried to scare the be-jeezus out of my MIL with inflated claims about how much she’d be paying in taxes if she didn’t enroll in deferred compensation (and the only eligible plan there was the one with the giant front load). I had to talk her down and project out what tax bracket she’d be in after retirement once that guy got done with her she was so terrified of giving the government more than absolutely had to.

        Probably doesn’t need to be said, to readers of this blog, but ask good questions and don’t assume they are looking out for your best interests when they get paid based on your decisions.

      • nicoleandmaggie Says:

        Yeah, that’s why she needs to make sure they’re up front and clear about fees. And if they recommend high fees, then tell them to hit the road.

        And with any annuity make sure you know how it works– when you can draw down and what happens if you die (some go to a spouse and those cost more, most do not). I really would not recommend an annuity to Susan at this point in time though.

  5. chacha1 Says:

    Susan seems to be in a pretty solid position, but I agree that retirement number is a little low. What I *personally* would do is …
    hold back 10% for fun money;
    open a savings account specifically for a new car (can’t assume the paid-off vehicle will last forever!) and park $20K in there;
    max out TIAA-Cref (403b or 401a I’m assuming?) and IRA;
    if there’s any money left over, prepay the mortgage.
    :-)
    I know “fun money” sounds frivolous, but this doesn’t necessarily mean “Manolos for every day of the week,” it could mean Anniversary Dream Vacation that you otherwise would never take because there is always something.

  6. Susan Says:

    I met with the TIAA-Cref adviser yesterday. Her suggestion was also to send it to retirement — but with a twist.

    I am eligible to put $17k of pre-tax earnings into my 403b. So, over 4 years, I can direct that much of my paycheck straight to the 403b (pre-tax, and this is the part of my income that hits the highest marginal tax rate), and use the lump sum to ‘replace’ that income (keeping it in savings or, if I feel brave, money-market in the meantime, or maybe CD ladder). This also keeps it fairly liquid for a while.

    (it wasn’t clear if this was what you meant by ‘put more money into retirement’, as opposed to depositing the lump sum itself directly)

    I am pre-tenure and in a small-ish town that we wouldn’t stay in if I lost or changed jobs. Because my spouse is underemployed here, we figure only on my income and if he earns anything, well, bonus! For those reasons (and the low rate) I don’t see an advantage to prepaying the mortgage. I think we’d be much more likely to sell and leave rather than reamortize to ease cash flow here.

    Again, thanks for the discussion.

    • nicoleandmaggie Says:

      Yes, that would be the putting money in retirement option– you are limited by how much you can put in each year tax-advantaged. The number should actually be $17,500, not $17,000 for this year. You may also be eligible for an IRA on top of that. http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits . (If you make too much money to be eligible for an IRA then having only 70K in your accounts at your age is definitely too little.) For that you would call up Vanguard and ask them for help in setting up an IRA. (I think you can also do it through TIAA-CREF but I’m not sure I’d recommend that.)

      Again, you’re thinking about the mortgage thing not quite right. You would not reamortize if you were able to sell, you would reamortize if you were UNABLE to sell and needed the cash flow. It’s a risk thing– something to do if there’s a money emergency and you can’t sell your house. If you CAN sell your house, then you get back all that pre-payment when you need it upon selling your house, but at a higher interest rate than it would have been in savings.

      Prepaying can also be beneficial in the short term– even if you’re not saving the full amortization period because you plan on selling, you can still save quite a bit over the next 3 years or however long until you might leave. The actual numbers are going to depend on where you are in your mortgage etc. and you can figure them out by plugging in numbers in the GRS amortization calculator linked above. You can see on our monthly mortgage updates we put the one month savings in. You can get that by subtracting the interest for the next month with the pre-payment from the interest for the next month without the prepayment. To get the total interest saved from a lump prepayment, you just use the total interest paid without prepayment minus the total interest with prepayment. And you can do that subtraction at any point in the amortization schedule (so at 60 months if you think you may leave 5 years after living in the house).

      I’m not sure that I approve of your financial planner’s plan for the full amount over the four year period. 3 years is a long time to be earning next to no interest when you have better places to put the money, AND it’s not clear that you should be spending all of your salary either. As in, you should be putting more of your actual salary into savings/investments, not just this windfall. When these four years are up, are you going to go back to not putting money into your 403b because you spend it all?

      Again, what I would probably do in your situation would be to max out my retirement options for the next year or two, both the 403b and the IRA (and again, if you make too much to be IRA eligible, then that indicates that you should look at your budget and make some spending cuts for the benefit of the long-term), and then put the rest into taxable stocks which would function as a secondary emergency fund.


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