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Q. I unexpectedly inherited $5,000 from an uncle. I don't want to keep the money in my regular low-interest bank account, but interest rates everywhere else are low, too. So I'm stumped. How should I invest this money?
A. Sometimes the best investment isn't an investment at all. In a typical savings account, your $5,000 would bring in only $25 a year in interest. Nor can you count on big returns in the stock market. Still, depending on your situation, there are ways to get a nice payback. If you walked into my office, I'd ask the following questions to help determine what you should do with your inheritance.
1. Do you have any credit card debt? If so, use the money to pay it off. By saving yourself 15 to 25 percent in credit card interest on $5,000, you'd effectively be getting a tax-free return of $750 to $1,250 a year, which is far better than any investment I could recommend.
2. Do you have an emergency fund to cover three to six months of living expenses? If not, open a money market or treasury fund. These accounts currently pay just 1 percent or so, but that's about double the interest of an average savings account (check bankrate.com for the best rates). Besides, the point here isn't return, it's about having an investment that doesn't fluctuate, so the principal will be there in full anytime you need to tap it.
3. Do you have any loans with an interest rate over six percent? Any debt -- whether it's a home mortgage or a car or student loan -- at six percent interest or higher is worth paying down instead of investing your $5,000 because you're locking in the equivalent of a six-plus percent return, something you would be hard-pressed to find right now. Start with loans in which the interest isn't tax-deductible.
4. Are you maxing out your 401(k) contributions? Only a small percentage of Americans do, so unless you're one of them, increase the contribution percentage withheld from your salary and use your $5,000 to offset the resulting loss in take-home pay. That provides the benefit of tax deferral and may get your company to kick in additional money (because many employers match a portion of their employees' contributions). And if you're enrolling in a 401(k) for the first time, it gives you access to free investment advice from the management company.
5. What's your time frame? If you don't have a 401(k) -- or even if you do and your net income is less than $92,000 (for a married couple) -- you can put the money into an IRA and write it off this year's taxes. And if your net income is under $173,000, you can put the money into a Roth IRA, which has no tax advantage now but can be withdrawn tax free later -- a huge benefit in retirement. Or you can simply invest in a nonretirement account. In any case, choose a single mutual fund based on when you anticipate needing the money:
Three years or less: In this short time frame, you can't take any risks so go with a money market or treasury fund (described earlier).
Four to nine years: Look for a "balanced fund," which combines the earning potential of stocks with the safer, steadier interest on bonds. You'll want a no-load fund, which means there are no fees for buying or selling shares. Go to the websites of a few mutual fund families, such as Fidelity or T. Rowe Price, to select some options, then compare their fees and Morningstar ratings, which are listed on the sites. (Morningstar ratings are an independent company's assessment of risk, reward, and expenses.)
Ten+ years: Go with an S&P or Russell 2000 index fund, which means that rather than paying high expenses for managers who try (and usually fail) to beat the average returns of these stock market gauges, you pay tiny expenses and lock in the indexes the costly funds are trying to compete with. This approach gives you the best chance of growing the money your uncle left you.
Elda Di Re is a partner in Ernst & Young's New York City Personal Finance Services group and author of Ernst & Young's Financial Planning for Women. She's a certified public accountant and personal financial specialist and has appeared on NBC's Weekend Today, CBS This Morning, and National Public Radio.
Originally published in Ladies' Home Journal, March 2012.