Maybe you just inherited money, sold a house, cashed out a pension or received a sizable bonus. Or maybe you’ve had cash sitting in a savings account for months, or even years, waiting for the “right time” to invest.
Whatever the reason, you’re holding money that could be working harder for you. The key questions are where to invest it, when to put it to work and what to buy.
One note before we start: If your lump sum is a pension buyout offer, the first decision isn’t how to invest it — it’s whether to take it at all. Run the numbers with our Pension vs. Lump Sum Calculator to see if the monthly pension payments are the better choice.
Before You Invest a Dollar
Two of these steps apply to everyone. The other two only matter if the money is new.
For Everyone
Pay off high-interest debt. If you’re carrying credit card balances at 20% or more, paying them off is a guaranteed return no investment can match.
Fill your emergency fund. Money expert Clark Howard recommends keeping three to six months of expenses in a high-yield savings account. If your cushion is thin, use the money to fully fund your emergency savings.
If the Money Just Arrived
Understand the tax bill. Some lump sums arrive with strings attached. Distributions from an inherited traditional IRA are taxable income, and most non-spouse beneficiaries must empty the account within 10 years. Proceeds from a home sale may include taxable gains above the exclusion. A pension payout needs to be rolled over correctly to avoid a huge tax hit. Know what you owe before you decide what to invest.
Spend a little of it. If the money is a true windfall, Clark has a rule that lets you enjoy some of it.
“What I like you to do is take 10% of the money and spend it however you want. Have a blast,” Clark says.
Spend the 10% guilt-free. The remaining 90% is what you invest.
Decide Where Before You Decide When
The timing question gets all the attention, but where the money goes is just as important.
You should consider the three most tax-advantaged places for your money first:
Your 401(k) match. If you’re not contributing enough to get your full employer match, raise your contribution rate and use the lump sum to cover the gap in your paycheck. The match is free money.
A health savings account. If you have a qualifying high-deductible health plan, the HSA is the only account with a tax break going in, growing and coming out.
A Roth IRA. If your income allows it, you can contribute up to the annual limit. Money grows tax-free forever.
After that, you face a judgment call. Do you max out the 401(k) beyond the match, or put the rest in a taxable brokerage account?
The 401(k) offers tax deferral, but it’s locked-up money. With a few exceptions, you can’t touch it before 59½ without a penalty, your investment choices are limited to the plan’s menu, and some plans carry high fees. A taxable brokerage account gives up the deferral but keeps the money available for anything, whether that’s a business opportunity, a house or retiring earlier. Long-term capital gains rates soften the tax cost.
Which one you choose depends on your plan’s quality, your tax bracket now versus in retirement, and how much you value access to the money. If you’re weighing this on a six-figure sum, it’s a good question to take to a fee-only fiduciary advisor.
All at Once or a Little at a Time?
Now the question everyone asks. Should you invest the whole amount today, or spread it out over months through dollar-cost averaging?
The math favors investing it all at once. Research from Vanguard found that lump sum investing beats dollar-cost averaging about two-thirds of the time. Markets rise more often than they fall, so money invested earlier has more time to compound. Every month your cash sits on the sidelines is a month it isn’t working.
But Clark doesn’t tell everyone to do the mathematically optimal thing, because investing isn’t only about math.
“I love dollar-cost averaging because of the psychological harm if you put in a lump sum and all of a sudden the market has a big decline,” Clark says.
That psychological harm is real, and it’s expensive. The worst outcome isn’t earning slightly less than you could have. The worst outcome is investing everything on Monday, watching the market drop 15% by summer, panicking and selling at the bottom. An investor who dollar-cost averages and stays invested will beat an investor who lump-sums and bails.
So here’s the practical answer. If you can invest it all today and sleep fine, do that. The odds are on your side. If a big immediate loss would genuinely rattle you, dollar-cost average, but do it with rules:
Set a fixed schedule. Equal amounts, every month, automated.
Set an end date. Six to 12 months is plenty. Longer than that and the cash drag starts to cost you real money.
No discretion. You don’t skip a month because the market feels high or double up because it dropped. The schedule is the schedule.
Dollar-cost averaging with no deadline can become an attempt to time the market if you aren’t careful.
What Should the Money Buy?
The specific investments you make depend on your personal situation and goals. There isn’t one right ETF or Fund to buy.
If you are managing your own portfolio, Clark recommends a low-cost, diversified portfolio built from index funds, with a stock-and-bond mix that fits your age and timeline, held across your 401(k), IRAs and taxable accounts as one portfolio.
If you aren’t comfortable managing your own portfolio, a fee-only fiduciary advisor can help you with how this decision fits into your larger plan.
Final Thoughts
There isn’t a perfect day to invest a lump sum, and there isn’t one investment that’s right for everyone. The important thing is to make a plan, put the money to work and stick with it. Time in the market almost always matters more than trying to find the perfect moment to invest.
The post How To Invest a Lump Sum or Cash You’ve Left Uninvested appeared first on Clark Howard.