What do you do with the proceeds from the sale of a house, after you've made the decision take a break from homeownership for a while?
That's an Ask GFC question that came in from a reader recently:
I am 50 years old and will be closing on my house the end of January 2017 with ~85,000 in equity after the sale. I have a daughter who is a Sophomore in College, less than $2,000 in credit card debt, but $30,000 in student loan debt for myself. I plan to pay cash ~$20,000 for a used car after the sale, put $20,000 in my checking because I can earn 2 percent interest up to $20,000.
Bottom line is, I should have ~$40,000 left to invest. I plan on renting for about a year after I sell because I'm not sure where I want to live. QUESTION: What should I do with this $40,000? I only have about $18,000 in an IRA and maybe about $20,000 in my 401k.
Karen has a lot to think about here. She just closed on the sale of a long-term investment – a house – and now she has to decide how best to invest the money.
Let's try to help her consider the possibilities…
Karen's Preliminary Plans Look Solid!
Karen gives us an idea of the plans she has for some of the proceeds. She lists about $2,000 in credit card debt, and another $30,000 in her own student loan debt. Though she doesn't exactly say so, it looks like she plans to pay those debts off with part of the money from the house.
If that's the case, then that certainly works for me. Paying off debt is usually one of the best ways to put a cash windfall to work. This is especially true of the student loan debt. $30,000 is a big debt, and one that could potentially hang around for many years. Now is the time to make that debt go away once and for all.
The elimination of the debt will lower her cost of living, and give her more money in her budget to do whatever else she would like to do. Maybe some of that extra budget room can find a the way into additional savings.
She's also planning to purchase a used car for $20,000. I like this strategy too. For $20,000, she should be able to get a late model used car that's almost as good as a new one, and should last for a very long time. And since she'll be paying cash for the car, that's one more major debt that she won't have to deal with.
Altogether, that accounts for $52,000. Karen says that she will have about $40,000 to invest, which brings the total amount of cash to $92,000. That's $7,000 more than $85,000 that she says she will net from the sale of the house, so we can presume that she already had some cash available prior to the sale.
She says she will put $20,000 into a checking account earning 2% (Good Deal!), and somewhere there's another $20,000 sitting in an undisclosed location.
As a short-term strategy, you're doing just fine Karen. But let's delve into what you might do with the leftover $40,000 in cash.
Matching Long-term Money with New Long-term Goals
Before we go any farther, I think this is a good time to talk some about what just happened, just for a bit of perspective. Karen sold her home, and given that she's walking away with $85,000 from the sale, we can presume that she's lived in a house for a pretty long time.
The point is, Karen just liquidated what looks to be her largest asset – her house. She'll have to be extremely careful in handling those proceeds, since they kind of represent “the family jewels”, in a very real way.
Or put another way, they are part of her core capital in life.
That means that they should be invested for her long-term greater good, whether that is the payoff of long-term debts, or actual investments, so that the remaining money will continue to grow in the future.
So maybe we should start with what Karen shouldn't do with the money:
- She shouldn't blow it on a new car (I've actually seen this happen, but clearly that's not what she's doing in conservatively choosing to purchase a new/used car)
- She shouldn’t spend it on traveling the world, or even going on vacation
- She shouldn't go off on an extended spending spree
- She shouldn’t use it to take a temporary early retirement
- She shouldn’t use it to impress friends
Karen isn't indicating that she's doing any of these things, but do you see where I'm going with this? My response to Karen is also for anyone who comes into a financial windfall.
Long-term money – like the proceeds from the sale of your house – shouldn't go into short-term pleasures. It should be preserved and invested in a way that it will continue to provide a tangible benefit.
Now that we got that out of the way…
Is there Another House in Karen's Future?
Since the money that Karen now has comes from the sale of her previous residence, she needs to seriously consider if she plans to invest it in another home. That could be the logical thing to do, but Karen has also indicated that she plans to rent, because she's not sure where she wants to live. That could be a game changer!
More from GFC, Below
If Karen is holding onto the remaining $40,000 because she has at least loose plans to purchase another home in a year or so, then the money should continue to sit exactly where it is, in a bank account earning interest. She can't take chances investing it, because if the market turns against her, and she loses some of her money, she may not have enough left to make a down payment on the next house.
Karen indicates that she lives in New York, and we can pretty much assume that if she lives in high-priced New York City or the surrounding suburbs, that she may be pushing it with a $40,000 down payment. If she loses any of that money in the financial markets, she may be shut out of the housing market completely.
So Karen needs to do some deep thinking. There are some compelling reasons why she may not want to buy another house. She needs to ask herself the following questions:
- Does it make sense to buy another house now that her daughter is in college? Karen doesn’t indicate if she's married or if there are any other family members living with her. But if she is now living alone, buying another house may not be absolutely necessary.
- Will a $40,000 down payment get her the kind of house that she wants? Again, we're talking New York real estate. But there may also be questions about her ability to purchase a home that is close to work, or other considerations that may increase the price of a home.
- How stable is Karen's job? If it's very stable, and especially if she needs a substantial income tax deduction, buying another house might make a lot of financial sense.
- Where does she expect to retire to? Karen indicates that she doesn't know where she wants to live, but is that also a consideration for retirement? And if it is, how soon does she expect to retire?
What we’re really asking is, how likely is it that Karen will purchase another home?
The answer to that question will determine if she needs to consider the next strategy.
The Case For Investing More for Retirement
Karen reports that she is 50 years old, that she has $18,000 in an IRA and about $20,000 in a 401(k) plan. She also uses the word “only” in describing these retirement numbers, which gives us a hint that she knows that she is inadequately prepared for retirement.
I agree. In fact, that's why I wanted to spend some time on the prospect of Karen buying another house. While there may be compelling reasons to do just that, as a financial planner, I see retirement as being Karen's most pressing future financial need.
As well, investing the money for retirement is a good long-term-to-long-term conversion of the cash that was previously invested in her house. And she needs to think long-term.
Karen doesn’t indicate what she has her retirement money currently invested in. But I'll take a high altitude view here, and make some investment allocation recommendations that are based on the total of about $78,000 ($38,000 in current retirement assets, plus $40,000 from the sale of house).
First of all, she should keep enough cash in her checking account – the one that's earning 2% – to cover at least three months of living expenses. That will represent her emergency fund, so that she will have cash for short-term emergencies, and won't need to disturb her investments.
Second, I’d gradually move as much of the money as possible over into tax-sheltered savings. This can include moving the money into her IRA account – which at age 50, could be up to $6,500 per year.
If that won't be tax-deductible, due to a high income, she may want to increase the amount that she is contributing to her 401(k) at work. She can max-out the 401(k) contribution, and even use some of the $40,000 in cash proceeds to cover living expenses, while more of her paycheck goes to the retirement plan. That'll be a kind of a backdoor 401(k) contribution, using the house sale proceeds.
A secondary advantage to either the IRA or the higher 401(k) contributions is that she will get a bigger tax break. That will also help to improve her cash flow at least a little bit.
Alternatively, Karen can also move up to $6,500 per year into a Roth IRA account. She won't get a tax deduction for a Roth contribution, but the money will accumulate on a tax-deferred basis, and then provide her with a tax-free income source in retirement.
If her income is too high to allow for a direct Roth IRA contribution, she can make annual contributions to her regular IRA, and then do a Roth conversion.
How to Invest the Money for Retirement
As to how to invest the money, she might go with a combination of growth (equity) investments, along with fixed income investments. If she has the risk tolerance for it, she might invest 70% in stocks, and the remaining 30% in interest-bearing investments.
As to the stock portion, she should favor index funds, since they are lower risk than individual stocks.
As to interest-bearing side of her portfolio, that 2% checking account that she has seems very attractive. But she may also want to look into certificates of deposit or even US Treasury Notes, which are also paying close to 2%.
The basic idea is to create a portfolio that will offer Karen an opportunity at a comfortable retirement, which is now just 15 years away.
Any other money that Karen can contribute toward her retirement – over and above the $40,000 in cash that she will have left from the sale of her home – would be an added plus.
That's my answer to Karen, and to anyone else in roughly the same situation, who was come into a cash windfall. I hope I’ve given you some ideas to think about!