These last few weeks in December present a good time to prepare your finances for the coming year. My personal goal is to start January 1 on a good note, moving my life forward. In the grand scheme putting your finances in order takes a back seat to cleaning up your life as a whole, but it’s an important task because it can set you up for financial success. I’ve suggested changing your 401(k) contribution level early and donating to charity. It’s also a good time to fund your Roth (or traditional) IRA.
Usually, the reminder to fund your Roth IRA comes in March or April. The deadline isn’t until your tax return is due in the following year. For example, I have until April 16, 2012 to transfer money into my IRA and have the contribution count towards my 2011 limit. But why wait?
When investing for retirement, you can choose between two approaches. You can contribute to retirement accounts in a lump sum investment or you can use periodic investments (often called dollar-cost averaging) to spread your contribution over a longer period of time. You can also use a combination of the two approaches. For most savers, the choice comes down to cash flow.
Choose between lump-sum and periodic investments
Dollar-cost averaging, or using the same dollar amount to purchase a theoretically different amount of shares of investment regularly, can help smooth out the short-term volatility in stock prices. When compared to investing a lump sum, with periodic investments, you’ll sometimes invest when the prices of the stocks or funds are higher, and sometimes invest when the prices are lower. It’s one way to mitigate a small amount of risk. If your options are between dollar-cost averaging and saving up to invest in a lump sum later, thanks to the general long-term trend of an increasing overall value of stocks, you’ll generally be better off in the end using periodic investments.
That’s because it’s generally to invest what you can as early as you can. This is why many people choose periodic investments. Cash flow plays a large role in determining how a family or individual will invest. Unless you’re borrowing money to invest into retirement — a dangerous proposition — chances are good you won’t have $5,000, the IRA contribution limit for people under age 50, ready to go on January 1. The first day of the year is also the first day you can contribute to the new year’s IRA.
It can take a while to save up $5,000, so if you can spread the contribution over twelve months at $416.66 per month, now is a great time to configure your coming year’s investment strategy on your IRA plan’s website. If you don’t have an IRA yet, you can start one at any discount brokerage. I use Vanguard, but Fidelity is also good, and TIAA-Cref offers the benefit of very low investment minimums. All allow you to configure periodic electronic investments from your bank account.
If you haven’t invested in this year’s IRA yet and you don’t have the cash available to invest in one lump sum, create periodic investments that help you invest as much as you can budget for between now and the April deadline.
On the other hand, you might have cash available. If so, fund this year’s IRA up to the limit now, and prepare to fund next year’s IRA soon after December 31, both in lump sums. There’s a chance that you won’t get as good a price on your investment as you would the day before or the day after, but if you’re investing for the long-term, the difference between days should be much less influential on your financial success than market performance leading up to the day you begin withdrawing and the period of time to follow.
Choose between traditional and Roth IRAs
While the laws could change at any time, traditional and Roth IRAs have a few differences. In general, if you believe you’ll be in a lower tax bracket than you are now and you qualify for the tax deduction with the traditional IRA, that would be a better option. That’s particularly the case if you don’t have an employer-sponsored retirement plan such as a 401(k). On the other hand, if you’re already receiving the tax advantage of a 401(k), and you believe you could get a better tax advantage by taking a deduction in retirement because you expect to be in a higher tax bracket, the Roth IRA might be a better choice.
Of course, you can hedge your bets by splitting your contribution between the traditional and Roth IRAs. If, however, you earn enough money, you might not qualify for a Roth IRA.
You can use this IRA contribution wizard at Mint.com to determine which IRA is best for your particular situation.
Just do it
Keep in mind that with a long-term view, a lump sum investment is preferable, if you can invest that lump sum right away. If cash flow is a concern, set up a periodic investment to invest smaller amounts over time. Every major brokerage can support this hands-off, automated approach. Saving up to invest is a last resort. If you are not enamored with the idea of investing in the stock market right now, you can always choose a safer investment, even a money market fund or a certificate of deposit. Regardless, the sooner you get invested, the better for your future finances.
Don’t wait for the deadline; for the most part, people who consistently invest the maximum on the first day (January 1 of the coming year) will be better off than those who wait to invest the maximum on the last day (usually April 15 of the following year), because those who wait miss 15 and a half months of potential growth.