So when should you make conventional investments? How about for IRA and 401k accounts? These allow tax deferral for decades. Suppose you invest $3000 in a 401k account. If it had been a regular investment, the government would take away about $1000 right from the start. Instead, you have an extra 50% ($3000 instead of $2000) from which to get dividends. This is almost as good as a 50% return at the beginning. Unfortunately, you eventually must pay the $1000, but the later the better. Suppose your investment yields 8% interest. After 30 years, assuming you are eventually taxed one third of the money, you will have $20,125. This is a true 8% return on your $2000. If you made the same investment the regular way, you would have $9506. This is a 5.3% annual return (8% times 2/3).

The above example may make tax deferral always look like a winner, but if you are paying apartment rent, you need to buy a home even more. If you have a non-deductible loan of more than 8%, you need to pay it off first. After these priorities are handled, tax deferral makes sense.

A big problem with these tax deferred investments is that you cannot easily cash them in early. Suppose you put $2000 into an IRA account and get 8% interest every year. After five years, you cash it in to help buy a house. If you are younger than 59.5 years old, you are penalized an extra 10%. You then have available $1675. If you try a regular account at 8%, you will have $1729 (less than $2000 because you were taxed at 33%). You are better off avoiding the IRA if you have plans for the money. This is especially true if you are in the 15% tax bracket.

It is impossible to calculate all of the tax deferral scenarios, but let us do one more. Suppose your employer is willing to match your 401k contribution. Your $3000 investment is now $6000. After 30 years, you have $40,251. This is a 10.5% annual return. Now, a 10% loan is tolerable.

Suppose you have paid off your non-deductible loans. Then a general, but not universal, conclusion is that you should have tax deferred investments if: 1) your employer matches your contribution, or 2) you already own the most expensive home you will ever want, or 3) you are nearing 59.5 years old.

The mathematics of tax deferred retirement accounts is so complicated, you may want to click on IRA to determine the rate of return that you can expect.

Emergency funds

Do not invest until you have satisfied more important obligations. Even after you have paid off your credit card bill, car loan, and mortgage, you need emergency funds.

If you are laid off from your job, you may need as long as six months to find another job. You need to save enough money to pay all of your bills for this time period. For example, suppose you earn $40,000 per year. After taxes, this may be $26,000. For six months, this is $13,000. You need $13,000 in the bank to be safe.

Another need for an emergency fund is for a car. Suppose you have an old car that is just one big repair from being replaced with a new car. If you read Your Car, then you know to pay cash for it. The average car costs $20,000. If we include the money from the previous paragraph, you need $33,000 in your emergency fund. This may sound like a lot of money to just sit, but you will rest more easily knowing that it is there.

Just because you have an emergency fund does not mean that you must receive peanuts for interest. You can get a short term certificate of deposit (CD). If you have enough money, you can split your emergency fund and get two separate CDs. Two 3 month CDs that are separated by 1.5 months means that half of your money is available every 1.5 months.

Currently, CDs provide about 5% interest. You can improve on this with treasury bills. This will get you an extra 0.5% interest. Treasury bills are also state tax free. For many states, this is like getting another 0.5% interest. The only catch is that you need at least $10,000 to invest.

These investments sound tame, but an emergency fund is not worth much if it is not there when you need it. How would you like to buy $10,000 in stock that fluctuates and be forced to sell at $5000 because you need the money immediately? Be patient and your emergency fund will grow so that you can buy intermediate term bonds (such as five year treasury notes). You will have so many bonds that there will always be one coming due.

Stocks

People argue that stocks are the most lucrative. Stocks have made 10% to 11% per year. Historically, this is only true if you average over 30 years. Take the sure thing. Psychologically, there are two reasons to avoid stocks:

1) If you pay down the mortgage, you know what will happen. No buyers remorse. No "buy high, sell low."

2) You have the potential to pay off the mortgage in a matter of mere years. This is motivation for people who might prefer not to save at all.

Finally, once you pay off your mortgage, you can invest in stocks (have your cake and eat it, too).

Stock brokers tell you to buy stocks because stocks provide the best profit ... for them. They get a commission. Figure 1 shows the Standard and Poor 500 stock index divided by the Consumer Price Index. This is to adjust it for inflation, of which there was much in the 1970s.

FIGURE 1

Brokers like to cite the enormous stock market surge of the last 20 years. Indeed, these years have been spectacular, but the previous 15 years were a disaster. Never mind why. What will the next 15 years be like? Unlike the stock brokers, I am not arrogant enough to make a prediction when I am not sure. But I am certain that it will help if you pay off your mortgage, establish an emergency fund, and contribute to a 401k plan.

The purpose of this section is not to dissuade you from stocks, but to save you from people who make promises just to get your money. Buy stocks with money that you do not need.

Your cash flow

When you pay off your mortgage, your cash flow greatly improves. If you are reading this web page, then hopefully you have already paid off your mortgage and you are looking to invest all of this extra cash. How much extra cash? Suppose you had a $1000 per month mortgage that is now paid off. This means that all of a sudden, your cash flow increases by $12,000 per year. If you invest your first $12,000 in safe treasury bills, you get 5.5% or $660 per year. After taxes, let us say one third, you get $440 per year. This is nothing compared to the $12,000 you get for having no mortgage. Your investment return is chickenfeed.

You can invest in risky stocks, but they would have to be extremely risky. Some brokers anticipate a 30% return. (Believe it or not.) This would give you $2400 per year after taxes. This is still chickenfeed.

Eventually, you will have so much money saved that the return from stocks will be big compared to your rate of saving. At this point, the return from safe investments will be big, too. However, your savings will be so big that you will not care. You are rich.

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