However it happens, you suddenly get a six-figure sum plopped into your bank account. Great news! Now what do you do with the money?
Should you invest it all immediately? Use it to buy a house or start a business? Trickle it into a retirement account such as an IRA year after year?
That’s what a listener of the Clark Howard Podcast recently asked.
Should I Use a Lump Sum To Max Out My IRA Each Year?
Should I plow the entirety of a lump sum of money into a Roth IRA year after year?
That’s what a listener wondered about on the May 2 podcast episode.
Asked Mac in Arizona: “My 18-year-old son is receiving a $100,000 settlement from a car crash last year. (Thankfully he has recovered!) He will graduate from high school next month and is not planning to attend college. He is a painter at an auto body shop and likely will pursue a career in that.
“We’re recommending he max out a Roth IRA for this year and the next two years. That leaves him approximately $80k to potentially save for a shop of his own, future home or to invest. If this were your son, what would YOU recommend?”
Asking Clark whether it’s a good idea to invest in a Roth IRA is like putting a steak in front of a dog and wondering whether it’s hungry. Clark calls himself “the man from Roth” and preaches its virtues to anyone who will listen.
IRAs allow you to sock away $6,500 per year based on the 2023 contribution limits ($7,500 if you’re at least 50 years old). At that rate, it will take Mac’s son more than 15 years to shift the $100,000 to a Roth IRA in small chunks.
“You’re on the right path with the Roth. [But contribute] year after year after year. Not just for a three-year cycle,” Clark says.
“Even though he may use part of this money for a down payment on a house, buy a shop, whatever. Because the Roth gives you this great advantage. The money grows tax-free and is spent tax-free if held until retirement age.”
Roth IRAs Offer Financial Flexibility
Putting money into a Roth IRA on an ongoing basis offers the benefit of flexibility.
On the income side, Mac’s son will be working and making money. So the pool of money available to him to contribute to a Roth IRA isn’t limited to the $100,000. (Plus, Mac’s son won’t be able to put a single dollar into a Roth IRA unless he’s earning taxable income.)
As far as expenditures, taking out earnings on your investments will subject you to IRS penalties unless you follow specific rules, including age requirements.
But a Roth IRA specifically — as opposed to a traditional IRA — will allow you to withdraw your contributions penalty-free at any time.
So if Mac’s son needs to use the money for a down payment on a house or to buy his own shop, he can still access it from inside his Roth IRA. In the meantime, he’ll be earning by investing it.
“If he just keeps putting the money in and ends up not needing the money for a down payment on a house, it stays in,” Clark says. “If he doesn’t need the money to buy a shop, it stays in. And then it grows tax-free forever.
“So a Roth can be both an intermediate-term savings account and a long-term tax-free investment account for retirement. It can play both roles in his life.”
The Importance of Investing Habits
The math of compound interest can be cruel.
For most people, by the time you understand how powerful it is to compound your earnings year after year for decades, you’re deep into your 20s or 30s. But even a small amount of money, given an extra decade to grow, can make a life-changing difference.
Mac’s son has an opportunity to start maxing out his Roth IRA contributions every year from an early age.
“[Contributing every year] gets him in the habit of building up future retirement savings. Doing that at 18? Man. It puts him on easy street down the road like you can’t imagine if he keeps doing that,” Clark says.
Should You Invest a Portion of the $100,000 Now in a Taxable Investment Account?
Waiting for 15 years to invest a portion of the $100,000 via a Roth IRA doesn’t seem especially feasible.
If you can earn, say, 8% returns every year for 15 years in a taxable investment account, you’ll outrun the benefit of tax-free growth in an IRA delayed by a decade and a half.
“If he’s putting money into the Roth each year, the money that is outside the Roth, probably half of it could go in because of the number of years it would be until he could put that money in.
“Half of the remainder could go into a simple index fund or balanced fund. Just go on Investopedia and read what a balanced index fund is. And the other half should go into a simple savings account at today’s best interest rates which right now would be somewhere at four-point-something percent.”
A Reminder: Clark’s 90/10 Rule
I’ve written about Clark’s philosophy on handling lump-sum income.
Whether it’s through a legal settlement, an inheritance, winning the lottery or some other method, what do you do in general if you’ve received a large amount of money at once?
Set aside 10% of the lump sum and spend it however you want, Clark says. Go on a dream vacation. Wager it on a cryptocurrency. Eat at your favorite steakhouse once a month until the money runs out.
It’s impossible to be totally disciplined with every single dollar. And if you don’t set a clear amount that you’re allowed to splurge with, you may find yourself continually “borrowing” from the $100,000 without realizing how much you’ve diverted.
Figuring out what to do with a six-figure sum of money is a good problem for an 18-year-old to have. It’s also a fairly impactful decision that can make a big difference for the rest of his life.
However, the fact that Mac and his son are having these discussions bodes well for the young man’s future.
“You have a son who doesn’t want to blow this money. Wants to build a future for himself. Which is priceless,” Clark says. “But the most priceless thing of all is he was insured in an accident and has made a full recovery.”