What to do with my tax refund?

The Best Ways to Invest $5,000

I came across this post on Facebook today and the question was whether or not this was a wise decision. Of course, not knowing the full details of her financial position limits my ability to specifically advise her but I thought with “tax return” season being upon us….this would be a great time to address the issue of what to do with your return.

A $5,000 windfall is unlikely to change your life, but it is likely to change how you invest — or give you a jumping-off point to start investing, if you’re not already.

With $5,000, you’ve turned the investing corner. The snags that investors with lesser amounts often hit — too high account and investment minimums, too little money to diversify adequately — are not big issues for you.

The bigger issue, potentially, is making a choice when you have a lot of choices. That’s why we’ve narrowed things down to the five best ways to invest $5,000. One of these is bound to suit your risk tolerance and goals, and all of them are within reach.

How To Invest $5,000

  1. Invest in your 401(k) and get the matching dollars
  2. Open or contribute to an IRA
  3. Buy commission-free ETFs
  4. Use a robo-advisor to manage your portfolio
  5. Trade stocks with a small portion of these funds

1. Get a guaranteed return with 401(k) matching dollars

If you have a 401(k), your company offers to match your contributions and you’re not taking it up on that offer, this decision is a no-brainer: Go after that match. Many companies match half or all of your contributions, up to 3% to 6% of your salary. It’s the highest guaranteed return in investing.

You typically can’t deposit a lump sum like $5,000 into your 401(k), but you may find that having that money in the bank gives you room in your budget to start grabbing those matching dollars. Those 401(k) contributions will make your paycheck smaller, but you can repay yourself from that $5,000, either after each paycheck or whenever money runs short for the month.

2. Bump up against the annual IRA contribution limit

The annual IRA contribution limit is $5,500, so you’re just a hair away from reaching it. Being that close might motivate you to pinch together the last $500, but even if it doesn’t, an individual retirement account is the best home for this money if you don’t have a 401(k) or you’ve already gotten your matching dollars.

Like a 401(k), an IRA is a retirement account, but you don’t need an employer to have one. You can open an IRA at any online broker. Many don’t have an account minimum; those that do either require much less than $5,000 or waive their minimum for an IRA.

» MORE: The best IRA account providers

3. Diversify with commission-free ETFs

A $5,000 investment gets you past most standard mutual fund and index fund minimums, which typically hover between $1,000 and $3,000. But one or two mutual funds do not a diversified portfolio make. (The exception is target-date funds, which are inherently diversified so you can put your full investment in a single fund. These can have high expense ratios but are one option for investors who prefer to be hands-off.)

Investing in five $1,000-minimum index funds would buy you an equal share of the five kinds of investments tracked by those funds, which probably isn’t the portfolio you want. In most cases, particularly if you’re young, you’d want much more exposure to stocks and minimal exposure to bonds. Putting the largest chunk of your $5,000 into an S&P 500 index fund, for example, won’t leave you enough left over to also buy funds that cover emerging markets, international markets and bonds.

Enter exchange-traded funds, which you can buy through that IRA or an online brokerage account. ETFs are a form of index fund that trades like a stock. That means you avoid the whole song and dance with minimums and instead buy in for a share price that is, in most cases, much lower than the typical fund minimum. You can buy more funds, get more diversification and spread your money in a way that makes sense for your age and risk tolerance.

ETFs tend to have low expense ratios, but you’ll also want to focus on commission-free ETFs so you’re not paying a fee each time you buy or sell. Those fees can run up to $10 and really drag down a small investment. Most brokers offer a list of commission-free ETFs.

» MORE: The best brokers for ETF investors

4. Get management from a robo-advisor

You could build a portfolio of ETFs, or you could have one of these computer-driven advisors manage a pre-built portfolio for you.

You’ll pay for taking the easy way out, generally a management fee of 0.25% to 0.35% of your account balance per year on top of the ETF expense ratios. However, there are a few free options. Wealthfront has a $500 minimum and manages up to $10,000 for free. WiseBanyan has no minimum and is free indefinitely. Charles Schwab’s advisor, Intelligent Portfolios, requires $5,000 and uses its own funds but charges no management fee.

5. Dip $500 in the stock-trading waters

Trading stocks has a kind of allure, and if you’ve been feeling the pull, now may be the time to do something about it — with a very small percentage of your portfolio. We recommend limiting buying stocks to 10% or less and dedicating the rest of your money to low-cost funds geared toward retirement.

Those pesky commissions pop up again here, too. Avoid or limit fees by using a low-cost broker or free trading app like Robinhood.


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