It's January, and that usually means you're motivated to make big life improvements. If one of those improvements involves your finances, 2022 could be the year you start investing.
Investing is the simplest way to build wealth and fund your retirement -- but it's not something everyone should be doing. Investing can be counterproductive if other areas of your finances need attention.
So how do you know you're ready to invest? Answer the four questions below to find out.
1. Do you have high-rate debt?
High-rate debt costs more than you can make investing. Every dollar of hard-earned cash you divert to an investment account slows your debt paydown and increases your cumulative interest expense. In the long run, you'll do better by directing all your free cash to debt paydown first.
Image source: Getty Images.
There is one possible exception: If you have access to a 401(k) with employer match, consider contributing enough to get your full matching contributions -- while you are paying down debt.
Many employer match programs give you $0.50 or more for every $1 you contribute. That return should outpace the interest on your debt. Those free contributions will also produce compound earnings, which can be significant over time.
2. Do you have an emergency fund?
You may have reservations about the potential to lose money in the stock market. This is normal and not an exclusive worry to new investors.
Fortunately, there are ways to insulate yourself from unnecessary losses. One strategy is to stay invested through downturns. If the market dips and share prices drop, you don't sell. Instead, you keep your securities and wait for the recovery that will inevitably follow.
But staying invested takes more than a commitment. You need cash savings. With cash on hand, you aren't forced to pull from your investment account if, say, you lose your job or wreck your car. Instead, you take any money you need from your cash emergency fund.
Shoot for a cash savings balance that's sufficient to cover three to six months of living expenses. That protects against short-term income losses and other unexpected circumstances.
3. What is your investment goal?
There is no ideal answer to this question. What's important is having a defined goal. Examples include investing for retirement or to fund college tuition for the kids.
The goal establishes your investment timeline and guides your decision-making. If you are investing for retirement in 30 years, you can take an aggressive approach, for example. You'd be more conservative, however, when investing for college in 10 years.
Without a goal, it's easy to lose focus. It's also easy to fall into the mindset of chasing profits. That lures you into heavy trading, which increases the chances you'll mistime the market and incur losses.
4. Do you have a tax-advantaged account?
A tax-advantaged account is a great place to start investing, for a few reasons:
- There are penalties for early or noneligible withdrawals. 401(k)s and IRAs provide tax advantages for retirement savings, while 529 plans do the same for college savings. The penalties encourage you to stay invested and keep working toward your goal, no matter what's happening in the market.
- Your realized gains, dividends, and interest are tax-deferred. In a taxable account, you pay taxes annually on your earnings. You don't have that tax liability in a 401(k), IRA, or 529 plan. That's another bit of encouragement to keep your money invested and earmarked for your goal.
- You may get tax deductions for your contributions. Tax deductions on your 401(k) or IRA contributions lower your cost of investing. When you're starting out, it just feels better to spend less on investing.
Once you feel comfortable investing in your tax-advantaged account, it's an easy jump into a less restrictive taxable account.
Say yes to investing in 2022
2022 can be the year you start investing. Just make sure finances are in order, you have a defined goal, and an account that supports your goal. Then you can look forward to January 2023 -- when you'll have a year of investing experience plus the start of a nest egg on your side.
