Wednesday, January 03, 2007

Make IRA and College Fund Contributions In January

I try to make our current year contributions to IRA and College Saving accounts as early in the year as possible, preferably in January. I would also do it for my 401K but the plan requires contributions be equally distributed over the remaining months in the year.

I make early contributions for the following reasons:

The funds will earn money tax free for a longer period. If a contribution to an IRA is likely, making one's 2007 contribution in January, 2007, instead of April, 2008 will provide an additional 15 months of tax free earnings.

No need to worry about looming deadlines. I always have enough other things to worry about at year end (Christmas holidays) or in April (with taxes due).

Psychologically, I feed good about being "ahead." I get to check off a New Year's Resolution right away:-) Making contributions in January clearly demonstrates my commitment to pay myself first. And it takes away any temptation to use the funds for something else.

For additional financial habits and practices that I have found useful, check back every Wednesday for The Practice of Personal Finance segment.

Photo Credit: morgueFile.com, Michael Connors

This is not financial advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

5 comments:

Savvy Steward said...

I'm guessing for a lot of people out there they don't have liquid cash to fully fund a IRA and a CSP in a lump sum.

Do you worry that you might buy at a high price with a lump sum instead of dollar cost averaging?

Super Saver said...

Savvy Steward,

Since our IRAs and CSP are long term investments, I don't worry about getting in an index mutual fund " at a high price." I once saw an analysis that showed even if one invested at the high of the S&P 500 every year, the return over the long term was still very good.

sun said...

Though "the long term was still very good", but it is better than, for example, dollar-cost-averaging over the same period? For a short term like one year, the return from investing at the high can noway be better than spreading the investments over the year. Since over the long term, the market can only go up, there's no doubt that one can get good returns as long as he/she keeps investing. In my opinion, the argument from the analysis is not very strong.

Super Saver said...

Sun,

Thanks for your comment. Your question is an excellent one.

I agree that the common belief is that dollar-cost-averaging over a year will outperform a single purchase during the year (especially if the single purchase is at the high price of the year:-)

However, based on your question I did some additional research and found this 1993 analysis, Lump Sum Beats Dollar-Cost Averaging, which showed a single purchase each year was the better option for 2/3's of the time for rolling 12 month periods from 1926 through 1991.

The caveats are, of course, past performance doesn't predict future performance and the study did not include 1992 to the present.

On the other hand, dollar-cost-averaging significantly reduces the market risk versus a single purchase. This phenomena is discussed in Dollar Cost Averaging - A Technique that Drastically Reduces Market Risk. Also, psychologically, it feels less risky to dollar-cost-average.

Hope this additional information helps.

Daddy Paul said...

One can put make their contibution in January and dollar cost average through the year. In a flat or bear market you win in a straight up bull you lose a bit. I will go with DCA every time.