Surplus Funds
Surplus funds in the investment world typically refer to positive cash flow or, in simpler terms, surplus funds represent money you don’t need to pay your expenses. When you have surplus funds, it’s not generally a good idea to let them sit in a non-interest-bearing account. Instead, it’s wise to put this extra money to work by investing it for a time you may need it.
Investing Surplus Funds in an IRA for Non-Retired Investors
For non-retired investors, getting surplus funds into an IRA can be as simple as setting up a systematic investment plan (SIP). Prior to retirement, most people need approximately 70% of income to pay for expenses and 20% of income for debt payments. This leaves 10% of income for savings, or what some financial planners call discretionary income or surplus funds. Assuming the investor has established an emergency fund and they have no high-interest debt, surplus funds should generally be allocated to retirement savings. If the investor has access to a 401(k) plan with a match through their employer, it’s wise to contribute at least enough to maximize the match. If there are surplus funds above this amount, the money should be invested in an IRA. A SIP can be established at most mutual fund companies and online brokerage firms. Depending upon certain income limits for IRAs, an individual may contribute up to $6,000 to an IRA, in addition to their 401(k) contributions, which are limited to $19,500 in 2021 (increasing to $20,500 in 2022). For those age 50 and above, the allowable contribution limits increase by $1,000 and $6,000, respectively.
Investing Surplus Funds in an IRA for Retired Investors
Investing surplus funds in an IRA can be challenging for retired investors but there are a few primary ways to do it:
Investing Earned Income: More and more retirees are working part-time during retirement. If you have earned income, you generally qualify to contribute to an IRA. If you don’t need any or all of your earned income, contribute it to a Roth IRA. This way, once the account has been open for at least five years, you can make withdrawals tax-free and there are no required minimum distributions (RMDs) associated with Roth IRAs.
Investing RMDs: At age 72, you must take RMDs for savings held in a traditional IRA. This also applies to savings held in a 401(k) if you are not still employed by the sponsor of the 401(k) plan. If you do not need the RMD money for income, a smart use of the surplus funds is to invest it in a taxable brokerage account. Most investment companies and brokers allow you to easily transfer the RMD (less applicable tax withholding) to your taxable account held with that firm. Also, RMDs are not required on Roth IRA money.4 Note, however, that money held in a Roth 401(k) is subject to RMD distributions. Converting to Roth: If you want to maintain the tax-deferred growth benefit of your traditional IRA and you won’t need the money for several years, it may make sense to convert surplus funds in a traditional IRA to a Roth IRA. Since you are required to take RMDs by 72 anyway, it may make sense to convert your traditional IRA to Roth over a five- to seven-year period. Roth conversions are not wise for everyone but generally the greater length of time before you need the IRA money, the more a Roth conversion makes sense. Also, RMDs are not required on Roth money.
Bottom Line
For retirees, deciding the best use of surplus funds can be a challenge, especially if the retired individual wants to invest surplus funds in an IRA. However, the general rules of thumb are relatively simple. If you have high-interest debt, pay it down first before investing. Also, emergency funds, consisting of at least three months of expenses, should be completely funded before investing. The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future performance. Investing involves risk, including the possible loss of principal.
