How Much Can You Afford to Risk In a Play Money Account?
Do you have a "play money" account — a self-directed brokerage account that you invest in for fun or to take greater risks? If you do, you're not alone. But be careful: Don't let the fun of testing out your own investment strategies make you short more important accounts such as your IRA, 401K, or emergency fund.
There's nothing wrong with having such an investment account. Not only can they be fun, but they can also teach consumers whether their investment ideas have merit or if they are more likely to flop. The problem comes when consumers become so focused on their "play money" that they invest to the detriment of their other accounts.
So how much is too much to invest in such an account? That depends on your individual financial situation. But here are some guidelines for how much you should be investing in your other, essential accounts before you drop big bucks on "play money."
Emergency Fund
Life is filled with unexpected expenses, and some of them are big. Your car's transmission fails? That could be a thousand-dollar repair. Your hot water heater goes on the fritz? Get ready for an unexpected multi-hundred-dollar replacement.
That's where an emergency fund comes in. As its name suggests, the dollars in this fund are reserved for those unexpected expenses. Not having an emergency fund can be trouble: If you don't have the dollars to cover that new furnace, the odds are high that you'll place that expense on a credit card.
And what if you lose your job? An emergency fund can help cover your daily expenses while you search for new work.
Financial experts recommend that consumers build an emergency fund that can cover at least six months of normal daily expenses. If your fund is larger, that's even better. The smart move, then, is to make sure that you have a sizable emergency fund saved up before you set aside any dollars for a "play money" account.
Retirement Accounts
How much will you need for retirement? That depends largely on the type of retirement you want to live. If you want to travel the world, you'll need more money than if you simply want to spend more time with your grandchildren. Don't shortchange your retirement years by investing too much in a "play money" account and too little in an IRA or 401K.
It can get complicated determining how much money you'll need to save for retirement each year. But there are a few general rules of thumb that you can use to determine how much money you'll need after you leave the workforce.
Financial planners have long recommended that retirees plan on spending from 60% to 90% of their most recent after-tax annual income each year of their retirement. As an example, say you were earning $50,000 each year immediately before your retirement at an effective tax rate of 15. You were then living on $42,500 in income after taxes each year.
If you decide that you'd like to live on 85% of this amount each year in retirement, you'd need $36,125 in income every year you are not working. You can get this income from a variety of sources, including everything from Social Security payments to pension income to withdrawals from your savings.
Again, make sure that you are saving as much as you need for retirement before you start a "play money" account. If your employer offers a 401K plan, withdraw the maximum amount from each of your paychecks to fund it. If you can't afford to do this, then you can't afford a "play money" account, either.
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