Investing Step #5: Retirement Accounts

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This post is step 5 in our Investing Template.

Retirement accounts are probably the type of tax-deferred vehicle with which people are the most familiar.  The number of people invested in the stock market has skyrocketed in the past two decades, much of which is owed to tax-deferred retirement accounts.  Some examples of these types of plans are:

401(k) – The most common type of plan.  They are generally offered through for-profit companies and often include matching.

403(b) – 403(b) plans are similar to 401(k) plans, but are offered by public schools and some non-profit organizations.  There are other differences, but that is the most obvious one.

Traditional IRA – IRAs are also tax-deferred accounts, but are not implemented through an employer.  You are able to deduct the amount contributed and it grows tax-free.  You pay taxes on the funds when you withdraw them. 

Roth IRA – A Roth IRA is different from a traditional IRA in that you do not get to deduct your contributions from your income from this year.  However, like an IRA the money grows tax free and you can withdraw it without paying taxes when you withdraw.  Additionally, there are a few exemptions available to withdraw from a Roth IRA before retirement that are not available with other vehicles.

Self Employed IRAs – There are several other types of IRAs, such as a SEP-IRA and SIMPLE IRA,  available to people who are self-employed, which can allow them significant deductions as well.

All of these programs have different income limits and contribution limits, and a wide variety of details.  Make sure to do considerable research and consult with a tax professional before deciding which one is appropriate for you.

Your Strategy

Which of these accounts make the most sense for you can be complicated, but keep these things in mind:

If your company matches your contribution, it is almost always wise to maximize your contribution to the point at which they match.  Even if they only match 33% or 50%, you are still making an amazing return immediately. Many companies match up 100%!  Imagine a guaranteed return of 100% instantly.  It’s an incomparable investment.  This should usually be your number one investment destination after you’ve established your emergency fund. 

With the exception of the Roth IRA, these are funds you should be setting aside for retirement.  That means that this is the longest window in your time horizon.  These are essentially your funds for when you don’t want to work anymore.  Thus, you should only tie money up in these funds that you will not need for a long time.  There can be severe penalties for withdrawing this money before you reach retirement.

By the same token, if you are setting money aside for retirement, there is no reason not to get it into some kind of tax-deferred vehicle.  Once you are comfortable that you can afford to deisgnate this money for retirement, at a bare minimum you want it to be able to grow tax-free.

Investing Step #4: Tax-Advantaged Accounts

This post is step 4 in our Investing Template.

Why pay taxes?  A lot of people claim they wouldn’t if they didn’t have to. However many of us are voluntarily paying taxes on money we could be pocketing tax-free with tax-advantaged accounts.  These are investment accounts where your taxes are either paid when you take the money out, or sometimes not at all.  Many people are familiar with retirement accounts like 401(k)s or IRAs, but there are other options that are often overlooked entirely.  Many times, if you know you’re going to have an expense in the near future, you can pay for that expense tax-free.  This many not seem like a big deal to you, but let’s do some simple math.

If I have a $100 expense this year and I’m in the 33% tax bracket, I have to earn $150 to pay for this expense if I have to pay taxes on the income.  If, on the other hand, I don’t have to pay taxes, I only have to spend $100.  This means that if I “invest” that money in tax-advantaged accounts that allow me the option to put away a certain amount pre-tax, I’ve immediately made 50% on that money.  A 50% guaranteed return is unheard of anywhere else, yet many of us overlook opportunities to achieve these same returns daily.  We’ll look at 4 broad categories of accounts that allow you to either defer, or completely avoid taxation on your income.

Tax-Deferred Accounts

• Retirement Accounts
• College Tuition Accounts
• Home Investment Accounts
• Health Savings Accounts

While each of these programs have nuances, they are closely related to your investing timeline.  Health Spending Accounts are for near-immediate expenses, home accounts are usually a fairly short timeline, college programs can be quite a while in the future, and retirment accounts are often the furthest off.   This collection of accounts can save you a great deal of money if used properly, so we’ll look at them individually over the coming days.

Investing Prerequisite #3: Goals and Time Horizon

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This post is step 3 in our Investing Template.

Once you have cleared out all your debt and created an emergency fund, it’s time to think about why you’re investing.  It is impossible to have a strategy without knowing what the strategy is intended to accomplish.  The investment strategy of a 20-something trying to buy a house, a 40-something trying to save for their children’s college, and a 50-something trying to catch up for retirement are very different.

The key component of all these things is this:

How Soon Do You Need The Money

The sooner you need the money, the less risky that segment of your portfolio should be.  Riskier investments typically give better returns over the long haul, but in the short term they can be disastrous.  The when of your strategy will be the single most important question in determining an investment strategy.

Milestones

Lay out your investing milestones.  Think about all the major life changes you would like to have and write them down.  This can be invaluable in deciding what investments are appropriate for you.  If you are going to need a certain amount of money for a house in 5 years, at which point you also want to have kids, you should be very cautious until you have a comfortable cushion to make those plans happen.  Look for all the major events that are going to affect your investing strategy and note them in a time line.

Be Realistic

When you’re designing your strategy make sure that your goals are realistic.  If you’re 55 and you have nothing saved, retiring in 5 years is probably not a viable option unless you want to move to a much cheaper country.  Similarly, do not be anxious to undertake major investments like a house.  Plan for the long run, and don’t overextend yourself.  You may not be able to retire as soon as you like, but taking gambles in the hope to get there faster can lead you to never getting to retire at all.

Other Considerations

Some other things to factor in your goals include:

Risk Aversion:  Some people are simply averse to risk.  They might want the returns a more risky investment could give them, but aren’t willing to take the additional risk.  There’s nothing wrong with this, and it’s important to realize if you are this kind of person.

Comfort: In addition to being realistic in your goals, you should be realistic in how much of your income you will be able to put toward investments.  At the same time, you need to be realistic about which expenses are necessities and which should be deferred.

Conclusion

This step of strategy building is simply to get a broad idea of your goals.  You need to know how much risk you should be willing to take and how soon you are going to need your money.  You don’t want to commit yourself to a 30-year bond if you’re going to need the money to buy a house in 5 years.   Create your milestone timeline and be diligent in assessing what makes the most sense for you.

Investing Prerequisite #2: Expanded Emergency Fund

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This post is step 2 in our Investing Template.

Many people will debate the details and priority of this, but quite simply there is no reason to begin investing until you have enough liquid cash to survive for a reasonable period.  Unfortunately, this can mean different things to different people.

What Kind of Survival?

One pivotal question in figuring out how big this fund should be is how you would like to live during a financial emergency.  Suppose, for example, that you lose your job; are you comfortable cutting expenses severely so that you can keep more money in better investments?  The stress of finding a new job may be enough on its own without deprivation to boot.

Additionally, you need to really think about which expenses are necessary.  While you don’t want to keep too little in your fund, you don’t want to keep too much either.  This is an emergency fund, so you don’t necessarily have to keep every element of your current lifestyle during this emergency.  You can probably eat out less and see fewer movies, but would want to keep enough funds to pay for your kids’ private school.  Use a budget (you do have one, right?) to get a real idea of what you would need per month to survive and what you want that survival to look like.

What Is A Reasonable Period?

Once you know how much per month it takes you to live, the next question is how long you would reasonably need to live this way.  While some people advocate fairly small emergency funds, it is often desirable to put away enough money to live for a considerable amount of time.  If you lose your job, you don’t want to be forced into taking an inferior job, or cash out investments prematurely, simply because your money is running out.  You may have a realistic idea of how long it would take you to find a job, but I say be very pessimistic when enacting your emergency fund.  I believe 3 months living expenses is a minimum. This is only my personal opinion, but I think giving up potential investment returns is well worth the security this extra time buys.

What is Liquid?

Liquidity is a measure of how quickly you can get the cash.  The most liquid accounts are savings accounts or money market accounts.  Accounts where you can either write a check against it, or get the money into a checking account within hours, not days.  Generally however, liquidity comes with a price.  The more liquid an asset, the worse the returns typically are.  Certificates of Deposit (CDs) for example, offer better returns generally, but require you to leave the money on deposit.  This may sound like a deal breaker, however an ideal solution can involve CDs.

CD Ladder

For those who wish to have a large emergency fund, but don’t want to earn terrible returns on the money, a CD ladder may be an ideal solution.  A CD ladder is a series of CDs that mature often enough that you can use them as your emergency fund.  For example, you might go every month and open a 6 month CD with enough to live on for one month.  If you did this every month for 6 months you would now have a CD ladder.  Every month a CD will mature with enough for you to live on for that month.  If you need that money, retrieve it and don’t allow the CD to renew. If you don’t need the money, leave it there and allow it to compound.  There are many tricks and optimizations for starting a CD ladder, but it can be an optimal way to build your emergency fund.

Now that you’ve eliminated your debts and created your emergency fund you are ready to start making more intricate decisions for your investment strategy.

Investing Prerequisite #1: How To Deal With Debt

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This post is step 1 in our Investing Template.

Deciding when and how to pay off your debts is not a simple matter.  While it can be comforting to be debt-free, that may not always be the most financially expedient approach-nor is it the whole picture. Here are a few steps, including analyzing and paying off debt, that really make your money work FOR you.

Step One: The Basic Emergency Fund

The absolute first thing you need to have is something to pay for unforeseen events.  I personally recommend keeping this fund as small as possible at the beginning.  We’ll get to creating a larger cushion later, but right now the goal is simply to get enough money so that you’re covered if your car breaks down or something else untoward happens.  In fact, in some cases I’d recommend skipping this step altogether.  If you have friends or family you believe you can reliably rely on in case of an emergency, get right down to paying off any debts.  Once your debts are paid off, go on to creating an expanded emergency fund.

Step Two: Minimum Payments

Paying off your debts is one of the best investments you can make, but it isn’t always the best.  You need to take a lot of things into account to decide when and how to pay off your debts, and the analysis isn’t always simple.  One main rule is this:

Always Pay Your Minimums

You cannot possibly hope to match the interest rate you will be charged with late fees and penalties, so you have to pay at least the minimum to every debt you have.  So no matter what other options are open to you, do not let yourself be subjected to these kinds of charges.  If you cannot meet your minimum payments, it’s time for another job, or to sell some things.  Getting your head above water is a separate subject, but make sure to do it.

Step Three: Tax-Deferred Options

Now despite the allure of being debt-free, there are some rare occasions that your bottom line will be better served by contributing to your tax-deferred savings.  Quite simply, if your company matches your tax-deferred account at 50% or better, you may be better off contributing to that account.  This is of course only true up to the amount that they match. Do not contribute more than they match until your debts are all paid off.

For example, if my company will match up to 3% of my salary in my 401(k) at 100%, I am possibly better off making this contribution instead of paying off my debts.  I will make 100% return on that money put into my 401(k), while I will probably be charged 20% on the debts I leave unpaid.

Generally speaking however, unless your debt is relatively small compared to your income, or you are very secure that your income will continue, you are probably still better off just paying the debt.

Step Four: Pay Off Your Debts

There is no sense investing in anything when you have the option of paying off your debts.  The only debt you may want to carry is a house or a car, and even those are questionable.  Even beyond the dangers of high-interest debt, it simply provides a security blanket to have your debt cleared.  There are various approaches to paying off your debt, but get it done before you start investing your money elsewhere.  Moreover, when in doubt: pay off your debts sooner than later.

Basic Investment Template

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My next several posts will be attempting to define a basic investment template.  Basically I’d like to develop a checklist to help anyone figure out where and how their money should be invested.  Most investment advice I read is very vague.  While most contain good advice it is usually in a vacuum.  You’d have to read hundreds of these articles to develop a coherent strategy and you still might miss a key point.  I will update this post as I create each installment and may reorder and edit them based on your input and questions.  I will also be posting much more frequently until the template starts to take shape.  Please feel free to start putting any questions below and I will attempt to answer them as I go.

Investing Prerequisites

• Step 1: Dealing With Debt
• Step 2: Your Expanded Emergency Fund
• Step 3: Goals and Time Horizon

Tax-Deferred Accounts

• Step 4: Tax-Advantaged Overview
• Step 5: Retirement Accounts
• Step 6: College Saving Accounts
• Step 7: Homeownership Accounts
• Step 8: Health Spending Accounts

Implementation

• Step 9: Allocation
• Step 10: Techniques