In the previous articles in this six part series. we discussed protection and your financial position. Today, we look at tow facts of life that will not go away: taxes and the the investments needed to make your personal finance goals a success.
This site is devoted to retirement, something we believe can be achieved in fifteen years. We don’t recommend that a 20 something call it quits at 35-years-old but we do believe that you should be well on your way, with all of the pieces in place. It is a tall order but requires so little of you (possibly as little as an hour or two a month) that achieving the kind of financial success we discuss is very doable.
We do know two things about that retirement or should I say we know about two things: taxes will be there (but we don’t know what impact they will have) and our investment choices will be key to the plan’s success (although the volatility of the markets in the present tense is troublesome). Since one affects the other we will focus on a few basics and a simple strategy.
You aren’t investing enough now to have what you think you will need. (Notice I refrained from writing “savings”? Savings is safe; investing has risk.) It is a simple enough truth based on the number of people who participate in their company’s retirement plans, the waiting period in many of those plans, the inadequate choices in still more of those plans and the fact that those who don’t have access to a company plan, don’t always invest on their own.
If this country were fully invested (not really a possibility since everyone woud need to be fully employed and that has never happened), then we would all understand the importance of the markets in our quest for investment success. It is a simple dynamic suggesting that if all the folks on the sidelines jumped in, the investment choices at their disposal would begin a bull market similar to the one that gave many investors the boost from 1982 to 2000. During that period, a moment in time when pensions were phased out and 401(k)s were phased in, the new investors drove the market to highs never before seen.
So we need to be invested. Knowing that is easy. What freezes a great many of us is where? The simplest of investments for all ages is an index fund. These are designed to be cheap (all mutual funds charge for the investments they provide but because an index does so little in the way of trading or selling, that these costs are minimal), they’re diversified (an S&P 500 index fund purchases a portion of the largest 500 companies) and they are in almost every 401(k) plan available.
This is a great first step but not the last by any means. Once in, the hard part is done. Now you can spend a little bit of time over the next several years building a customized portfolio that suits your needs as you determine your ability to stomach risk. Risk increases with each new investment. But so does diversification and done correctly, the balance each other out. Taking the first step is key.
The minimum investment you should make in your 401(k) is 5% of your pre-tax income. This has the net effect of leaving your net income unchanged. This allows you to keep financially fit in the short-term as you learn the process. Remember I mention we don’t invest enough. Five percent is far from enough; it is only a baby step.
If you only have access to a traditional IRA (Individual Retirement Account, a plan that allows you to deduct your contribution when you do your taxes) you should put at least $25 a week, automatically taken from your bank account. But this is also a baby step.
Because taxes are the great unknown, there is a strategy you could use to hedge your eventual payment owed on those investments. The pre-tax nature of those retirement accounts suggests that you will pay taxes in the future, a time when it is assumed your tax bracket will be lower (in retirement). But no one can say for sure that your bracket will be lower or your income from those investments will not be taxed at a greater rate.
So you should do the following: Put the 5% in your 401(k) - or the $25 a week in your IRA. Then open a Roth IRA. This plan allows you to invest in after-tax income (the taxes are already paid) and the only taxable portion will be the growth of those investments. You should contribute the full amount allowable to this plan ($5,000 a year if you are under 50, $6,000 if you are over 50). Sounds like a lot but keep in mind, you are still under invested.
Once that is achieved and you learn to live on less income, go back to your 401(k) – or traditional IRA – and fully fund those to the maximum the law allows.
Next up in our series: accumulation goals.
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