This answer bothers me in a couple ways. Take my friend who does fairly well. I don't know how much she has saved up, but it has to be in the thousands. So based on that answer, she has several thousands of dollars invested in something, evidently called a "fund", and she is entrusting the management of this "fund" to somebody who claims to be an expert because they say they are. I don't know about you, but wouldn't you feel better if YOU took care of your own money? I'm not trying to knock financial advisors. I'm sure there are a lot of terrific ones out there, and it may be useful to have someone to discuss ideas with from time to time. But I think it's important to have some clue of where your money is. So in this blog, I'm gonna go over some basic investment options.
So you have some money in your piggy bank. What should you do with it? Well, one option is nothing (leave it in the piggy), which is always the wrong answer, because money depreciates due to inflation. That's why it costs more to buy a soda today then it did ten years ago. So please, never put your money under your pillow.
Before you decide where to put your money, you have to separate your savings into two pots. In one pot is your retirement savings, money you do not anticipate needing until you are 59 1/2 years old. In the other pot is money you want still to grow, but may need to use in the next 40 years. This distinction is important, because if you put all your savings into an Investment Retirement Account (IRA), and you want to withdraw some of it before 59 1/2 years old, you will have to pay hefty early withdrawal fees. First, we'll talk about your non-retirement savings.
The simplest way to save your non-retirement money is probably your good ole savings account. These are straight forward accounts set up by banks which allow you to deposit or withdraw at anytime, without any fees. The problem with these accounts is that their interest rates are usually the lowest of any investment options, often between 0.1%-5%. These rates are dependent on the borrowing rates set by the Federal Reserve, the government institution which oversees all banks. The rates are higher usually in good economic times, and lower in poor times. One pearl is that online savings accounts usually have higher rates, since they require no maintenance costs for the banks, so check them out. A similar entity to a savings account is a money market account. For our purposes, they are the same.
The only other way to save your non-retirement money and have it available at any time is the stock market. Now, the stock market is so complex that I'm going to devote several posts to it. Suffice to say for now that it's not really meant for frequent deposits and withdrawals...that would be called DAY TRADING, which is only a little bit better than gambling. Actually, gambling probably has better odds, since about 90% of day traders lose money. Investing in the stock market should be viewed as a long term strategy, because stocks can be very volatile in the short run.
Another option for your non-retirement money includes certificates of deposit (CDs) and bonds. CDs and bonds are money you lend to a bank or the government, respectively, but there is a specified period of time, anywhere from 6 months to years, before you can take the money out. They have unique interest rates to them, which are usually higher than interest rates of savings accounts. For example, currently a ten year bond yields about 4%, whereas an average savings account these days gives you 1%.
OK, on to your retirement savings. There is no question when it comes to retirement savings, IRAs are the way to go. The reason is that the returns you get are not taxed, and hence they will give you the best yield of any of your investments. For instance, if you put $1000 in a one year CD with a 3% interest rate, at the end of the year you expect to earn $30, right? Wrong, because you are forgetting that you'll be taxed on that $30, so what you're really gonna make is around $20. But if you had put that CD in the form of an IRA, you would be able to keep that full $30. This example also brings up another point. You can't just dump money into an IRA and leave it there. You have to specify to the financial institution managing your IRA what investment vehicle you want the money in. In my example, I used a CD. You could use anything really, even a savings account, but that would be oxymoronical as savings accounts are meant to give you the capability of moving money in and out whenver you want.
There are different types of IRAs, but for all intents and purposes, if you're a beginning professional, you need only be concerned with the Roth and the Traditional IRAs.
If you are single and making less than six figures, the Roth IRA should be your first choice. You can't open one if you're making more than $116K, and there is a maximum contribution of $5000 a year if you're making less than $101K. If your income is between $101-$116K, you can make a partial contribution, and there is a chart from the Internal Revenue Service (IRS) on those limits. These income limits are higher if you have a spouse. The best thing about a Roth is that you can withdraw your money tax free, at the age of 59 1/2, of course. A disadvantage is that your contributions are not tax deductible, so essentially you're taxed in the front end, which if you think, is better than being taxed in the back end. For instance if you put in $5000, you're really putting in $1000-$2000 more, because the $5000 is post-tax. But in 40 years, when your $5000 grows into $25K, taxes on that would be approximately $7000-$8000. So you don't want to be taxed then.
For a traditional IRA, there are no income limits. Contribution limits are based on age. If you're younger than 50, than the limit is $5,000. The advantage of the traditional IRA is that your contributions are tax deductible...but only for certain incomes, e.g. <$62K for a single person. Withdrawals are subject to income tax, so not as good as a Roth. There are other subtleties to IRAs, but I've given you the basics. If you want to read more about them, go to the website of the IRS.
There are several investment vehicles I haven't mentioned. One is the popular mutual fund. A mutual fund is simply a portfolio of stocks and bonds that investment managers have created. They are for investors who don't really want to spend the time to create their own portfolios. An important point is that when it comes down to your retirement savings, mutual funds should not be relevant when you are starting out. When you are a beginning professional, you want to put your retirement savings in stocks, because they will give you the best return in 40 years. But as you age, more of your retirement pot should be shifted to bonds, which give you less return, but are less risky. So you could potentially use mutual funds to adjust your stock/bond ratio. A good rule of thumb is that every ten years, you should shift about 25-30% of your retirement savings into bonds.
Another investment vehicle is the employer sponsored plans, and these are basically 401Ks and Keoghs. 401Ks and Keoghs are similar to IRAs, but come from your employer, so that you can elect to reserve a portion of your paycheck for your retirement. The tax implications can vary like IRAs, and in fact there is a Roth 401K, which allows for tax free withdrawals. There are even 401Ks where your employer will match dollar for dollar, your contributions. In terms of Keoghs, they are generally unique in that they have the highest contribution limits of all the investment vehicles. Different employers will offer different 401Ks and Keoghs, so make sure to inquire about them!
You also may have heard of an investment vehicle called an annuity. Essentially, this is a contract between an individual and an insurance company, where initially the person pays the company a sum of money, and agrees on an interest rate which can be fixed or variable, until a specified time upon which then the company starts paying the individual an agreed amount periodically. Annuities are attractive, because they give individuals a "steady income" after they retire, sort of like a pension plan. Also, there are annuities, in which their returns are tax free. There's nothing that's a free lunch though, because the knock on annuities is that they often have expensive management fees attached to them. A good rule is that for your retirement money, you should maximize your contributions to your IRAs first, then if you have money left over, a tax-sheltered annuity would be reasonable. However, if you do have a 401K which does not have a contribution limit, there is no reason to set up an annuity.
Whew! So many choices, right? Well, let's see if we can't simplify things.
Back to the money in your piggy bank. So, remember the ultimate goal is to save for retirement. But at the same time, it's not a good idea to put all your money into retirement accounts, again because you can't use it until 40 years later. You want an emergency fund you can access anytime, just in case you need it. If you have enough savings to maximize your IRA account(s) (you could potentially have BOTH a Roth and a traditional IRA), and still have some money left over, you should maximize those accounts. The left over money, you can then use to put a portion in your 401K if you have one, and the rest into a savings account. I personally am not a big fan of CDs and bonds for your nonretirement money, because their yields are usually not that much higher than online savings accounts, and also you have to wait these certain time periods to take your money out. If you don't have enough to maximize your IRAs and have some money left over, just split what you have. Put 3/4 into the IRAs and 1/4 into a savings account.
So that's it really, a portion in your retirement accounts, and the rest in a savings account...all you really need! If you are more risk averse, you can reserve some money to play the stock market. I don't recommend doing that if you can instead maximize the IRAs.
Alright, until next time, may you make some moolah.
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