Today we continue down the steps to investing
and talk about setting up retirement accounts, including a 401K and an IRA. This is a critical thing to do before you even consider putting money into other investments because retirement is coming sooner than you think and it is a steep hill to climb to be ready. It is very manageable if you work at it over several decades, but very difficult to overcome if you don’t start until you are within 15 years of retirement or later. Ideally you will set up your retirement accounts and start sending in money regularly (10-15% of your income) right when you start your first job because:
1) You will make far more from the money you save in your twenties than that you save later in life due to the compounding effect of investing,
2) It is far easier to find money to save for retirement if you start a job than it is after you’ve already started spending your whole paycheck on things.
Even if you didn’t start saving early, the sooner you start, the better, so make today the day.
How to setup 401K and IRA accounts.
Setting up a 401K (or 403B) is easy if your company offers one. Just fill out the form HR gives you when you start work or check with them on how to get started. You will need to say what percentage you want deducted from each paycheck. Enter at least enough to get the full company match, usually 5% of your income. If you don’t want to mess around with an IRA, go ahead and put 10-15%. (If you make more than about $100,000 or have a very generous company match, you’ll need to verify that you’re within contribution limits if you go above 10%. Check with HR, go online to the IRS site and check the current limits, or check with your CPA.)
You’ll also need to select initial investments. If you need more time to go through options, just put the money into a large cap stock fund or a total market stocks fund to start, or maybe divide it into a couple of stocks funds. This way you’ll be able to take advantage of any market surges that happen while you’re figuring out your plan and you’ll have a decent investment mix for a young investor should you get busy with other things for a while and take a few years to come back. It is possible that the market may decline during this time and the account will then be worth less than you contributed, but this will be a temporary thing. If you keep investing regularly and hold for a long period of time, you’ll end up with far more than you invested.
Setting up an IRA will require going through a broker or a mutual fund company. Again you’ll just fill out some forms, by hand or online. You’ll also need to make an initial minimum contribution, which may be a few hundred dollars up to a couple of thousand, so you may need to save up money in your bank account for a while until you reach the minimums. After that you can setup monthly deductions from your bank account or just send in a check periodically. You can choose to just make one contribution per year, provided you make the contribution by April 15th of the following years, or you can spread it out. You’ll get the best return by investing the money longest, which means making the full contribution for the year as close to January 1st as you can, but most people won’t have the cash available to do this.
What to Invest In
People who haven’t invested are often intimidated, but there is really no reason to be, particularly when you’re investing in a 401k. (Note, some of you may work for a government agency and have a 403B instead, but the same principles apply.) The reason is that your choices are very limited and anything you buy will be spread out over a lot of different investments, so there is no way you’ll lose money if you invest for a long time (like 10 years or more). There are two critical mistakes that you can make with investing in a 401K account, however, and these are:
1) Being too conservative and putting all of your money in a cash account, like a money market fund. This investment will not give you the growth you need to reach your retirement goals. In fact, it will lose value due to inflation over your lifetime, meaning you might have half of what you put in when you retire. You need to be putting your retirement money into stocks, bonds, and real estate (through REITs) until you get to within maybe ten years of retirement. Then, you convert a portion to cash for money you’ll need within a few years to help protect yourself against downturns.
2) Putting all of the money into one investment, particularly your company stock. Unfortunately, some companies decide to give out company stock for 401K accounts instead of just giving cash. It is never good to have all ( or even a large portion) of your money in one stock or one bond, particularly in your company’s stock since then you can lose your job and your retirement all at once. If you have no choice to accept company stock, sell as soon as you can and put it into mutual funds.
The things you should be invested in are:
1) Stock mutual funds with the lowest fees you can find. Most of your money should be in stock mutual funds when you are in your twenties. As you get closer to retirement, you shift some money into income investments like bonds and REITs, but these will provide lower returns over long periods of time than will stocks. When selecting funds, buy funds in different categories such as large caps, small caps, and international. You can also divide between growth and value funds. Find the funds with the lowest fees (less than 0.50% is good) and don’t worry too much about past performance. Index funds are best choice if they are available.
2) Income funds like bond funds and REITs. Income funds help protect your portfolio during downturns since they will not fall as far as stocks and also provide a steady return when stocks are going nowhere. Over long periods of time they will return maybe 6-8% before inflation, where stocks will return 10-15%, so you don’t want to load up on them in your twenties. But as you start to get a respectable account balance and you start to get old enough to where a big downturn in the market would cause a big setback, bonds and REITs can provide some stability and protection. In your twenties you might own 0-20% income investments, where in your fifties it might be 30-50% and 40-60% in your sixties. Again, look for funds with the lowest fees, like a total bond market index fund, and spread out your money among different types of bonds, REITs, and high yield stocks.
3) Cash investments. Cash investments like money market funds and short-term bonds should be very limited when you have a long time to invest, but as you get close to needing the money, you should move some money into cash. Given that most market downturns last for two years or less, having enough cash to pay for everything for the next two years is usually enough. If you wanted to be really conservative, you could keep five or even ten years’ worth of cash, but it is probably better to just have some income investments since more cash increases the chance that you’ll outlive your money unless you have way more than you need saved. Another strategy is to raise cash when the market has done well, selling stocks then, then spending from your cash reserves when the market is doing poorly until you reach some critical threshold.
Investments in an IRA are just the same, but perhaps in a different form such as an ETF instead of an index fund. If you have an IRA with a brokerage account, you can buy virtually anything. The best choices are index funds and ETFs in the same categories as those used for a 401K. Avoid buying the high load funds your broker will try to sell you. You might also chose to include some individual stocks (choose growth stocks and plan to hold for a long time) and bonds to increase your returns, but realize that you’re giving up diversification when you do, which increases risk. It also requires more skill and knowledge than buying mutual funds.
If you have an IRA through a mutual funds company, just select their funds. Vanguard is a good choice since they have lots of low-cost mutual funds from which to choose. Setting up an account through your bank or credit union is a possibility, but be careful to be sure that you’ll have good investment choices, which means low fee funds. Be sure they don’t convince you to put the money into CDs or something unless we enter an extreme interest rate environment and those CDs are paying 12% or more. Otherwise, you’ll do far better invested in stocks.
Allocating between a 401k and IRA, and between Roth and traditional plans.
I like to have some money in an IRA, rather than putting it all in a 401k, because there are a lot more investment choices, I have full control of the money, and I’m not charged a fee based on the value of the account. If you are lucky enough to have the choice of several index funds in your 401K, this is less of an issue, but if all of your choices are high fee managed funds, it is much better to be buying ETFs and index funds in an IRA. Because you should be putting 10-15% of your income into retirement, I usually put enough in my 401k to get the full company matching amount, then max out my IRA contributions, then go back to the 401K until I reach my goal. There are also limits due to tax regulations, and IRA contributions may or may not be deductible, so you should work out a plan with help from a CPA. The important thing is to be putting 10-15% away, however you can.
There is also the choice between a traditional IRA and 401K and Roth plans. The difference is that you get a tax deduction with the traditional plans (again, subject to complex tax rules), where you get to withdraw the money tax-free from a Roth account since you pay taxes on the money before you put it in. Mathematically, the Roth is usually better assuming tax rules stay the same, but there is a risk that the government may change the rules by charging a consumption or value added tax in the future, such that you would be paying taxes on the money anyway, or just break the agreement entirely and start taxing Roth account withdrawals. You might also find that you’re in a higher tax bracket now than you will be at retirement, so the tax deduction now may be better than tax-free withdrawals later. For this reason, you might even wish to put a little money in both types of accounts, and/or sit down with a CPA and look at options particular to your situation.
This is a series on the steps to start investing. To find all posts in this series, just select “How to Invest” from the categories to the right.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.