Guest Post: Investment Super Basics by Ben Norkin
When you’re 30 the most fun thing to do with money is to save it for when you’re 60! I know that’s not true for most of us, but what IS true is that starting with your retirement investing early will yield huge benefits for your future self.
Obligatory compound interest example to get us started: If you are 30 years old and invest $100 a month for 30 years you will have invested $36,000. Assuming an average return of 7% your investment will have grown to $116,945.26, an earning of over $80,000! If you don’t start until you are 40 you will need to invest more than $225 a month to reach that same $116,945.
In this post I’m going to cover the very basics of two of the most common retirement investment accounts out there; 401Ks and ROTH IRAs. We’ll discuss how each one works and what the benefits and limitations are of each one.
The important thing to know before we start is that this is very specific to your retirement investing. This is money that you should assume you can’t touch until you turn 59-1/2 years old. There are other short and long-term savings options/products/strategies out there, emergency funds, vacation savings, etc. That’s not what this is about. This is just about money you are putting away for your retirement.
You might already be familiar with a 401K through your work. If you work for a small business you may have a Simple IRA and if you are self-employed you can create a SEP IRA. These retirement accounts have different rules and requirements for the business or person that is offering them, but for the end user the key thing is that these are all tax-deferred accounts. That means money you put in now is not taxed but you will owe taxes when you withdraw the money later.
The advantage here is that money you contribute to your 401K this year will reduce your income tax this year. If your salary is $60,000/year and you contribute $3,000 to your 401K, your income, for tax purposes, is reduced by $3,000 so you pay income tax on only $57,000. At the 22% tax bracket that $3000 investment saved you $660 in tax. This is a great thing to keep in mind when considering your investments…yes you put $3,000 in your 401K but you saved $660 in tax, so that $3,000 investment really only cost you $2,340.
The catch here is that when you remove that money when you’re 60 you will owe taxes on it at that point, and it will likely have grown quite a bit! The reason people do this is that theoretically you will be in a lower tax bracket when you retire. If you and your spouse make $150,000 a year combined you will be in the 22% tax bracket. Maybe when you retire you can live on $75,000 a year from your investment (house paid off, kids gone, etc). That would put you in the 12% tax bracket, so when you take out that original $3,000 you will only owe $360 on it!
Another huge benefit is that many employers will match 401K and Simple IRA* contributions. Every company is different, but if a company offers a 3% match it means that if you put 3% of your salary into your 401K they will put an equal amount of money into your account for you. That is as close to free money as it gets. If you have an employer that matches contributions you absolutely must contribute at least as much as they match. I know it can be tough to have 3% coming out of your paycheck every two weeks, but at $60,000 that match is $1,800 of bonus money. Cut costs elsewhere in your life, NOT in a matched 401K. I think this is so important that I’ll say it again. You absolutely must maximize your employer’s contribution to your 401K.
* Employers offering a Simple IRA have to provide a match of 2-3%
Unlike a 401K, money you put into a Roth IRA is taxable now. The major benefit is that it grows tax free, so you do not pay additional taxes when you withdraw your money at retirement. That’s huge!
The current maximum contribution is $6,000 per year. If your salary is $60,000 per year and you are able to contribute the full amount to your ROTH, you will still end up paying income tax on your full salary this year. In 20 or so years when you’re ready to withdraw those funds you will not have to pay tax on that money!
Let’s math for a bit: If you invest the $6,000 every year for 20 years and get a conservative 7% return you will have invested $120,000 but your total balance will be $246,000! That’s $126,000 of tax-free interest earnings, or two and a half semesters of architecture school in 2040.
Also, because compound interest is so awesome, if you invest $500 per month instead of a one-time $6,000 payment at the end of the year you will earn an additional $7,000 of interest!
Like a 401K, ROTH IRAs are designed to allow withdrawals after the age of 59-1/2, BUT there are some helpful exceptions.
First, you can withdraw up to $10,000 for a first-time home purchase. You can also withdraw for some educational expenses, birth of a new child, medical emergencies and a few other things.
Another benefit of using a ROTH IRA is that because you pay tax on this money before you invest it, you are always allowed to withdraw your contributions penalty free. That means if you contribute $6,000 to your ROTH, then it grows to $10,000 and you have an emergency you are allowed to withdraw your initial $6,000 with no restrictions.
This should be considered a last resort though, so try to think of that ROTH money as retirement money only, not as your emergency fund, though it is there is you absolutely need it.
Interest that is added to principal savings and in turn increases the amount of money that is earning interest. Can be compounded daily, monthly, annually, etc. Usually your debts are compounded daily, your cash savings might be on a longer schedule, like monthly.
Notes on Both
One important thing to note is that 401K and ROTH IRAs are really just shelters for money, they are not investments themselves. You designate money to these different types of accounts, but then to actually make it grow you need to invest it in different…investments. This means that with the money you have contributed to your ROTH IRA you can then buy and sell individual stocks, bonds, index funds or other savings products. And that’s a whole different blog for another day!
You will probably want to do more research before deciding how to invest your retirement money, but I’ll tell you what I do.
First, I max out my ROTH IRA contribution as soon as possible. Using cash savings and my tax refund, this year I was able to do that in February…just in time for the market to crash. I turned $6,000 into $4,000 in just a few weeks! The max limit for ROTH contributions makes it a good fixed goal to try to achieve.
Second, I make small quarterly contributions to my SEP IRA. Being self-employed I am required to pay quarterly estimated taxes. Every time I earn some money I have to save a large percentage of it for my income tax, and pay that in four installments over the year. Usually I oversave for this, so at the end of the quarter I have some money left after I pay those taxes. I take some of that and put it into my SEP. You all should be doing regular 401K/Simple IRS investments direct from your paycheck every two weeks, but you can usually invest more as you want.
Third, at the end of the year I determine how much cash I have on hand and how much I am comfortable saving for retirement. I make sure to calculate how much income tax I will save with further contributions to my SEP. The maximum SEP contribution is over $50,000 and if you have that much spare cash to invest you are probably not reading this blog. I find the open-endedness of the SEP/401K makes it a little more difficult to have a goal. Sure, I could always do little bit more, but I want to spend some money now too and my daughter always wants a new Elsa doll, so…
Now you know just enough to be dangerous, so go out there and be responsible with your money! Your future self will thank you.