So you’re ready to start saving / investing for your financial freedom. The main question is, how do you get started? I thought I’d share my own challenges and questions to break the process down to the bare bone. Based on my current situation, retirement savings can be broken down into 3 buckets: 401K, IRA, and brokerage account. Of course there are other tools such as Health Savings Account (HSA), Simplified Employee Pension Plan (SEP), etc. I’m not as familiar with those, but just know that there are more options than the 3 buckets I mentioned. Also, the info mentioned is based on a single tax filer. There are different limits for a married couple.
401K – Some general background, it’s nothing new but a refresher instead. A 401K is something most of us are familiar with. 401K is sponsored by most employers as a tool to facilitate retirement savings for employees. In most cases the employer would provide matching contribution up to a certain percentage (e.g. 100% match up to 5% annual gross compensation). For a traditional 401K, the money that an employee can contribute is tax deferred (i.e. you don’t pay any taxes now on the $ you put aside to a 401K), as well as any interest or dividends earned. In 2015, you can contribute as much as $18,000 a year. If you’re 50 or older, you can contribute an additional $6,000. Upon reaching the retirement age and when you start to withdrawal funds from your 401K, you’ll then be taxed for the withdrawal. For roth 401K, the contribution you make is with “after tax” $$$, however upon retirement, you will not be taxed for withdrawals make.
It is to be noted that regardless of the type of 401K contribution you make, you can only contribute in total up to the allowable limit set by the IRS, which is $18,000 in 2015. You could have some contribution in a traditional 401K and some in a roth 401K, but no more than $18,000 combined in one year. The key difference is when you’ll be taxed (now or later). If you’re in a higher tax bracket, it may be more beneficial to maximize the tax benefit of a traditional 401K to help bring down the taxable income. Some argue that roth 401K is a better option since you know for certain how much taxes you’ll pay now rather than the unknown 30+ years later. In my opinion there is no right or wrong way to use a 401K, it all depends on your own situation. If you are not contributing to the max, at least contribute up to the employer match. After all, it’s free money, take it (if not, give it to me. =P).
After you’ve made your contributions and selected investment options based on your risk appetite, this doesn’t and shouldn’t stop here. I myself made the same mistake. For the longest time I just left things alone and figured as long as I’m making monthly contribution, I’m all good. WRONG! It is so easy to overlook fees and not re-evaluating your investment portfolio based on your investment goals. By using Personal Capital (it’s a free retirement tracking website, just go to www.personalcapital.com), I saw how much fees I was being charged for the various investment options I’d selected, and I wasn’t happy. The fees basically reduce your earning potential throughout your investment life. Typically, 401K investment option consists of mutual funds. Some of the big names are Fidelity, T Row Price, Vanguards, etc., and the fees are paid to the money managers. Based on Personal Capital, the average bench mark for fees is around 0.50%. I’m not in a position to say which funds you should avoid or select, but just know that you should be aware of the fees that you’re paying and how it impacts your investment in the long run.
Secondly, portfolio rebalancing / re-evaluation is something you should be aware of as well. Some people may elect to invest 80% in stock and 20% in bond, and your initial investment election may reflect so. However, we may be neglecting the fact that your investment may perform differently; even if your intended election is 80/20, your stock portfolio may out perform bonds, which potentially would skew your investment balance resulting in an actual portfolio of maybe 85/15, or 90/10, just as an example. To a more conservative investor, they may not be comfortable with a portfolio of 90% in stock and 10% in bonds when their intend is 80/20. This is when you can rebalance your portfolio by trading some of your shares in stock fund to a bond fund. You should do a health check on your portfolio regularly (maybe once a year) to determine if a rebalance is needed. As your investment appetite changes, you should also re-evaluate whether 80/20 still works for you. Maybe you’re more conservative now and are more risk adverse as retirement age approaches, then you can perhaps decrease your investment election in stock fund and increase bonds or money market investment (and rebalance it accordingly).
IRA – Individual Retirement Account. This works similarly to a 401K, except that it’s not employer sponsored. You can go to most financial institutions or online brokerage firms to open an IRA account. A traditional IRA is tax deferred. You can reduce your taxable income by the money you elect to contribute to an IRA account each year. In 2015, the IRS allowable limit is $5,500 ($6,500 if you’re 50 or older). Now there are certain rules and limitations as to whether or not you can quality for an IRA (i.e. if you make too much money (nice problem to have), you may not be able to deduct the full $5,500 or even quality to use this tax deferred tool). If you don’t quality for an IRA or don’t want to use a traditional IRA, there is also the roth IRA (also has wage limitation). It is the same concept as a roth 401K where your contribution is made with “after tax” money. Conversely, once you reach the applicable retirement age, you will not be taxed for the withdrawal made. Whether you choose a traditional IRA or a roth IRA, the contribution limit for 2015 is $5,500 in total.
This may sound silly, but when I first opened a roth IRA account (I chose roth IRA instead of a traditional IRA since I wanted to diversity my retirement investment), I wasn’t sure what to do exactly. I figured once I put the $5,500 there for the year, then i’m set. Well, wrong again. After few days of wondering, I realized I had to choose my investment option similar to choosing my 401K investments. If not, the money is just gonna sit there like it’s sitting in a checking account. This was a bit difficult since I wasn’t given a list of options to choose from as with a 401k. I had to make my own selections, which was pretty confusing for an investing newbie. I did some research based on the analysis from the brokerage account site and picked a mutual fund that I thought may be a good performer. My strategy will be updated in the future though. See more info in the “brokerage” bucket.
Brokerage account – So this is your Scottrade, Merrill Edge, TD Ameritrade, Vanguard, Fidelity, Charles Schwab, etc. With a brokerage account, you can purchase stock (e.g. Apple, Microsoft, Google, etc), mutual funds, EFT’s, etc. This was where I had absolutely no clue what to do. I’m not a day trader, can’t really afford to buy big name stocks, and don’t really want to worry about locking my $$$ in a specific company. I’ve had an account with Merrill Edge for a few years and it just kinda sat there idle. Recently I crossed path with some blogs which touch on early retirement and how to reach financial independence (see prior post here). Through those sites I learned that investing for the long run doesn’t have to be complicated. This is not to sell any product, but many references have been made to the Vanguard Index Fund (there are a few, but main one is VTSAX. I can’t get my hands on it, but found something similar VTSMX). This fund or investment strategy mirrors the S&P Index. As my intention isn’t to out smart the market but to earn a reasonable return and leverage compound interest, I feel it is the simplest way. Only time will tell what the outcome might be, but you won’t earn any reward without taking any risk. And your portfolio won’t grow if you don’t save.
There are some details that I did not touch on, however all the information can be easily accessed when you google them. I’m still learning and exploring, so please take what I’ve shared with a grain of salt. Oh and I’m not licensed to provide financial advice and don’t intend to. This is really just something that I wanted to share based on my own personal journey. Please do what make you feel comfortable financially. 🙂