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What You Need to Know Before Rolling Over Your 401K

scale representing weighing the pros and cons of rolling over your 401k

With the staggering job losses in 2020, many people are asking what they should do with the 401K they have with their former employer. Brokerage firms will tell you that rolling over your 401K into an IRA is the best option, but what they don’t tell you is that they make A LOT of money from these rollovers. So should you take their advice? Here is everything you need to know before you decide to roll over your 401K.

DO NOT WITHDRAW YOUR MONEY

The absolute worst thing you can do is withdraw your money from your 401K. In the finance world, this is sometimes referred to as an indirect rollover, so watch out for those. The reason it is so important to do a direct rollover and to avoid withdrawing your money is that if you do, you’ll pay income taxes on it and unless you’re 59 ½ or older, you’ll also pay a 10% penalty. That’ll leave you with significantly less money. So, whatever you do, make sure to do a direct rollover and DO NOT WITHDRAW YOUR 401K MONEY!

Your Rollover Options

You have two options as to how you can roll your money over. If you have a new job (first of all, congrats!) and that job offers you a 401K, you can roll your old 401K into your new plan. Not all plans allow transfers, so first, you’ll need to check that your new one allows this. If it does, you’ll also want to check that it offers low fee investing options before transferring your balance. The average 401K investment fund fee is .45%, so if your plan only offers investment options with higher fees than that, you may want to consider option two instead.

Your second option is to roll your 401K into a traditional IRA. Since an IRA is a completely different type of retirement account, you’ll need to take some more things into consideration before switching. To help you decide whether you should switch or not, here are the pros and cons of rolling your 401K into an IRA.

Pros of Rolling Into an IRA

More Investment Options

One of the main arguments you’ll hear for rolling your old 401K into an IRA is that you’ll have more investment options. While this is true, this is also where many people get themselves into trouble. Remember when I said that brokerage firms make a lot of money by getting you to switch to an IRA? Well, offering you access to more or “better” fund options is usually how they do it.

While you will have access to more investment options with an IRA, many of these options will charge much higher fees than your 401K options do. That’s because a lot of the new funds you’ll be able to choose from will be actively managed mutual funds that are notorious for charging exorbitant fees without providing the excessive returns they promise.

If you decide to switch to an IRA to take advantage of having more investment options, make sure you aren’t swindled into investing in high fee funds that will benefit the brokerage and could end up costing you thousands.

No Terminated Participant Fees

Some companies charge former employees a fee for leaving their money invested in their 401K plan with their previous employer. These are sometimes called terminated participant fees. Check your prior employer’s plan info to see if you’ll be charged this fee. If you will be, switching to an IRA will allow you to avoid paying it.

Access to Cheaper Funds 

While many people get misled into investing in high fee mutual funds when they change over to an IRA, you also have the potential to save money on fees if you switch. Depending on which brokerage provides your 401K, you may have access to super low-cost index funds, ETFs, and even target-date funds with your new brokerage. Make sure to evaluate the full fee structure for your old and new plans before you make the switch.

Maintain Full Bankruptcy Protection

One benefit 401Ks have over IRAs is that they are fully protected from creditors if you file for bankruptcy. However, rolling over your 401K into a traditional IRA allows you to retain this protection. The key is that you need to be able to show that the original source of funds was from a 401K. To reduce confusion on the source of funds, make sure to open a separate rollover IRA if you have already been contributing to another traditional IRA.

Cons of Rolling Into an IRA

No Loans or Early Withdrawals 

You should exhaust pretty much all other available options before taking out a loan from your 401K, but you do have the option to do so if you get into really dire financial straits. If you switch to an IRA, this loan option will no longer be available to you.

The minimum age for early withdrawals is also higher for IRAs at 59 ½ than with a 401K where you can begin to withdraw the money at 55, penalty-free.

Huge Tax Bill for Company Stock

Many people who work for large companies receive some of their compensation in the form of stock options. If this is you, it may be a better idea to transfer your company stock into a taxable account and pay income taxes now, so you only have to pay capital gains tax (which is typically much lower) on any future earnings. The rest of your 401K can then be rolled into a deferred tax account like a traditional IRA. If instead all of your stock is rolled out into a traditional IRA, you’ll have to pay income tax on all future earnings, which could land you with a much higher tax bill. Make sure to check with a tax professional to find the best option for you before deciding to switch.  

Required Minimum Distributions 

If you’re a workaholic and planning on working forever, you may want to consider when you will be required to start taking distributions. 401Ks never require you to start withdrawing your money, while IRAs require that you start taking the minimum distribution at 70 ½.

Weighing all of the tax, fee, and distribution options before rolling over your 401K can save you money and heartache in the future. Don’t fall prey to the brokerage firm’s promises about the benefits of switching to an IRA. They’re trying to make money off of you, not help you live your dream retirement. Make sure you do your own research on all of the hidden fees and taxes you could end up paying by blindly rolling your money into an IRA. As the saying goes, the grass isn’t always greener on the other side.

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3 Steps to Recover from a Late Start to Investing in Your 30s

We’ve all heard the advice that you need to start investing as early as possible, but the fact is that many of us are late to the game when it comes to starting to invest.

If you missed getting on the investing train in your early twenties and are now consumed with anxiety every time you see one of those charts about how the 20-year-old investor is going to become a millionaire, while the 30-year-old investor will never be able to catch up, keep on reading, my friend, because there is hope for you.

Here are 3 things you can do as a 30+-year-old investor to start investing, maximize your earnings, and become a millionaire before retirement.

1. Stop Putting Investing Off

Pour one out for the earnings you’ll never receive because you didn’t start investing in your twenties, and then move the fuck on. If you don’t start investing now, 40-year-old you is going to have an even harder time preparing for retirement, so stop wallowing in your sorrows and start investing.

Remember the anxiety-inducing chart about the 20-year-old investor whose earnings blow the 30-year-old investor’s earnings out of the water? Well, the same principle applies to a person who starts to invest as a 30-year-old vs as a 40-year-old. Take a look at the graph below. 

*Graph totals assume a 10% annual return

You can see from this graph just how important it is to start investing right NOW! The person who starts investing $100/month at 30 will have $226k at 60, while the person who starts investing $100/month at 40 ends up with only $76k at 60. That’s a difference of $150k in earnings, and the 30-year-old investor will only contribute $12k more! So yes, the 20-year-old’s earning will be even higher than this, but your options now are to end up like the 30-year-old investor or the 40-year-old investor. You take your pick. 

2. Stop Trying to be Debt Free

Becoming debt-free is a goal for many people and being debt-free is great, but not if you’re foregoing investing to do it. Needing to be debt-free before investing is a myth that is perpetuated by many in the debt-free community, but it’s terrible advice

The problem with this approach is that the opportunity cost of the earnings you could have received from investing your extra cash instead of paying off debt is WAY HIGHER. Let’s break down what this actually means.

Opportunity cost is the loss of a potential gain from other alternatives when one alternative is chosen. In our scenario, you have two options. You can use your extra cash to pay off your debt or use it to invest. If you choose to pay off your debt, the opportunity cost is the earnings you could have received if you had invested that money instead. If you choose to invest, the opportunity cost is the interest you could have saved if you had chosen to pay off your debt instead. 

When evaluating multiple opportunities, you should choose the option with the highest return, and forego the opportunities that would provide lower returns. Otherwise, you’re going to lose money. Let’s make more sense of this by looking at some numbers.

Let’s say you have $100k in debt at an interest rate of 3.5% on a 15-year loan. If you’re only making the minimum payment of about $700/month on that loan, you’ll end up paying almost $29k in interest over those 15 years. Spending $29k on interest sounds like a total waste of money to you, so you decide to instead pay $1,000/month so you’ll only wind up paying $18k in interest and save $11k. 

While a savings of $11k is nothing to scoff at, let’s instead look at the opportunity cost of investing that extra $300/month over 15 years. Let’s assume you invest in the S&P 500 and receive an annual return of 10%. Over those 15 years, you will earn $70k in interest! Earnings of $70k vs a savings of $11k? I’ll take the earnings of $70k, please. Not to mention that you can continue to make even higher returns from the money you’ve invested long after these 15 years have passed.

Since the opportunity cost of investing far exceeds the benefit of paying off your loans faster, you should choose to invest vs pay off your debt earlier. The further and further you keep pushing investing off, the harder it will be to get the earnings you’re looking for by retirement. (Reference the graph above again if you need a reminder.) 

Contrary to a lot of popular financial advice, debt freedom does not build wealth. If you want to make more money, you’re going to have to start investing.

*If you have high-interest debt, like credit card debt, it may make more sense to pay that off before investing, so make sure to evaluate your specific options before choosing a path.

3. Don’t Take on Any More Debt

While you should 100% start investing before becoming debt-free, that doesn’t mean that you can continue taking on debt to finance purchases because you can afford the minimum payments. Debts are financial obligations. That means that you have to make all of your minimum payments each month no matter how much money you have. The more of these obligatory payments you keep stacking up, the more of your money is going to be tied up in debt payments.

This is super important for later investors because you have some catching up to do. If you want to get anywhere close to the earnings 20-year-old investor you would have made, you’re going to have to contribute a lot more money.

We already saw in the earlier example that a 30-year-old starting to invest $100/month will have $226k at 60, but an investor who started at 20 and contributed $100/month is going to have a whopping $632k at 60. That’s $406k more! So if you’re late to the investing game and want to make up that $406k, you’re going to have to up your contributions.

To get to $632k by 60, a 30-year-old investor will need to contribute $280/month. That’s almost 3X what the 20-year-old investor needs to contribute, so you’re going to need to find that extra cash somewhere. A great place to find extra cash is from former loan payments.

Like I said earlier, debt is a financial obligation, so the more payments you are making toward your debt, the more of your money is tied up. As you start paying off your loans, you’ll begin to free up more money that you can then allocate toward your investments. The best way to figure out when you’ll have your loan paid off is to use a loan payoff calculator. Once the loan is paid off, you can use an investment calculator to look at how moving that money into your investments will affect your earnings.

Here is an example.

You have the following loans (assume 3.5% interest on all of the loans).

  • Car – $7k loan balance at $300/month payments
  • Student loans – $16.5k loan balance at $300/month payments

Plug all of the loan info above into a loan payoff calculator and you’ll find that your car will be paid off in about 2 years, and your student loans will be paid off in about 5 years.

Now let’s assume you’re 30 and you start investing $100/month this month. (assume 10% annual return on investments)

Here is your contribution schedule and potential earnings.

  • You contribute $100/month for 2 years before any loans are paid off = $2,644 earnings in year 2
  • Once you’ve paid off your car, then you start investing $400/month (current $100/month contribution + former $300/month car payment.)
  • $400/month contributed for 3 more years = $20,277 earnings in year 5
  • If you continue to contribute $400/month until you’re 60, you’ll earn $775K! Congrats! You’ve now beaten the 20-year-old investor’s earnings!
  • If instead, you increase your contributions to $700/month ($400/month contribution + $300/month former student loan payment) once you’ve paid your student loans off then at 60 you’ll have $1.17 MILLION!!

So you don’t have to start investing as an infant to see huge returns. You just need to be strategic about how you allocate your money. By starting to invest today, paying your minimum monthly debt payments and investing the rest, and increasing your investment contributions as you pay off debt, you’ll be able to out-earn a young investor who starts earlier and is far less strategic about their investments. So what are you waiting for? Go open your investment account so you can become a millionaire and live your dream retirement!

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Creating a Bulletproof Financial Plan for a Recession

As a millennial, I always feel the impending doom of a recession looming in the back of my mind. I turned 18 in 2008, so for the first years of my adulthood, I was away at college studying finance while witnessing the utter devastation that recessions cause families. Fast-forward to January 2020, and I would have told you that I expected another mild recession just like everyone else that follows the economy, but I never expected anything like this.

After years of comparing the economic conditions of the Great Recession to the Great Depression, it was comforting to think that we probably had a long time to wait until we saw another catastrophic jolt to the economy. Sure there would be ups and downs, but nothing like the Great Recession, right?

Well, coronavirus had other plans, and just like that all of the trauma we millennials experienced in 2008 has risen to the surface again. The thought of going through this every decade is anxiety-inducing, to say the least, but if it’s taught us anything it’s how incredibly important it is to build healthy finances so you aren’t devastated every time one of these ‘Great Recessions’ pops up.

If you’re looking to create a financial plan before the next recession, you aren’t alone. These are the 3 steps you should take to make a good financial plan for a recession so you don’t lose all of your money, and can even come out ahead.

1. Build an Emergency Savings

I seriously can’t stress the importance of this enough. It’s probably the least “sexy” thing you can do with your money, but the most critical one if you want to adequately plan for a recession. That’s because recessions = job losses. Maybe your job wasn’t affected this time, but that doesn’t mean you’ll be spared during the next recession.

In 2008, the high rate of mortgage defaults caused jobs at banks and insurance companies to be severely affected. In 2020, social distancing has caused the airline, hospitality, and service industries to be hit hardest. What causes the recession affects which jobs are the first to go, and next time, it could be yours.

If this happens to you, your emergency savings will be a Godsend. It’ll allow you to pay all of your bills, put food on the table, and keep your sanity and Netflix subscription. If you want to focus on getting a new job and getting back on your feet as fast as possible, you can’t be spending all of your time trying to make ends meet. Instead, you’ll need to be focusing on what your next move is and how you can land a new job. Your emergency savings gives you the stability needed to shift your focus from what’s happening right now, to what you can do to build your future.  

As a good rule of thumb, you should have 3-6 months of expenses saved in your emergency savings and keep it in a high-yield savings account. The more responsibilities you have like loans, kids, or a mortgage, the closer you should be to 6 months of savings. A high-yield savings account is the best place to keep your money because they pay you about 20 times more than traditional savings accounts just for keeping your money in them. Who doesn’t want more money for doing the same thing?! If you need more guidance on how to set up your emergency savings, this post has all of the info you’ll need.

2. Invest in the Stock Market

The second step to building a solid financial plan for the next recession is to start investing. The S&P 500 is widely regarded as the best indicator of how the overall stock market is doing. In 2008, the S&P 500 entered a bear market, which means that stock prices were declining. After prices began to fall, it took 5 years for the S&P 500 to reach its pre-recession price of around $1,500 per share.

Since then, the share price for the S&P 500 index has more than doubled. So even if you lost money in the 2008 crash, as long as you held your investments, you made it all back in 5 years and have more than doubled your money since.

The bear market for the Coronavirus Crash began in early March and was the fastest fall of global stock markets in financial history. It was short-lived though, and the drop ended in April. Since then, stock prices have risen to above pre-Coronavirus Crash levels, and investors have made money.

So while crashes are scary and make it seem like you should sell all of your investments, that is the exact opposite of what you should do when we enter a bear market. When prices fall, the value of your investments goes down on paper, but you don’t actually lose money until you cash out your investments at a loss. This is the difference between taking a paper loss (you see the price is lower), and a real loss (selling your investments at a lower price). Unless you absolutely need to use the money you have invested to pay your bills right now, you should ride out the bear market, because as history has shown, the market will rebound. A bull market awaits you just over the horizon and you stand to make even more money if you can be patient.

And that brings up another point about your investments. They can provide additional passive income during tough times. If you invest in a diversified portfolio of stocks, like the S&P 500, a portion of these stocks probably pay dividends. A dividend is a share of a company’s profits that it pays out to its shareholders. When you’re trying to grow your wealth, you usually reinvest all of your dividend payments, but if you find yourself in a financial bind, you can skip reinvesting your dividend payments and instead use them as a passive income source to cover some of your expenses during a tough time. Again, this only works if you remain invested through the lows of the recession, so try to avoid selling your investments in a bear market if possible.

3. Keep Investing When You Get Scared

Market crashes aren’t great for the money you already have invested, but they are fabulous opportunities to make more.

When prices drop and the market crashes, stocks are essentially on sale. It’s like if you bought a dress for $100 full price, and the next day it gets marked down to 50% off. Same dress, half the price. Buying a diversified set of investments like the S&P 500 index when prices drop is basically like getting them at a bargain rate.

Let’s assume you were an investor in 2008. If you had continued investing through the 2008 recession, you would’ve made a lot more money than if you’d gotten cold feet and stopped investing. Before the market crash, S&P 500 shares were trading for around $1,500/share. At their lowest point, these same shares were trading for less than half that price at around $700/share. If you continued investing through the recession and purchased shares at their lowest price, your investments today are worth 5X more than they were when you bought them in 2008! In comparison, all of the shares you had purchased before the 2008 recession have only increased in value by 2.3Xs. While doubling your money is great, quintupling it is even better. By continuing to invest through a recession you can offset your losses on the money you already have invested and make huge gains.

Since recessions affect different companies in different ways, this strategy only works when you invest in diversified instruments like index funds or ETFs. Some companies are bound to fail during the recession, so hand-selecting companies to invest in increases the likelihood that you’ll lose a significant amount of money if one of them goes under. To avoid this, stick to investing in index funds and ETFs during a recession unless you’re willing to lose everything.

The easiest way to stick out your investing strategy through a downturn is to use a method called dollar-cost averaging. This is just a fancy way of saying ‘invest at regular intervals’. The first benefit of using this method is that you’ll be able to buy when prices drop because you’re consistently investing. The second advantage is that you can automate your contributions so you never have to think about making them. Making more money without having to lift a finger sounds like a huge win to me. Whatever type of investment account you’re currently using, it’s a good idea to automate your contributions now because you’ll be more reluctant to do it during the next recession when the market is volatile or you’re struggling financially.

Since many people only invest through their 401K, if you lose your job and therefore your 401K contributions, you’ll need to take some extra steps to keep investing. Opening a Roth IRA is a great option because all of your contributions grow tax-free forever. If you lose your job and have enough financial stability to keep investing, open a Roth IRA and begin making automatic contributions to that.

By taking these 3 steps, you can create a financial plan that will significantly minimize the effect the next recession will have on your finances and avoid losing all of your money. Your emergency savings can save you from financial devastation if you lose your job, your investments can offer a source of passive income, and if you’re able to continue investing you can make significantly higher returns. Taking these steps to create a financial plan for a recession will not only allow you to coast through the next one, but will also help you come out ahead in the long run. Trust me, your future self is going to thank you.

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The Easiest Way to Start Investing in The Stock Market

person walking through a path of money trees grown from investing in the stock market

Starting to invest in the stock market can seem terrifying since most of what is portrayed about investing is dramatic. There are stock market crashes, extreme swings in stock prices, and investors losing fortunes! These highly publicized, dramatic events make entering the world of stock market investing seem more like entering the Wild West.

Based on this coverage, it’s no wonder you feel so stressed about starting to invest in stocks, but if you want to get rich or just simply retire one day, you better start. The good news for you is that becoming a successful investor is actually quite simple. You don’t have to keep track of what the stock market is doing, know anything about the financials of individual companies, or worry about losing everything. With these 3 tips, you’ll be able to open an investment account, develop a super simple and low-stress investment strategy, and feel confident that you can start investing in the stock market today.

Tip 1: Invest in a Retirement Account

Retirement accounts are the simplest way to start investing in stocks. They offer great tax benefits and can be easily automated so you never have to worry about tweaking your investments or tracking how they’re doing. They are the ultimate account to use if you want to utilize a ‘set it and forget it’ investment strategy.

These accounts are perfect for beginner investors because contrary to what you may believe, investing in the stock market is a long game. The difficulty that comes to mind when you think of investing is probably more in line with trading. Trading means that you try to time to market, or buy stocks at their lowest price and sell them at their highest price. To be a successful trader, you need to keep up with a litany of things like what’s happening with the companies you’re invested in, how the market sector they’re in is performing, if there are problems in the country where they perform their operations, what the current economic conditions are, and the list goes on. If this sounds like a lot of work, that’s because it is. Just the thought of keeping up with all of this is daunting and is exactly what turns many people away from investing.

That is why you should ditch the idea of trading and become an investor instead. Investors regularly invest money in a broad range of companies and leave their money invested for years or even decades. They can do this because in general, the stock market goes up over time. That means you can invest in a diversified set of companies, not worry at all about current market fluctuations, and you will still make money. The simplest way to use this strategy to start investing is with a retirement account.

Types of Retirement Accounts

401K

The best option, if it is available to you, is a 401K. That’s because employers will often match a portion of your contributions. That means that if you contribute to you’re 401K, your employer will also contribute to it. Usually, this is written like this, “Employer will contribute 50% up to 5%.” That means that if you contribute up to 5% of your salary to your 401K, your employer will also contribute 50% of what you contribute. To help you understand why this is so amazing, let’s look at some numbers.

  • Employee salary: $50k
  • Employee annual contribution: 5% or $2,500
  • Employer annual contribution: 50% of $2,500 or $1,250

In this example, you can see that contributing to your 401K gave you a $1,250 raise, and you didn’t even have to take on any ‘additional duties as may be assigned’! This is what makes 401Ks so amazing. If your employer offers a 401K and a company match, at a minimum you should set your contribution level to receive the maximum match from your employer. In our example, that was 5%.

IRAs

If you don’t have a 401K as an option, or you want to open another account in addition to your 401K, opening an IRA is your best option. There are two types of IRAs, a traditional IRA and a Roth IRA.

The difference between the two is how they’re taxed. Like a 401K, traditional IRA contributions are pre-tax. That means that the money is deposited into your 401K before payroll taxes are deducted from your paycheck, and instead, you pay the taxes later when you withdraw the money during retirement. Roth IRA contributions on the other hand are after-tax. That means that the payroll taxes are deducted now, and you don’t pay any additional taxes on your earnings when you withdraw the money later in retirement.

One advantage IRAs have over 401Ks is that they offer a wider selection of investment options. Since 401Ks are employer-sponsored, your employer hand selects the funds that you are offered. With IRAs, you aren’t limited to what your employer selects and instead can invest in a much wider array of options.

Each of these types of retirement accounts varies slightly, but unless you’re trying to build a strategic tax advantage by using one account over another, you shouldn’t stress too much about which account is the absolute best option for you. Pick the one that is the easiest for you to open TODAY and open it.

What Funds to Select

Once you choose an account type, then comes the fun part, which stocks you invest your money in. The easiest solution for this is to use a target-date fund.

These are the Holy Grail when it comes to effortless stock market investing because they do all of the work for you, forever. When you invest in a target-date fund, it will allocate your money appropriately for your age. It uses your age to determine your asset allocation because of how you should manage the risk of your portfolio over time.

When you’re younger, you should invest in riskier assets because they typically provide a higher return on investment. Unfortunately, with greater risk also comes a greater chance of losing money. When your retirement is far into the future, any losses you experience now can easily be recovered before you need to start using your money in retirement, so it is worth it to invest in riskier assets to try to maximize your return. However, as you approach retirement, you have less and less time to recoup any losses, so you should shift your money into less risky investments to preserve the higher returns you received when you were younger. I know this sounds like a lot of work, but don’t worry, your target-date fund is going to do all of this work for you.

That is why target-date funds are the easiest way to invest. You can literally buy a target-date fund and never look at it again until you retire, and be confident that you will make money because your target-date fund will be managing your investment strategy for you. It can’t get any easier, or better than that.

Tip 2: Avoid Fees

When opening your account, your provider is probably going to offer you a lot of different account options, so which one should you choose?

When it comes to using a passive investing strategy, like a target-date fund, you do not need anything fancy. Accounts like a full-service brokerage account offer lots of investor perks and advising services, and while that all sounds nice, it’s also expensive. Since your target date fund is going to do all of the hard work for you, there is no need to pay extra for any of these “perks”. Your best bet is to choose the lowest fee account your provider offers.

Even the lowest fee account you can find will most likely charge you an admin fee, or something similar. These are usually only $25 or so a year, but that $25 still eats into your returns! Getting these fees waived is often as simple as signing up for paperless statements. If you don’t see a way to waive this fee when you’re opening your account, give your provider a call and they can help you get your fee waived.

While going to these lengths to get a fee waived may seem petty, fees are an investor’s archenemy. They may seem small at first, but over time fees can lead to significant reductions in your returns. On top of your admin fee, the funds that you choose to invest in will also charge management fees, often called expense ratios. Passively managed funds, like target-date funds, offer much lower expense ratios than actively managed funds. Remember all of the work that goes into trading? Trading is active management, so when you invest in active funds, the fund manager charges you a higher fee for all of their extra work.

To put into perspective how detrimental fees are to your earnings, here is a real-life example. If a millennial invests $10k a year into their retirement account for 30 years and receives a 7% annual return, they will have $1,010,730 after 30 years. If this money is invested in a low fee target-date fund with an expense ratio of .15%, they will only end up paying a total of $28,250 in fees. Instead if they invest their money in a high-cost mutual fund with an expense ratio of 2%, they will end up paying a total of $313,122 in fees. That is almost $300k of earnings that they lost to fees! So make sure to invest in the lowest fee options you can because while it may seem petty right now, lowering your fees will save you A LOT of money in the long run.

Tip 3: Use Dollar Cost Averaging

Dollar-cost averaging is just a fancy way of saying to make regular contributions. 401Ks are automatically set up to do this since you make a contribution to your account every time you get paid. IRAs on the other hand are not automatically set up to do this, so if you’ll be investing using an IRA you’ll need to set up regular contributions manually.

To do this, choose an interval and a contribution amount that you’re comfortable with, and start contributing ASAP. No amount is too small to start with. Contributing $20/month still makes you an investor, and still gets you closer to your retirement goals. Once you get more comfortable with investing or start making more money, you can increase your contributions. For now, the important thing is that you’re starting to invest!!

Dollar-cost averaging is the best way to invest because again, it does all of the work for you. You don’t have to worry about making investing a priority, checking your account every month, or remembering to transfer your money consistently. You just set up your automatic contributions, forget about your account, and go on about your life.

And now you’re an INVESTOR!! While investing in the stock market seems daunting, using target-date funds and automating your contributions makes investing extremely easy. You no longer have to be fearful of the time it will take to learn which stocks you should pick, or worry that your lack of knowledge will cause you to lose it all. You’ve done all of the work upfront to maximize your returns and become a successful investor. Since there’s no work left to be done, it’s time to sit back, relax, and enjoy your newfound investor lifestyle.

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A Beginner’s Guide to Hassle-Free Investing

a beginner's guide to hassle-free investing

When you think of investing, what are the first things that come to mind? Maybe it’s the image of people running around on the trading floor, or a news segment showing a graph of a company’s stock price shooting up or plummeting. No matter what the exact image you picture is, it’s probably something dramatic and panic-inducing.

While investing may be portrayed as a theatrical, anxiety-inducing boy’s club, that couldn’t be further from the truth. Investing is actually quite simple and easy, and requires almost zero effort on your part. If you’re turned off by the thought of researching stock picks, having to keep up with the markets, or just nervous about investing at all, this hassle-free investing guide is for you.

Trading vs Investing

To understand why investing is so easy, you first need to understand the difference between trading and investing. A lot of people who call themselves investors are really traders. Trading is the frequent buying and selling of financial instruments to try to beat the overall return of the market. To be a successful trader, you need to research companies and markets, and predict when their stock prices are going to rise and fall. Predicting when a stock’s price will rise and fall is called timing the market. Unless you want to seriously dedicate time to studying stocks, you won’t be able to accurately time the market. Honestly, many traders who dedicate serious time to this aren’t even able to do it.

Trading also comes with higher fees. Fees are the enemy to any investor because they eat into your returns. Each time you buy and sell a stock, there is a trading fee associated with that transaction that takes a portion of your money and pays it to your broker for executing the transaction for you. The more you buy and sell stocks, the more money you’re paying in trading fees.

Frequent trading can also affect the amount of taxes you pay on your earnings. If you hold a stock for less than a year, you’ll be charged the short-term capital gains tax rate, which is equal to your income tax rate. Earnings on investments held for longer than a year are taxed at the long-term capital gains tax rate, which is lower than your standard income tax rate. Trading stocks frequently could result in an increased tax bill that, like fees, will eat into your overall returns.

Investing, on the other hand, has the goal of building wealth over a long period of time by buying and holding a diversified portfolio of investments. Unlike trading, you’re seeking to receive the same return as the market, not beat it. When investing, you buy stocks, bonds, and other investment instruments and hold them for years or even DECADES! That means almost no transaction fees, or time spent constantly keeping up with your investments. This is the approach I use and what I recommend to everyone looking to get into investing and grow their wealth.

How to Build Your Hassle-Free Investing Portfolio

Now that you know how easy it is to be an investor, here are some easy investment options you can use to quickly set up your hassle-free investing portfolio, and then sit back and allow your investments to do all of the wealth-building work for you.

Index Funds

The S&P 500 is an index that tracks the performance of the largest companies listed on stock exchanges in the U.S. These companies make up 80% of U.S. equities by market cap. A company’s market cap, or market capitalization, is the total value of all of its shares of stock. Because the companies included in the S&P 500 index make up the majority of the stock market’s value and span all industries, the S&P 500 is widely regarded as the best representation of the overall performance of the U.S. stock market.

While there are short-term peaks and valleys in the market’s performance, over the long-term the stock market rises. This gradual increase in the overall stock market is why investing works. Since the S&P 500 is a great gauge of overall market performance, if you want to invest in something that provides the same return as the market, buying shares of an S&P 500 index fund is one way to do that.

Index funds are a type of mutual fund that tracks and matches the performance of an underlying set of investments. When building an index fund, the fund manager seeks to buy and hold a set of investments that will provide the same return as the market or a segment of it. This buy and hold strategy means index funds are passively managed because unlike actively managed funds, the fund manager isn’t consistently executing trades to try and beat the market’s performance. Index funds are great options for investors because they use a buy and hold strategy and have the goal of achieving the same return as the market, which is in alignment with an investor’s strategy and goals.

Pros to Index Funds

  • Passive management means lower fees for investors
  • Composed of a basket of companies in a market sector, or across many sectors which provides diversification

Exchange-Traded Funds

Exchange-Traded Funds (ETFs) are very similar to index funds. The main difference is that you can buy and sell ETFs throughout the day, while index funds can only be bought or sold at the beginning or end of the trading day. Since you’re not concerned about making trades daily, this shouldn’t matter to you.

One advantage ETFs have over index funds is that they typically require a smaller investment, which can be beneficial for early investors. If you’re just starting out and only have a small sum of money to invest, you may not be able to afford an index fund. In this scenario, ETFs are a great alternative. If you aren’t constrained by your investment amount, there are some differences in the fees associated with index funds vs ETFs, so you’ll want to consider that when deciding which to buy.

Pros to ETFs

  • Lower initial investment required
  • Passive management means lower fees for investors
  • Composed of a basket of companies in a market sector, or across many sectors which provides diversification
  • Can be more easily traded than index funds

Target Date Funds

The holy grail of hassle-free investing is a target-date fund. These funds build you a diversified portfolio AND manage it for you over time. While index funds and ETFs are considered diversified stock holdings, a diversified portfolio also contains foreign investments and other investment instruments like bonds. Target date funds combine all of these instruments to construct an entire diversified portfolio for you.

Building your portfolio is the first step, but you’ll also need to maintain it. To do that, you will need to review your portfolio each year and adjust it as necessary to keep your portfolio’s structure. The structure of your portfolio depends on the percentage of it you allocate to each investment type. If you start the year invested 90% in stocks and 10% in bonds, at the end of the year your portfolio structure may be different depending on how each investment performed. To return it to its structure of 90% stocks and 10% bonds, you will need to sell off some stocks and buy some bonds, or vice versa. Target date funds make these adjustments for you.

In addition to structural adjustments, target-date funds also automatically reduce your risk over time. When using a target-date fund, you select the fund with the date closest to when you want to start using the passive income it generates. For most people, this is their retirement date. As time goes on and you near the target date you selected, your portfolio will automatically be reallocated to reduce your risk. With greater risk comes a greater potential for losses. Reducing your risk is important because as you near your target date, you have less time to recover any losses you experience. This management style allows you to receive a higher return when you can take on more risk, and then maintain those earnings by reducing your risk later. While all investors should use this approach to reducing risk, the great thing about target-date funds is that they do all of this work for you.

Pros of Target-Date Funds

  • Include investment instruments other than stocks to build a fully diversified portfolio
  • Automatically manage your risk over time
  • Automatically maintain your portfolio structure over time
  • Passive management means lower fees for investors
  • Composed of a basket of companies in a market sector, or across many sectors which provides diversification

Starting to invest can be intimidating, but using a passive investing approach and tools that do most of the heavy lifting for you make investing hassle-free. Index funds, ETFs, and target-date funds allow you to become an investor without sacrificing a lot of time or applying serious effort, and still make it possible to build substantial wealth and become a rich bitch.

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Dividend Stocks vs Growth Stocks. Which should you buy?

Lately, I’ve been seeing a lot of articles about how great dividend stocks are. I assume that this uptick in the love for dividend stocks is because they’re seen as safer investments than growth stocks and investors are trying to find certainty in an uncertain marketplace. But what makes dividend stocks safer than growth stocks? In this post, we will break down the differences between dividend and growth stocks, what makes dividend stocks safer investments, and why you should skip dividend stocks and go for growth stocks instead.

Dividend Stocks vs Growth Stocks

Dividend stocks are simply stocks that pay a dividend. A dividend is a percentage of a company’s profits that it pays out to its shareholders at regular intervals. Most companies that pay dividends tend to be better-established companies with large market shares and minimal opportunities for substantial growth. Growth companies, on the other hand, are usually newer and trying to seize market share. They have ample growth opportunities and reinvest all of their profits to try to continue growing at a rapid rate. Think Microsoft (dividend) vs Tesla (growth).

Why Are Dividend Stocks Safer than Growth Stocks?

The fact that companies who pay dividends are well established with a large market share makes dividend stocks less volatile than growth stocks. If you’re familiar with the golden rule of finance, the greater the risk the greater the expected or required return, then you know that volatility increases risk but it also increases your possible returns. Because of the higher volatility of growth stocks, their stock price will typically increase much faster than a dividend stock’s price. On the other hand, your risk of the company tanking and you losing all of your money is also higher with growth stocks.

The steady income stream dividend stocks provide also adds to their safety. Your return on investment from dividend stocks includes any increase in stock price, as well as the sum of the dividends you receive. Receiving dividend payments regularly means that you realize some of your returns in the form of cash payouts throughout the time you hold the investment. With growth stocks, your return comes solely from any increase in the stock price, and you don’t realize any returns until you sell the stock in the future.

Another reason dividend stocks are considered safer is because they usually aren’t as negatively affected by market declines. If the stock price does decline, you’ve also already received some dividend payouts to help offset your losses. Since growth stocks don’t pay dividends, you have no dividend payments to help offset your losses if the stock price declines. However, dividend payments aren’t a guarantee. In a declining economy, a company may reduce or eliminate its dividend payouts, which usually causes the stock price to plummet, and can create substantial losses for investors.

The ability to mitigate your downside risk with dividend stocks does make them the overall safer investment choice vs growth stocks. However, sometimes struggling companies will use dividends to try to cover up problems they’re having. When a company has operational issues but is still paying dividends, investors may assume everything is fine because they’re still receiving their dividend payouts. To avoid falling into this trap, look at a company’s performance vs its dividend yield. The dividend yield is the percentage of profits that the company pays out in dividends. Obviously, the higher the dividend yield, the more you’ll be paid in dividends, so you want to invest in companies with the highest dividend yields, right? Not necessarily.

When a company pays a dividend, it’s essentially saying that it can’t find anything to invest those profits in that would provide investors with a larger return than the dividends they’re receiving. For a well-established company with a large market share, having a high dividend yield isn’t a bad thing, but the company also needs to show some growth in the form of increased earnings, and enough free cash flow to pay their dividends. A company with stagnant or declining earnings, and/or limited free cash flow, which also has a high dividend yield should ring your alarm bells. If a company’s operational health is declining, that means that there ARE growth opportunities that could provide better returns for investors. The reason growth companies don’t pay dividends is because they reinvest all of their profits into opportunities to grow the business. If the overall health of a dividend company is declining, it should reinvest its profits more heavily into growth opportunities than into dividend payments. Investing in a declining company that isn’t investing in itself is a bad idea whether it has a high dividend yield or not.

Dividend stocks are also more affected by interest rate risk than growth stocks. Most people invest in dividend stocks for the income stream the dividends provide, so when interest rates rise Treasury bonds become an attractive substitute. This is because as interest rates rise, the return you receive from bonds also increases. Since bonds are considered safer investments than dividend stocks, as the return on bonds approaches the same return investors are receiving from their dividend stocks, they could reduce their risk but continue receiving the same return if they sell their dividend stocks and purchasing bonds instead.

Should You Invest in Dividend Stocks or Growth Stocks?

The battle between whether to invest in dividend stocks vs growth stocks is pretty clear cut. That’s because to make enough money from your dividend payments, you need to have A LOT of money invested. The average dividend yield is only 2.2%, so even if you have $100k invested in dividend stocks, you’ll only make $2,200 per year off of dividend payments. That is not even close to enough passive income to live on.

To build the large amount of investments you need to reap the benefits of dividend payments, you should skip the dividend stocks and invest in growth stocks while you’re young. A young person can take on much more risk because they have plenty of time to make up any losses before they need the money later in life during retirement. By investing heavily in growth stocks when you’re young, you can grow your investments much more substantially, and as you age, you can transition to safer investments like dividend stocks. Just make sure to keep a well-diversified portfolio that also has other less risky investments in it, like bonds, that provide many of the same benefits of dividend stocks. This will reduce the overall risk of your portfolio, but also allow the growth stocks to work their magic and lead you down the path to becoming a rich bitch!

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Are You Headed for Your Retirement Dream or Nightmare?

When you envision your retirement, what do you see? A vacation home on the beach? Finally being able to travel around the world whenever you want? Whatever your ideal retirement life is, I bet it doesn’t involve anxiety over mounting medical bills and a dwindling cash supply. While most of us have dreams of grandeur when it comes to our retirement, few of us ever get there. Starting to invest in your retirement early gives you a serious leg up on being able to one day live your retirement dream, but the majority of us will spend our youth ignoring the enormous benefits of starting to save early for retirement, and instead spend all of our hard-earned cash on things that provide us short-term gratification.

The benefit of investing early for retirement is compound interest. Compound interest is your BFF when it comes to long-term investing because it allows you to earn interest on your interest. It works like this. If you invest $100 and earn 10% interest this year, you will have $110. Next year you’ll earn 10% interest on $110, so you’ll earn $11 and have $121. And so on. When you start investing early for retirement, you have more years to earn interest on your interest, which can lead to significant wealth generation. Let’s take a look at a real-life example.

If you start investing at 20 and invest $100 a month until you’re 60, and receive a 10% annual return, you’ll have $632,500 at 60. Only 8% or $48k of that will have been from your contributions. $584,405 will have been made from compound interest. (See, I told you it was your BFF). Let’s use the exact same scenario, but say you started investing at 30. In this scenario, by 60 you will only have $226,048. That’s a difference of $406,452 because you didn’t benefit from compound interest for 10 more years. On top of that, 16%, or $36k of your earnings will be from your contributions, instead of only 8%.

If you’re in your early 20s and reading this, you’re in good shape. Just start investing in a retirement account now. If you’re already 30 and you’re like OMG I’m f***ked! Better late than never. Start a retirement account today, and keep reading to learn how you can still reach your retirement goals. (For info on the types of retirement accounts, see this post.)

If you’re starting a little bit late on your retirement savings, you’ll have to make larger contributions, but you can still reach your goal of a fruitful retirement. Even if you start saving early, it is important to understand if your current contributions will get you to the retirement you desire. To do this, you need to figure out what you want your annual income to be when you retire, and how much you need to have invested to get that. The best way to figure this out is by calculating when you’ll reach financial independence.

Financial independence (FI) means that you can generate enough income from passive sources, like your investments, to fund your lifestyle with no fulltime job. It is usually associated with the FIRE movement. This is a fringe financial movement that has gained popularity among millennials and stands for financial independence retire early. Maybe you’re not looking to retire early, but you’re probably looking to retire at some point. Setting a goal of reaching FI by retirement means that when you retire you’ll be generating enough money through your investments to live on, so in theory, you should never run out of money. If the retirement you’re picturing isn’t one of minimalism and penny pinching, you’ll probably need to have a lot more money saved for retirement than you think you will. Calculating your FI will tell you how much you need to have invested to hit your retirement income goal, and live your retirement dream.

How to Calculate Your FI

You should start by calculating your current FI income. Figure out your average monthly spending, including discretionary spending, and multiply by 12. If you want to maintain your lifestyle, make sure you include expenses like shopping, travel, restaurant dining, etc. Literally ALL of your spending. Let’s say the passive income you currently need to reach FI is $75k/year. Divide that number by 10% (the average annual market return). $75,000/.1 = $750,000. Based on this, you’ll need to have $750,000 invested in the stock market to reach FI.

Once you know how much it costs to maintain your current lifestyle, list out the goals you have for the future. Do you want to take at least 1 international trip each year? Increase your FI income by the cost to do that. Want to shop twice as much? Increase your income amount again. Be honest with how you see your life in the future and increase your spending accordingly. Do not remove things you won’t have to pay in the future like student loans. These will probably turn into other expenses like medical bills, and your lifestyle will probably get more expensive in general as you age, not less. Now divide your goal income level by 10%, and you have your retirement goal FI.

You’re probably shocked at how much you actually have to invest to achieve this goal. If you want to have $200k to live on each year, you’ll need to have $2M invested in stocks to get that. That’s a lot of dough. So now that you know your investment amount to reach retirement FI, how can you make sure you get there?

Setting Up Your Investment Plan

The easiest way to determine if you’ll reach FI by retirement is by using a retirement calculator like this one. Start by setting all of the values at their current levels. This will show you if your current plan will get you to your goal. The average return on the stock market is 10%, so if you’re young and mostly invested in stocks, this is a good annual return percentage to use. If you contribute to your 401K, make sure to include your contribution, as well as your employer match. Once all of your values are entered, calculate your estimated retirement savings. If this number is below your FI investment amount, you’re unlikely to reach FI by retirement.

If you won’t reach FI based on your results, you can play around with your contribution amount and retirement age to see what you’ll need to start contributing to reach your goal, or when you will reach it based on your current contributions. Also, keep in mind that you’ll likely move your money into less risky investments as you age. Less risk = less reward, so you should assume that you will receive a lower return as you get older. (You can learn more about the risk/return trade-off here). Take your goal retirement income and divide by lower annual rates of return to see how a lower return affects the amount you’ll need to have invested to reach FI. Then you can play around will lower annual return values in the calculator and look at how this changes your retirement plan.

Once you figure out what your contribution level needs to be to achieve your retirement goal FI within the time frame you want, begin working toward increasing your investment contributions to that level. You don’t need to make the leap all at once, but at a minimum, you should make a plan to get your contributions up to the appropriate level. Once you’ve hit your contribution goal, you can let compound interest work its magic.

While there is no secret formula that gives you the perfect amount to have invested by retirement, setting the goal to reach financial independence by then is a great way to set yourself up to live your retirement dream. Most people set a goal to have a lump sum saved to start chipping away at during retirement. These people end up living the retirement nightmare. Penny pinching to make sure their lump sum doesn’t hit zero before they do. By setting your goal to reach FI by retirement, you’ll be generating enough passive income to sustain your lifestyle into eternity and live your retirement dream, whatever that may be.

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The Tortoise and The Hare

Using Compound Interest to Win the Race and Become a Rich Bitch

You’ve probably heard the fable about the tortoise and the hare. To sum it up, the tortoise and the hare are in a race. The hare is fast and confident that he will win the race with ease, so he runs most of the race super fast, then he stops to take a nap, and ends up losing to the tortoise. The tortoise knows he isn’t fast but maintains a steady pace toward the finish line throughout the race, and gets the W. The moral of the story, slow and steady wins the race. But what on earth does this fable have to do with finance?

In an earlier post (that can be found here), you learned why trying to pick a unicorn company to invest in doesn’t usually work out. Instead, you should create a diversified portfolio and invest in a herd of cattle. Diversifying your portfolio helps reduce your risk, but what grows your money? The answer is compound interest, and that is what you’ll learn about today.

First let’s discuss what interest is. Interest is the charge you pay for the privilege of borrowing money. It is usually expressed as a percentage. For example, you borrow $100 for 5 years with an interest rate of 5%. When you pay back your loan, you’ll pay back the principal amount of $100 plus an interest payment of $5 for a total of $105. Pretty simple.

Compound interest follows the same premise, but the interest rate is set per period. Let’s continue using the example above, but say you borrowed the $100 at 5% interest, compounded annually for a period of 5 years. Each year you will be charged interest on the principal, as well as any interest you’ve accumulated. Paying interest on interest is how the interest compounds. Take a look at the table below.

YearBalanceInterest Accrued
1$100.00$5.00
2$105.00$5.25
3$110.25$5.51
4$115.76$5.79
5$121.55$6.08
Final Balance $127.63

You can see in the table that the interest you are charged goes up each year because not only are you paying the 5% interest on your principal of $100, but also on any interest you’ve already been charged.

Now that you have an understanding of compound interest, back to the tortoise and the hare. In our discussion on diversification, we used a unicorn and a herd of cattle as examples. Well in this example, the hare in the fable invested in the unicorn, and the tortoise invested in the herd of cattle. The tortoise’s approach to investing is all about using compound interest as a long-term growth strategy. With this strategy, you reinvest the interest you make each period, compounding it over time, which adds up to significant gains over the long term.

This is how retirement accounts (like we discussed here last week) work. The earlier you start, the more compound interest you can accumulate before retirement. Let’s continue our table from before and assume that you invested the $100 when you were 20, and you plan to retire at 65. Let’s also assume you make 5% interest annually for those 45 years. If you make no additional contributions, you will have $898.50 in your account just from compounding your interest. That might not sound that great, but imagine it in larger terms. If you had invested $100,000, you would have $898,500 after 45 years. That’s almost ONE MILLION DOLLARS! And you didn’t have to do anything. It’s all thanks to the compound interest from your tortoise investing approach.

Let’s look at a more realistic example. We will keep all of the same parameters defined above, but you will contribute $100/month for 45 years. Over these 45 years, you will have contributed a total of $54K, but you will end up with $192,538.69! That means you will make 3.5X the money you contributed! That’s a pretty good deal, if I do say so myself.

In the tortoise and the hare’s race, and the race to wealth, slow and steady will always triumph. While you won’t have a cool investment story, you will make a lot of money over the long term. If you’re skeptical, just ask Warren Buffet. He is a huge advocate of growing your wealth using compound interest. And he is a billionaire, so I’d say he knows a thing a two. Compound interest is why you should start investing today, slowly and steadily build your investments, and eventually win the race and become a rich bitch.

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How to Become and Old Rich Bitch

The 411 on Retirement Accounts

Retirement accounts are one of the most important investment tools to begin using while you are young to grow your wealth. There are several different types of retirement accounts that you can use, and each one has different advantages and disadvantages. Below we will discuss the pros and cons of the different types of retirement accounts, and the ways that you can utilize them to become an old rich bitch.

401K

The first retirement account we’ll discuss, and the one you’re probably most familiar with is a 401K. 401Ks are retirement accounts that are offered by employers to their employees. These accounts are defined contribution accounts, meaning that the employee contributes a percentage of their income to their 401K each time they are paid. If you make $50,000 a year and set your 401K contribution at 5%, you will contribute about $96 to your account every 2 weeks when you get paid.

Pros

Employer Match – The biggest pro of a 401K is that you can give yourself a raise just by contributing to it. Welcome to the beauty of the employer match! Many companies will offer to match your 401K contributions up to a certain amount. This is usually written something like this, 50% match up to 5% of your salary. They are saying that for every dollar you contribute to your 401K, up to 5% of your salary, they will contribute an additional $.50. Let’s take a closer look using our previous example. You are contributing 5% or $2,500 of your $50,000 salary each year. The company you work for is also going to contribute 50% of what you’ve contributed, or an additional $1,250! So, your total annual contributions just went from $2,500 to $3,750! Some companies get a little more complicated with this and offer a tiered match. These look something like this. We will match 100% up to 2% and 50% up to 5%. This means that for the first 2% of your contributions, they will give you $1 for each dollar you contribute. For your contributions above 2% up to 5%, they will give you $.50 for every dollar you contribute. Let’s look at some numbers. You contribute $2,500 annually, or 5% of your $50,000 salary. For the first 2% you contribute, or $1,000, your company will match you 100%, amounting to an additional contribution of $1,000. On the remaining 3% that you contribute, or $1,500, they will match 50%, amounting to an additional contribution of $750. In total, they will contribute $1,750 to your account. When added to your $2,500 contribution, you increase your total annual contributions to $4,250! You just gave yourself a raise for trying to help yourself get richer. Who doesn’t love that?!

Tax Advantage – The money you contribute to your 401K is pre-tax. This means that you do not pay any taxes on the money before it goes into your 401K account. This is an advantage because it reduces your taxable income. In the example above, if your salary is $50,000 and you contribute 5%, or $2,500, of your salary to your 401K, you will only pay income tax on $47,500 instead of $50,000. Not only are you saving money you would otherwise be paying in taxes, but you are also contributing more money to your 401K due to this tax advantage. This allows you to benefit more from compound interest. Here is an example. If you contribute 5% of your pretax salary of $50,000, you contribute $2,500. If the 5% you contributed to your 401K was after-tax money and you had a tax rate of 25%, you would only contribute $1,875 to your 401K. That is a difference of $625 each year that you wouldn’t get the benefit of compound interest on!

High Contribution Limit – The 2020 contribution limit for an employee is $19,500. This is the most you are allowed to contribute to your 401K in a single year. 401Ks have extremely high contribution limits when compared with other retirement accounts, as you’ll see later in this post.

Cons

Early Withdrawal Penalties – The money you contribute to your 401K can’t be taken out until you reach the age of 59½. 401Ks are tax-deferred accounts, which means that you don’t pay income tax before making your contributions, but instead pay the income taxes when you withdraw the money. If you decide to withdraw money from your 401K early, you will pay the income tax on your withdrawal as well as an additional penalty. The penalties are quite steep at around 10%, and will significantly eat into your earnings. Since these accounts are not very liquid (see this previous post on liquidity), you should always make sure to have other easily accessible money saved to help cover any hardships or unforeseen expenses.

Limited Investment Options – Since your employer selects your 401K plan, you are limited to the investment options from their chosen plan. Your employer dictates which financial services company you use, as well as what funds you can choose from.

IRAs

Individual Retirement Accounts (IRAs) are retirement accounts that are opened by individuals, not employers. There are two types of IRA accounts, Traditional IRAs and Roth IRAs. For ease, we will refer to Traditional IRAs as IRAs and Roth IRAs as Roth IRAs. Let’s take a look at the pros and cons of each.

Traditional IRA

Traditional IRAs are more similar to 401Ks than Roth IRAs, so let’s start with them.

Pros

Tax Advantage – Like 401Ks, the contributions you make to your IRA are tax-deductible.

More Investment Options – Unlike 401Ks, you will get to choose which financial services company you open your IRA with. Each company charges different fees and offers different services, so you can find the firm that fits your investment needs best. You will also have much broader investment options when compared to the options your company selects for your 401K. This allows you to further diversify from the 401K investment options selected by your employer. (See this post on the benefits of diversifying.)

Cons

No Employer Match – The biggest con when comparing IRAs to 401Ks is that there are no employer contributions. If you are offered a 401K match from your company, you should ALWAYS choose to contribute up to their match percentage before you consider opening an IRA. If you don’t, you are leaving money on the table.

Early Withdrawal Penalties – Like 401Ks, there are penalties for early withdrawals from your IRA. Since the money contributed to your IRA is tax-deductible, the penalty is the same as with a 401K, taxes plus about a 10% penalty.

Low Contribution Limit – The contribution limit for IRAs is less than half of 401Ks at $6,000 annually if you’re under 50, and $7,000 annually if you’re over 50.

Roth IRA

Pros

Tax-Exempt Withdrawals – The biggest advantage of Roth IRAs is, by far, that all of the earnings you make on them are tax-exempt. The main difference between Roth IRAs and other retirement accounts is that the money you contribute is after tax. This means that you have already paid income taxes on it. This is the money in your bank account that you can use to buy anything you want. When you invest your money in a Roth IRA, any earnings from your investments are tax-exempt. So, if you contribute $5,000 and make 10% or $500 on your investments, you will NEVER pay taxes on that $500 you earned. Not even when you withdraw it. Legally earning income without paying taxes is nearly impossible. That is why Roth IRAs’ tax-exempt withdrawals are so incredible.

Penalty-Free Withdrawals – Another huge advantage to Roth IRAs is that you can withdraw any contributions you’ve made penalty-free. If you contribute $5,000, you can withdraw that $5,000 any time you want. No age limit, no taxes since you’ve already paid them, and no penalties. This makes Roth IRAs the most liquid retirement account option. (Again, more on liquidity here.) Any earnings you make on your Roth IRA investments are subject to a 10% penalty if withdrawn before age 59½. This penalty would apply to the $500 you earned on your Roth IRA investments in the previous example. There are some other exemptions to these penalties, but we won’t get into those here.

More Investment Options – Roth IRAs offer all of the same freedoms as IRAs such as choosing who to open your Roth IRA with and the breadth of investment options available.

Cons

Low Contribution Limit – Roth IRAs have the same contribution limits as Traditional IRAs, and also have salary caps. If you are single, you can’t contribute to a Roth IRA if you make more than $139K, and if you’re married you can’t contribute if you have a combined salary of over $206K. You can only partially contribute if you are single and make between $124K-139K, and married and making between $196K-206K combined. Roth IRAs should be started as early as possible, so you can contribute as much as you can before you reach the salary cap. Once you reach it, you will have the highest possible amount invested, and be able to take advantage of tax-free compound interest until you reach retirement.

No Employer Match – Same as with Traditional IRAs, you won’t get any free contributions from your employer.

Key Take-Aways

1. Always contribute up to your full employer match to your 401K before contributing to any other retirement account.

2. Roth IRAs are the most liquid retirement account. Once you’re contributing up to your full employer match to your 401K, consider opening a Roth IRA.

3. If you’re self-employed or your employer doesn’t offer a 401K, consider opening a Traditional IRA to take advantage of the tax benefits.

After opening any of these retirement accounts you will need to decide how you want to invest your money and build your portfolio. (Info on building your portfolio can be found here.) Building a diversified portfolio and allowing compound interest to work its magic over time is the key to becoming an old rich bitch with your retirement accounts. Since you already know how to build a diversified portfolio, next week we will discuss the magic that is compound interest.

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Portfolio Diversification 101: Investing in a Unicorn vs a Herd of Cattle

Let’s face it. None of us can predict the future. We don’t know when the next stock market crash will happen, when the market will hit new highs, or which companies will be the next Unicorn. This is why individual stock picking is so hard. Yes, sometimes you get lucky and buy a stock like Apple when the company is in its infancy, and years later you become a rich bitch. But picking the unicorn of companies to invest in is like playing the lottery. Pure luck.

To increase your odds of winning the investing lottery, you can diversify your portfolio.

Portfolio Diversification Basics

Let’s start with some investing basics. Buying Apple’s stock is an investment. When that stock is grouped together with all of your other investments, this conglomerate of investments makes up your portfolio. Your investment portfolio includes all of your stocks, bonds, real estate, crypto currencies, etc. Your goal should be to receive the highest possible return on a portfolio with a level of risk that you are comfortable with. (To get a more comprehensive understanding of the risk/reward trade off, see this post.)

Stock picking, like playing the lottery, has a high level of risk because the odds of you winning are very low. If you manage to beat the odds and win, you will receive a high return, but most people lose money playing the lottery. The same concept can be applied to picking a unicorn company (this is a real term by the way). Venture capitalists use this strategy. They invest millions of dollars in lots of risky startups, and sometimes they get lucky and find a unicorn company and make shit loads of money. But most of the time, they’re losing money on their risky investment choices. This is like buying a bunch of horses with a disease that turns 1% of them into unicorns the other 99% die. The odds aren’t great and you’ll probably end up with a bunch of dead horses. So if you’re a venture capitalist, you can stop reading now. For the rest of you, let’s keep going.

Decreasing Your Risk with Portfolio Diversification

To decrease your level of risk you want your portfolio to be well diversified. This means that your portfolio contains various investment types, in several market sectors, and in diverse geographical regions. This type of investing is more like buying a herd of cattle than a unicorn. You have lots of cows (investments), and if one gets sick, you still have the rest of your healthy herd (portfolio) to keep making you money. It isn’t as shiny or fun as investing in a unicorn, but it is a much less risky investing strategy. So how do you choose well-diversified investments for your portfolio? You have several options.

Target-Date Funds

My favorite diversification option is to invest in a target-date fund. A target-date fund is a diversified fund that decreases your risk level as you get closer to your target date. This is popular with retirement accounts like 401Ks or IRAs where the target date is your retirement date. The premise behind this is that a higher percentage of your investments should be in riskier assets when you are younger because if you experiences losses, you have plenty of time to recover from those losses before retirement. The closer you get to retirement, the more impactful losses will be because you will have less time to recover from them. Therefore, you should reduce the risk level of your portfolio and lower the percentage of your investments in riskier assets as you age. Target-date funds do this for you. Each year they will reallocate your investments based on your target date and automatically reduce your risk over time. This saves a lot of time on your end, and an added bonus is that many of these funds have low or zero trading fees, and minimal maintenance fees.

Index Funds & ETFs

If you don’t want to use a target-date fund, you can research your own strategy for diversifying, and then pick investments that fit it. See the chart below for an example of different asset allocations in a portfolio.

Chart from an article by Fidelity Investments.

If you decide to build your own portfolio, two great options for diversifying are index funds and Exchange Traded Funds (ETFs). Indexes track a group of companies. You are probably familiar with these even though you may not know it. The S&P 500 index compiles 500 companies and tracks all of them together as 1 investment. The Nasdaq and Dow Jones do something similar. There are also lots of foreign indexes to choose from.

Index funds can be quite expensive, so ETFs allow you to buy a portion of 1 share of the index fund. This way, you can still reap the diversification benefits of the index, but at a fraction of the price. Both of these investments track the overall market in a region as opposed to a singular company. This can be beneficial when certain sectors of the market burst or perform poorly. A great example of this was when the dot-com bubble burst in the 1990s. If you were heavily invested in tech stocks and were therefore not well diversified, you would have lost a lot of money compared to someone who had investments in many market sectors. Again, when one cow is sick, you still have the rest of the herd.

The downside to structuring your own portfolio is that it is much more time consuming because you need to reallocate your investments at regular intervals (ie: annually) to compensate for any percentage changes that have occurred. For example, if you had a really great year and made a lot of money on your US stocks, you may now have too high of a percentage of your portfolio invested in US stocks and need to reallocate the extra funds to the rest of your portfolio. On top of that, you will also need to review your overall investment and diversification strategy as time goes on to make sure you are reducing your risk over time. Unless you are extremely interested in investing, I don’t suggest this approach.

Hire A Financial Advisor

The last option is to pay someone else to manage your portfolio for you. Unless you have hundreds of thousands of dollars or more to invest, I think this is a terrible option. Your portfolio manager will charge you tons on fees that will eat into any gains you make and lower your overall return. They also usually don’t perform better than the market, so why pay them to do what you can for free!

So there you have it! Don’t invest in the shiny unicorn. Invest in the herd of boring ass cattle! Slowly but surely and with minimal stress, they will make you a rich bitch!