How to Invest?

Tommy

Just a Millennial living in the real world...

Interesting fact. Did you know that Millennials have the greatest savings percentage increase than any other generation in the past 3 years? Per a study by Fidelity, Millennials are saving about 7.5% of their income compared to 5.8% in 2013. Typically Financial Advisors say that you need to save 15-20% of your income for retirement. In my honest opinion, that amount is pretty absurd with the current situation that Millennials are facing with student loan debt, high rents, and inflation. However, when there’s a will there’s a way.

Also per the Fidelity study, only 45% of Americans were likely to afford their essential retirement expenses. In a perfect world, I would hope that 100% of Americans could afford their essential retirement expenses since everyone deserves happiness. That is why it is still imperative to save money.

Why is saving for retirement and investing important?

My main question for Millennials and all people is do you want to be able to live comfortably when you’re retired? Assuming you have your home and student loans paid off with little debt, you will still need money for daily expenses like food, clothes, and medical expenses.

There are three reasons why it is important to save for retirement.

First, the median retirement savings of households aged between 55 – 65 is $104,000. Assuming you live for another 20 years past age 65, that is a whopping $5,200/year you can withdrawal to live off of! Do you really think you could live off of that plus social security?

Second, is social security. Most people think that they can live off of social security income when they retire. Well what is the average benefit? It’s $1,503/month or $18,036 in January 2020. The majority of us probably can’t afford to live off of that based on medical costs alone. Per Fidelity, the estimated cost of medical expenses during retirement is $285,000 per couple or $14,250/year assuming 20 years for retirement.

One nice thing about social security is that it adjusts for inflation automatically so there might be a COLA. When the US GDP is growing at approximately 3%, medical costs are growing at 5.5% per this study. Also in 40 years, social security might not be around and is expected to run out in 2035 because the program is being underfunded.

Lastly, inflation. Money loses value over time due to rising costs. $10,000 won’t be worth $10,000 in 40 years and you won’t be able to purchase as many goods and services due to inflation. For example, remember when a gallon of gas used to cost less than a $1. Yeah, I wasn’t even born when that last happened. Now gas is averaging about $3.00/gallon. That’s inflation.

Also, the average savings account interest rate at a bank is about 0.09%. If inflation rises approximately 2% per year, your purchasing power will be little and you won’t be able to afford goods and services in retirement. Since 1960, the S&P500 has averaged a 13.7% rate of return. That is why it is important to invest!

Step 1: Choose Your Broker

So you want to invest money? That’s great news! The first step is to choose your broker or financial institution where your money will be held at. There are thousands out there and you can even open up IRAs and Roth IRAs at banks. I would recommend opening accounts up at a company with low transparent fees, a reputable company, and lots of investment options. My 401(k) is held at Charles Schwab and I also have retirement accounts held with TD Ameritrade. Other companies I would also recommend are Edward Jones, Merrill Lynch, Northwestern Mutual, E*Trade, and Robinhood. TD Ameritrade, ETrade, and Robinhood offer financial advisors, but are more do-it-yourself investing.

Step 2: Choose Your Investment Vehicle

My Dad earned a pension (defined benefit plan) from the federal government for his 30 years of service in the Navy. A pension is a guaranteed income stream for the rest of your life paid for by your employer. For the most part, these retirement plans do not exist anymore. Why? Because the employer takes on the risk of guaranteeing payments and having to fund shortfalls if necessary based upon the value of the funds. If the fund is underfunded and the employer decides not to pay then you will have some very angry people.

Almost all employer sponsored retirement plans are now defined contribution plans, where the employee makes contributions to the retirement plan. Sometimes employers are nice enough and they match your contributions. But you usually have to be vested 100%, which means that you have to work for the company for a specific amount of time to claim 100% of the matching contributions. The average vesting time period is typically 5 years or 20% vested per year of service. You have the option to choose your investments and you bear the risk of losing money. These plans consist mainly of 401(k)s for private companies, 403(b)s for public schools & nonprofits, and Thrift Savings Accounts for military.

401(k)s, 403(b)s, and Thrift Savings Plans:

401(k)s, 403(b)s, and Thrift Savings Accounts are tax-deferred retirement accounts. Employees can make contributions up to $19,500 with a $6,500 catchup for people over 50 in 2020. Employers may choose to match contributions. Since employer-sponsored plans are ran by employers, they get to choose the investments so there may be limited options. Contributions grow tax free and are available for withdrawal after age 59.5.

Individuals are taxed on withdrawals at their marginal tax rate at the time of distribution. If you withdrawal early, then you are taxed as ordinary income along with an additional 10% penalty. You are also required to take required minimum distributions (RMD) if you are 70.5 before 1/1/2020 and all others are required to take RMDs by age 72. The deadline to make contributions is December 31.

You can also borrow from your 401(k) up to $50,000 or 50% of your vested amount, whichever is less. If 50% is less than $10,000, then you can borrow up to $10,000 if your plan allows it. There must be a written agreement for the loan. Interest rates must be reasonable set by the business owner. Repayment is to be made within 5 years (10 years if used to purchase a home) and must be made at least quarterly in equal amounts of principal and interest. The money that you pull out won’t be invested until you pay it back so if the investment gains in your account are greater than the interest you pay yourself, then you will be missing out on investment gains. If you can’t pay back a loan, then there will be a 10% early distribution penalty and the distribution will be taxed as taxable income.

IRAs:

IRAs are also tax-deferred retirement accounts, but it is not employer-sponsored. Individuals can make contributions up to $6,000 or $7,000 for people over 50 in 2020. Contributions grow tax free and are available for withdrawal after age 59.5 like 401(k)s. Also like a 401(k), individuals are taxed on withdrawals as ordinary income at their marginal tax rate at the time of distribution if with an additional 10% penalty. Also, you will be required to take RMDs if you are 70.5 before 1/1/2020 and all others are required to take RMDs by age 72. The deadline to make contributions is April 15.

You can deduct contributions in full if you or your spouse do not have a retirement plan at work. If either one of you have plans at work then the deduction is reduced or eliminated. The nice part about IRAs and Roth IRAs is you get to choose the investments instead of your employer. Here is more information about IRAs and the deduction limits.

Roth IRAs:

Roth IRAs and Roth 401(k)s are tax-advantage accounts where your contributions are taxed as ordinary income at your current marginal tax rate at contribution and your withdrawals are tax free. Individuals can make contributions up to $6,000 or $7,000 for people over 50 in 2020. Contributions grow tax free and are available to withdrawal after age 59.5 tax free. So if you expect yourself to be in a higher tax bracket during retirement than currently, then a Roth IRA is a good strategy.

Also, you can withdrawal your contributions at any time with no taxes or penalty. You have to have owned the Roth IRA for at least 5 years or earnings may be subject to income tax for early withdrawals on earnings. Roth IRAs do not have RMDs like IRAs and 401(k)s.

Roth IRAs have income limits. If you make too much money, you are not allowed to make contributions to a Roth IRA. Here is more information on a Roth IRA along with the income limits of those who can contribute.

Roth 401(k)s:

A Roth 401(k) works the exact same way as a Roth IRA except in a few ways. Employees can make contributions up to $19,500 with a $6,500 catchup for people over 50 in 2020. Employers can offer matches like 401(k)s and contributions made directly from paychecks. Like a 401(k), you can take a loan from a Roth 401(k). The loan rules for Roth 401(k)s are the same as a 401(k). There are no income limits that prevent you from contributing to a Roth 401(k) unlike a Roth IRA. Roth 401(k)s do have RMDs beginning at age 72.

Other Retirement Accounts:

Simplified Employee Pensions (SEPs) are another retirement plan and are popular with self-employed professionals with no employees. You may contribute up to 25% of your income up to $53,000 into the retirement account. Contributions are tax-deductible and distributions are taxed at the marginal tax rate of the employee in retirement. For more information, click here.

SIMPLE IRAs are popular with small businesses up to 100 employees. These allow you and your employees to contribute up to $13,500 annually, but the employer usually has to make a 3% matching contribution. They’re typically easier to administer than 401(k)s. For more information, click here.

Brokerage Account:

Brokerage accounts are where you can fund money into the account and a licensed Financial Advisor or financial services firm can place orders in the market on behalf of the investor. It is wise to have a brokerage account because you can invest and it acts like a savings account with a potentially higher rate of return. A brokerage account is very liquid and you can withdrawal cash after you sell your investments. Beware of fees though!

Step 3: Find Your Risk Tolerance

Before you even start to invest, you need to figure out your risk tolerance. To be honest investing is like gambling, but the returns can be a lot higher with less risk than gambling over time. In order to assess your risk tolerance ask yourself, how you would feel if you had to the possibility of losing $1,000 or gaining $2,000. Would you be comfortable with that scenario? If you are not comfortable with that, then you are risk adverse, meaning you like to minimize your risk. If you don’t mind risk, then you have a higher risk tolerance. Equities are riskier investments while bonds and cash investments are less risky investments.

Here is a link to the free risk tolerance questionnaire by Vanguard. This will help you assess your risk tolerance.

Step 4: Choose Your Investment Strategy

The next step is to choose your investment strategy. The two ways to invest contributions and they are with a lump sum amount or use Dollar Cost Averaging (DCA), which is what I use. Dollar cost averaging is a strategy that divides up a certain amount to be invested and makes periodic purchases (usually monthly) of specific assets in order to reduce the impact of volatility on the overall purchase. The purchases occur regardless of price at regular periods.

The main investment strategies are below:

Buy and Hold: Ever hear that you want to buy low and sell high. Well that’s what buy and hold investors do. They find investments that they believe will perform well for long periods of time. They do not get rattled by market dips in the short-term and hold onto investments and stay the course.
Growth Investing: Growth investing involves investors finding emerging companies that they believe will grow at a rapid pace in the future. Growth investing will allow for greater return at a faster pace, but it is definitely riskier as emerging companies are in the earlier stages of life than a mature company. Start-ups companies are prime examples.
Value Investing: Value investing is finding companies that you believe are under-valued.

Step 5: Choose Your Investments

There are many different types of investments, stocks, bonds, mutual funds, ETFs, REITs, commodities, etc. There are thousands of different investments and it can be overwhelming process to choose them. That is why you can hire a Financial Advisor or robo-advisor to do the research. But some people, like myself, like doing their own research. See the “My Investments” page for what I invest in.

Remember it’s important to diversify your investments so you don’t lose all of your money in one investment. Don’t lose all of your eggs in one basket. This is called diversification.

Step 6: Stick to Your Strategy

Time and compound interest are a Millennial’s best friend for retirement saving. We have a ton of time until we retire so it’s best to start investing now. When you make periodic contributions, you increase your investment accounts and those accounts compound interest over time.

So once you have your investment strategy in place then it is important to stick to the plan until you reach retirement.