This week I was meeting with a financial adviser and had a chance to ask my questions. If you are like me, investments and investing is a stressful hustle. With the permission of the advisor I am sharing with you the questions I asked and the responses I received.
Q: I want to get started investing, but I don’t know how… what do I need to consider?
A: That is probably the toughest question to answer because the answer can be very different for every person but I think the best place to get started is to ask yourself for what are you trying to save? Retirement? Home purchase? Children’s college? Rainy-day fund? Just because? Depending on this answer the type of investments and the types of accounts change significantly so it is best to first define your goal for the savings.
Q: Lets start with retirement, how do I make the biggest dent in those future uncertainties?
A: Retirement planning is a critical step for every person regardless of socioeconomic status. To start, we first need to talk about your job. Per IRS rules, in order to make a contribution to any retirement account you must have earned income in the same year you want to make the contribution. If your company offers a workplace savings plan such as a 401(k) or 403(b) then it is probably best to start saving in that plan because your employer might do some type of matching incentive for your money, i.e., they match first 5% of the money you put in from your paycheck dollar for dollar.
Most employers offer some type of matching incentive so you should check with them to find out what that is. Company plans typically also make it pretty easy for novice investors to pick investments because someone has already created a list of choices so you don’t get lost in the tens of thousands of options. If your company does not offer a retirement plan then you would need to look at an IRA (individual retirement account) which can be opened at nearly any brokerage firm or bank – many will do it free of charge.
Any person regardless of whether or not their employer offers a plan can open and contribute to an IRA but there are some important rules set by the IRS to consider.
Q: I have heard the term Roth and Traditional, what does that mean?
A: That’s great that you have even heard of them. Roth vs Traditional is one of basic questions that you must ask yourself when getting started retirement investing. In the simplest of terms, Roth means after-tax and Traditional means pre-tax. Here is the difference in a dollars and cents example:
- Traditional. Let’s say for simplicity’s sake that you make $50,000 per year. Now let’s say that you want to make $5,000 worth of contributions into either your company plan or an IRA. When you file your taxes come April, the IRS is going to act like you actually only made $45,000 for tax purposes (keep in mind this is a simple example so we aren’t getting in tax write-offs and all that other stuff). This would more than likely put you in the 25% tax bracket so you pay tax on the $45,000. That $5,000 is in the retirement account and let’s say that it grows to become $20,000 by the time you are ready to retire. At retirement age (59 1/2), you choose to withdraw this money and the IRS now considers it earned income that needs to be taxed. So the entire $20,000 is taxable at whatever your tax bracket is at that time (determined by other income in that year). This is called tax-deferred growth.
- Roth. Let’s take the same $50,000 of income and the same $5,000 contribution. The difference begins with how the IRS acts come April. Now they are going to tax you on the entire 50k despite the fact that 5k is sitting in a retirement account. You pay tax of about 25% on $50,000. Now in that retirement your investment grows to same $20,000. However, now at retirement age you choose to withdraw this money….. none of it is taxable. You don’t owe anything to Uncle Sam. This is called tax-free growth.
Now sometimes when I explain this people think great, I want Roth because I don’t want to owe anything later but not so fast. Each type of account has its benefits and should be weighed carefully and the right answer for you may change from year to year so let’s try to use the tax law to your benefit. By making contributions to pre-tax/Traditional accounts you may be able to put yourself into a lower tax bracket so instead of paying 25% or worse 39.6% on your income you could get into maybe the 15% or 33% brackets change nearly every year so it pays to do some research on what your income is approximately and figure out if some last minute contributions or maybe changing the way your paycheck contributions are made would be of benefit.
You can consult with any tax advisor or do some quick searches on the internet by typing “IRS tax brackets (and whatever year we are in).” You also could split your investment and do some Roth and some Traditional.
Q: Are there any limits on how much I can contribute? Any restrictions on getting the money out?
A: Unfortunately, yes to both. The IRS mandates the dollar maximum dollar amounts that can go into these accounts per year and the amount can change year by year. As of this Q&A (tax year 2017), IRA maximums are $5,500 per person total between Roth and Traditional with a catch-up contribution of $1,000 for persons over the age of 50. Employer plan maximums are $18,000 per person total with a $6,000 catch-up.
Now the IRS also says you can only contribute up to these maximums or your total income, whichever is lesser. For example, if you only made $2,000 for the year you couldn’t make a $5,500 contribution. Another limiting factor is that depending on how much money you made and your marital status you may not be allowed to either make or deduct your contribution. So without getting into the weeds on the explanation, if you make above certain dollar amounts and your employer plan status, you may not be able to make contributions to a Roth IRA or the IRS may not allow your contributions to a Traditional IRA to be deducted from your income.
These situations could cause some pretty interesting and complicated results so it is best to talk with a tax professional or do some quick searching on the internet to find out what those limits are for your situation. You can get some generic info about these limits from your brokerage firm or bank as well.
When it comes to restrictions on taking money out of retirement accounts, you generally should wait until 59 1/2, which is the IRS designated retirement age, however you still can do it. If you take money from your Traditional/pre-tax account prior to that age then you pay not only tax at your income bracket but also a 10% penalty to the IRS. There are some qualifications on taking some money out without the penalty for certain reasons like school or first-time home purchase which I won’t get into here but you can look those up pretty easily online. When it comes to taking money out of a Roth/after-tax account you can always take out contributions without tax implications but if you take out any growth or earnings that your contributions have made then the tax situation gets muddied if before that magic age of 59 1/2, after that age – your money!! Now there is something called a 60-day rollover which allows you to take money and then replace it within 60 days and not have to pay any taxes, you are allowed to do it once per rolling 12 months per person, not per account.
If you plan on taking any money you should always check with a tax professional first to find out exactly what the implications will be for your situation and what your best options are. When it comes to employer sponsored plans – 401(k), 403(b), etc. – there will be some additional restrictions to consider, not just taxes, and those restrictions can change from plan to plan. The only way to get that info is directly from them so you will need to call the provider to find out what you are allowed to do.
Q: What else should I consider when choosing retirement accounts?
A: Well, so far we have only discussed the basic types of retirement accounts. There are other types for self-employed individuals like a SEP IRA or Self-Employed 401(k) among others. If you fall in this category more than likely you have a person who helps with your taxes so you should consult with them on what your options are. Also let’s not forget that if choosing your account type is 1(a) for importance, choosing the actual investment is 1(b) – and maybe those priorities should be flipped. The good news is that once we do start talking about investment options the principles apply to all accounts regardless of the pre-tax or post-tax status or even if the account is not for retirement at all.
Q: Can you explain the other accounts types, other than retirement?
A: Of course! The most common other account type for saving is referred to simply as a non-retirement account. Some people might call it a brokerage account but retirement accounts are usually brokerage also so that isn’t the best term. In simple terms for those who do not know, brokerage means that you can buy and sell brokered products, i.e. stocks, bonds, mutual funds, ETFs, certain CDs. This account would be good if you want to save for any purpose for the most part. A car, house, rainy day fund, or just saving. This is where you can do it. If it is for college for your kids there is a better place which we can get into another time but I’ll just say 529 or UTMA. Google it.
Q: You just mentioned stocks, bonds, mutual funds, ETFs and brokered CDs, can you give some basics on what the differences are?
A: These are the most common types of investments that you can buy. Remember you don’t “buy an IRA” in the say way you don’t “buy a savings account.” You buy or sell different investments within the accounts and these investments can.
- Stock is issued by a company as an ownership interest. If you buy a share of stock you are a part owner in the company. The price of a any stock will vary greatly depending on the company you choose. If the company sells more goods or services then the value of your share can go up. You can sell the stock at the higher price and get the cash to either buy another investment or use it for whatever else you want. Keep in mind that the stock could also go down as the company performs relatively poorer than it was. Stocks trade constantly throughout the trading day.
- Bonds are issued mainly by companies and governments as debt financing. Bonds are typically sold in $1,000 increments for a specific period of time at a certain interest rate. There are several types of bonds but probably the most common one is that you pay $1,000 up front and get interest payments for a predetermined amount for a specific period of time and then get your $1,000 back at the end. For example, a bond could be issued at par value of 100, meaning $1,000 for 1, 3, 6, 9 or 12 months or maybe 2, 3, 5, 10, or 30 years (these are just the usual lengths). Depending on the length, the interest rate will change, the longer the time, the higher the rate. When investing in bonds you should consider (a) credit worthiness of the issuer – are they reputable so that they will continue to make the payments (b) bond length – because you may lose money to sell out early (c) and interest rate risk – if/when interest rates change, a new bond may be paying a higher interest rate. Bonds trade constantly while the market is open.
- Certificates of Deposit, or CDs follow the same principles as bonds but have FDIC insurance because they are issued by banks.
- Mutual Funds are investment funds that use your money to go buy stocks or bonds that match the funds goals. For example, let’s say that a mutual fund manager says that the fund is going to invest in technology companies. You buy shares of the fund and the manager buys shares of stock in whatever technology companies the manager and team see fit. There are thousands of funds that have countless objectives. One of the main things to consider when picking funds is the cost of the funds. Whereas you typically pay a flat fee to buy a stock or bond, because you are paying for some type of management fee is normally a percentage of the money you have invested. Some of these fees you can avoid buy picking the right fund but the expense ratio you not avoid. This fee ranges from around 50 cents per thousand to as high as $20 per thousand. How active the manager is going to be, how challenging the stocks or bonds are to pick or some other reasons I don’t know will determine what that fee is. Mutual funds also have direct relationship with the share owners. When you buy, you buy directly from the funds managers and sell/redeem shares directly with the manager as well. For this reason mutual funds only trade once per day, so at the end of the day the manager goes through to see how many shares of of the stocks or bonds they own and how many shares of their fund they have sold and determine a price for one share of their fund. If you had placed an order to buy or sell that day then you get that price, so it is kind of like buying or selling and only having a reasonable idea of what the price may be.
- Exchange Traded Funds, or ETFs are funds as well so they are extremely similar to mutual funds in how they are organized and the expense ratio for its fee. A main difference is that ETFs trade just like stocks throughout the day. Because they have a fund structure but also trade throughout the day they have an advantage over mutual funds in that you can jump in and out during a trading day (aka you see a good price you can buy, you see a good price you can sell – get in and it at a price point you know). However, this same benefit creates a problem because the underlying securities go up and down throughout the day and the fund itself can go up or down they typically do not perfectly match. There is what is called a tracking error – on the most popular ETFs the error is relatively small, say 99% accurate but I have seen ones that are lower so that is worth knowing before investing.
We are pausing our conversation until next time. Hopefully, this information helps you understand the basics of investments.
If you have questions about investments that you would like to ask, please, comment below. Our financial advisor will be happy to answer them as soon as he can.