This is a long overdue article on the nuts and bolts of investing. Here I provide an overview of the top three things you can control when it comes to investing.
Before we get started, please know a few guidelines:
- Keep your hands and feet inside the vehicle at all times.
- Investing in the market (either stocks, bonds, real estate, cows, crypto, whatever) is best done with money that you won’t need for the next 3-5 years.
- Don’t invest what you’ll be using for your home’s down payment or for your kids college if they’re a couple of years away from starting.
- Get rid of HIGH interest debt – anything over 5-6% would be considered high in today’s environment. Please note that this number may change depending on inflation.
- Have an emergency / just in case / opportunity fund in CASH
- As painful as it is to have cash doing “nothing”, it’s a buffer between you and high interest debt because emergencies happen.
- The amount should be between 3-6 months of your basic living expenses.
- Take advantage of any employer investment matching – that’s free money!
- You can watch really fun videos on investing 101 over at Wealthsimple – a Canadian investment firm. They cover:
- The pitfalls of individual stock picking (summary a monkey and a cat have a better track record than individual mutual fund managers…)
- The awesome power of compound interest
- The benefit of automating your finances
Here are the three main things you can control in investing:
- Cost
- Investment allocation
- Taxes
How much are you paying to be in the market?
First off, let’s talk about costs. I personally use a robo advisor, like Betterment, Wealthfront, Ellevest, or a target date fund at Vanguard. The cost runs around 25 basis points, maybe up to 50. That means that for every $100 you invest, you pay 25, or up to 50 cents for the investment management.
When you hire a financial advisor or a financial planner to invest for you the cost goes up. It can be as much as a hundred basis points, or even 120 basis points. You pay more because instead of having an algorithm invest your money, you’re having a person do so. Sometimes this makes sense, especially when you’re focused on social justice investing.
When you invest through an employer retirement plan (think 401(k) or 457), take a look at the available investment options and consider the costs.
What should you invest in?
The longer your time horizon, the more heavily weighted you should be towards stocks, which is ownership in a company. Stocks tend to be more volatile and can feel like a roller coaster, but they also tend to have higher returns. By investing money you won’t be needing anytime soon you can detach more easily from the markets’ ups and downs.
The other key building block is bonds, which are loans you’re making to a company. They’ll pay you interest and at the end of the loan period give you back the original amount you loaned them. The returns tend to be lower than stocks and also have less volatility.
The longer your time horizon, the more heavily weighted to stocks you should be. If you are 30 years old and are looking to invest for retirement, then the recommended amount will be somewhere between 70-90% in stocks assuming you’re comfortable with the market volatility. This is to take advantage of compound interest, where the earnings then start to have more earnings.
Paying the government their cut of the profits
The three most common investment accounts are after-tax investment accounts, traditional pre-tax accounts, and Roth post-tax accounts. Other notable mentions are Health Savings Accounts for medical saving, 529 accounts for college saving, and custodial accounts for under age savers.
Investing in a taxable account
In this type of account you take money that you’ve already paid taxes on and put it in the market. Every year if there are payouts from your investments (dividends from stocks or interet payments from bonds) you’ll pay taxes on that. If you’ve had the investment for less than a year, it’ll be short term taxes and counted as part of your regular ordinary income. If you’ve been investing for over a year you’ll pay a reduced amount known as long term capital gains.
Also, when you take money out, you’ll pay taxes on earnings.
If your head is spinning because I’ve used the word taxes a million times in the past paragraph, please remember to breathe. At the end of the day, investing in regular taxable accounts is usually the last option after fully funding accounts specifically created for retirement, which I get into below.
Investing in a deductible aka traditional aka pre-tax account or a Roth aka after-tax account
Now that you may be mildly nauseous, know that we’re at the top of the investing jargon rollercoaster, and are just about to head down…
The image above is thanks to Capstone Financial Advisors, a Registered Investment Firm. They did a great job of simplifying visually how contributions, investment growth and withdrawals are treated for tax purposes.
A few definitions:
- Contributions: the money you added to the account
- These are meant to stay in the account until age 59 ½, otherwise you pay a 10% penalty on withdrawals
- Investment growth: how much the money has grown over time
- Withdrawals: the money you’ll take out
On traditional accounts:
Although the image is focused on Individual Retirement Accounts (IRA), the taxation method also applies to employer and self-employed retirement plans such as 401(k), 457, 403(b), and SEP-IRAs.
The amount you contribute to the traditional retirement account is deducted from your adjusted gross income. Meaning that if you earn $80k and contribute $6k to your IRA and $10k to your employer’s 401(k), you’ll only be taxed on $64k.
The investment growth will be tax-deferred and you’ll pay taxes once you withdraw. You can withdraw as early as 59 ½ or wait until Required Minimum Distributions (RMD), which is currently 72 ½. The government set up RMDs to make sure that you do take the money out so that they can tax it.
At the time of withdrawal the government will tax the initial contributions AND the earnings at your ordinary income rate.
RMDs are based on your account balance the prior year and life expectancy tables at the time. If you’re in your 30s now and thinking what that might mean for you in 40 years – relax, there’s no way to know that. As I mentioned at the top of the article, there are three things you can control when it comes to investing, and life expectancy tables are not one of them.
For all we know, in 40 years people may be living until 150 or we may have decimated the world so much that reaching 80 will be a major feat. My crystal ball does not see into the dark mind of the IRS and their actuarial (life-expectancy) tables.
What I can tell you though, is that our current tax rates are much lower than they were in the 50s and 60s, so it’s possible that tax rates may be much higher in 40 years.
On Roth accounts:
A Roth investment account is where you contribute money that you’ve already paid taxes on and as a result the earnings are tax free at the time of withdrawal. Since the government is getting their cut now, they do not tax the earnings.
This can be REALLY attractive. If you invest now and withdraw in 40 years, then all of those years of growth will be TAX-FREE. If your money quadruples, you don’t have to pay taxes on that growth.
Because this is such an awesome deal, there are income limitations on who’s eligible to invest in a Roth IRA. However, if your employer offers a Roth retirement plan there are no limitations!
Another benefit of Roth IRAs is that five years after your initial contribution, you can withdraw the contribution itself. For example, if you deposit the max of $6,000 for five consecutive years, you’ll have $30k plus the earnings. You can then withdraw the contribution, but not the earnings. This is the only retirement account that allows you to tap into the contributions without penalizing you 10% and charging you taxes on the earnings.
So, what did we learn on this investment rollercoaster?
You can control the cost of your investments and who’s doing the investment selection for you. You can control your investment allocation – the general rule of thumb is that the longer your time horizon, the more stock heavy it needs to be. And taxes are confusing – yet can be figured out.
On community liberation through investing:
The great and powerful Audre Lorde reminds us that the master’s tools will not dismantle the master’s house. This can be a hard truth to swallow as an investment professional working with many wonderful people who want to invest their money for the benefit of their community .
You may be left with the question: does social justice fit into your investing? Yes. Social justice fits into all of your life and is a way of being and moving through the world, rather than a one time decision.
Tune in next week to learn more about how you can integrate your social justice values into your long term investment and money in general.