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Roth or Traditional 401(k)s and IRAs?

Roth or Traditional 401(k)s and IRAs?

Taxes are a large cost when it comes to investing. In the United States long term investments (held 366 days or longer) are taxed at 15% for most people. For those in lower tax brackets long term capital gains are taxed at 0% and for those in the top tax bracket the IRS calls for a 20% cut.

So, if one has $20,000 in gains 15% would be $3,000. In another example $100,000 in gains would be $15,000 paid to the IRS. It’s not an inconsequential amount. Furthermore that amount of gains is very realistic, particularly over a long period of time, $10,000 invested over a period of 40 years with an 8% interest rate would grow to over $217,000.

Fortunately there are ways to shield long term retirement savings from these destructive taxes. One way is a 401(k) and another is an individual retirement account (IRA).

Traditional 401(k)s and IRAs

Many employers offer 401(k) plans. A 401(k) allows pre-tax money (money for which income tax hasn’t been paid) to be invested. Unfortunately the medicare and social security payroll taxes are still due. One can start taking money out of a 401(k) at age 59 and 1/2. Any distributions from a 401(k) (with some exceptions) prior to age 59 and 1/2 will result in taxes being due plus a 10% penalty.

No capital gains taxes are owed when the investments are sold and distributions are made but the money is taxed as ordinary income at the state and federal level.

The main advantage to a traditional 401(k) or IRA is that the money grows tax deferred and it is only taxed once. If one were to simply invest money from a paycheck without a retirement vehicle it would be first taxed at the Federal and State level and then any capital gains would be taxed as well.

For example, if one were to allocate $10,000 from a paycheck to an IRA or 401(k) it would not be subject to any state or federal taxes. It would hopefully grow (lets say at 8% over 30 years). After 30 years it would have grown to $100,626.57 and all the money is withdrawn from the 401(k). At this point (assuming the person is over 59 and 1/2) the money would be taxed as ordinary income. Let’s assume for the purposes of this example it is taxed at the 25% tax bracket, and thus the IRS would be expecting $25,156.64. The total proceeds would be $75,469.93.

A traditional IRA would work the same way with an important caveat. Your employer isn’t aware of the IRA so you will be overpaying in your federal and state withholding taxes in each paycheck (and get a larger refund which I think is a BAD thing), because the income reduction won’t come until you file your taxes the following April. But you can compensate for this by increasing withholding allowances.

This brings up the secondary advantage of IRAs and 401(k)s: they allow you to reduce your taxable income. This can be particularly helpful if one is on the cusp of a tax bracket. For example, lets say you made $40,000 in otherwise taxable income in 2016. If you contributed $4,000 to a 401k, instead of having to pay 25% on the amount over $37,651, you’d be taxed no more than 15% on any earnings that year.

Roth 401(k)s and IRAs

Traditional 401(k)s and IRAs are not taxed initially, but are taxed when money is withdrawn. Roth IRAs and Roth 401(k)s work in reverse. You don’t get any tax benefits initially with a Roth 401(k) or Roth IRA. You use after tax money to save for retirement but you don’t have to pay any taxes on distributions.

If your tax bracket is the same when you put money in the IRA as when you withdraw the money, it doesn’t matter if you have a Roth IRA or a traditional IRA, the tax savings is going to be the same.

However, if you’re in a higher tax bracket later in life as compared to earlier in life, the Roth 401(k)/IRA is better because you can pay taxes at say 15 or 25%, invest the money, it grows tax free, then if you’re in a 35% tax bracket because you’ve made it big and you’re still working at age 59 and 1/2 you can withdraw that money and you don’t have to pay any additional taxes.

Conversely, if you’re in a lower tax bracket when you retire the traditional IRA or 401(k) is going to be better.

But because of the move towards a more socialized society and given the monstrous debt in the US I anticipate taxes will only go up in the future. So I’d rather pay them now when tax rates are lower.

The Advantage of an IRA or 401(k)

Let’s compare a Roth IRA/401(k), to a traditional IRA/401(k), to simply investing the money without a retirement savings vehicle in a regular taxable account. Let’s say you earned $10,000 of W2 income and want to invest all of it. I’m ignoring social security and medicare taxes because there is no way to avoid those on W2 income in the US, for all three scenarios they are due up front.

As you can see, if one is in the same tax bracket when the investment was made, as when the distributions are made, it doesn’t matter if one has a Roth or traditional 401k/IRA. But there is a $10,000 advantage over a non-tax advantaged brokerage account.

Roth or Traditional?

I prefer after-tax, Roth IRAs/401(k)s in general but in specific circumstances using a pre-tax vehicle makes more sense. I like Roths because I can check the balance of my Roth IRA or Roth 401(k) and I know that is how much I would have access to when I achieve an age of 59 and 1/2. I don’t have to figure in taxes. I also hope to be making more when I’m 60 than I am now. Plus, I think taxes are going to be going up in order to pay for unfunded entitlement programs and to pay the national debt (not that I think it is repayable).

I also generally prefer IRAs versus 401(k)s of any kind because with an IRA you can choose a broker that has more investment options than the limited range of choices employer sponsored plans typically allow. Pretty much all the investment options I’ve seen for company sponsored 401(k)s are very limited and are focused in the US.

But I will use a traditional 401(k)/IRA under certain circumstances. 1) If I can use it to get to a lower tax bracket. 2) If my employer offers a 401(k) with company matching–I will contribute to the 401(k) until I’ve maxed out the employer match. 3) If I’ve already maxed out the Roth IRA contribution for the year ($5,500 for a single person under 50 years old in 2017) then I would consider contributing to a 401(k).

Wether you go with a Roth IRA or traditional IRA you can only contribute up to a combined total of $5,500 in 2017 if you’re under 50. If you’re 50 or over you can contribute $6,500.

For 401(k)s the 2017 contribution limit is $18,000 but goes up to $24,000 if you’re 50 or over.

So if you contribute to both a 401(k) and an IRA you could save a total of $23,500 in tax advantages funds ($30,500 if you’re 50 or older).

Source: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits

Source: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits

So in general I prefer Roth to traditional, and I prefer IRAs to 401(k)s. However, if my employer offers matching I take advantage of that.

SEPs, solo 401(k)s

There are other tax-advantaged ways to save for retirement, like a SEP or a solo 401(k). I haven’t taken advantage of these options but it is something I’m researching.

I think saving and investing for retirement is important. But there are some strong headwinds working against folks planning for retirement in the US: taxes reduce income and gains, pensions are becoming a thing of the past, Social Security is woefully underfunded, inflation ravages savings.

Tax-advantaged retirement savings vehicles like IRAs and 401(k)s provide needed advantages when it comes to investing for retirement. It’s important to understand how they work and to make use of the tax-advantaged benefits they provide when suitable.

How I Avoid a Tax Refund

How I Avoid a Tax Refund

I’ve written about how I hate tax refunds.

I want to share three ways I avoid getting one.

I’m not a tax advisor, CPA, or attorney. I’m just sharing what I’ve done in the past as an individual subject to United States taxes.

This isn’t tax advice.

In my experience there are two steps to avoiding a tax refund.

Step one is to have an accurate prediction of how much tax I will owe (or get refunded) at the end of the year and (this is the key) knowing this information before the calendar year ends when I can still do something about it.

The second step is to take action to influence how much tax will be owed at the end of the year. All while being careful not to owe too much.

It’s important to know the maximum one is allowed to owe in federal taxes and the state level as it could change.

In past years it was $1,000 at the federal level. If one were to owe more than $1,000 in taxes there would be penalties.

Step One: Know How Much Tax you will Owe (or be Refunded) in Advance

Most people don’t look at their taxes until the next year.

For example, right now, most people probably haven’t even looked at their 2016 taxes yet. When they do and they realize they will be getting a $2,000 tax refund, well there is nothing they can do now, except file their taxes as soon as possible to get the refund check.

But if one were to assess his or her tax situation in June of 2016, there would still be half a year to make changes.

So how do I predict how much tax will be owed at the end of the year?

There are several ways.

Use Last Year as a Proxy

At a very basic level, one could use the past year as a proxy.

Ask yourself, did I get an income tax refund last year? If so, ask, am I going to be making the same amount next year? Will I have the same or similar capital gain/loss. Will I be making similar charitable contributions?

If one’s tax situation last year is likely to be very close to what it will be this year then it makes sense there will be a similar tax refund.

This isn’t a very sophisticated approach but it is a start.

In order to make an accurate prediction of how much income tax will be owed more a more detailed and comprehensive approach is needed.

Use Income Tax Calculators

Last year I put together a complicated spreadsheet that basically enabled me to calculate my income taxes during the year.

But rather than reinvent the wheel manually like I did–it would have been better to use the prebuilt tools and resources available to calculate taxes due.

One could experiment with the TurboTax W4 Calculator. Armed only with a copy of the most recent pay stub, as well as some other information, like charitable contributions, capital gains/losses, one can tweek allowances to avoid getting a refund.

Turbotax also has something called Taxcaster.

I wish I had known about these last year.

They key is having tools available to predict how much tax one will owe (or have overpaid) during the current tax year, while a person can still make changes.

Another strategy I’ve used is to start my taxes in December. By December 2016 I had filled out most of my tax information in Turbotax.

Sure, I didn’t have 1099s, W2s or many other tax documents, but I can look at pay stubs to figure out how much my W2 will be, I can look at my brokerage statements to see gains and losses.

This allows me to make decisions when I can still influence my 2016 taxes.

Step 2: Take Steps to Avoid a Tax Refund

Once I have a good prediction of how much of a tax refund I’ll get based on income, charitable giving, capital gains, and other tax situations it’s time to do something about it.

Strategy One: Increase Allowances on the W-4 Worksheet

Increasing allowances on a W-4 reduces the amount of tax withheld from each paycheck.

The tools referenced above enable one to tweek withholding allowances to make sure some money will be owed at the end of the year.

If the max I’m allowed to owe at the end of the year was $1,000, I would try to owe around $500 or so.

This provides some wiggle-room, because despite best efforts, the tax situation could change and I’m only able to estimate what I think my taxes will be Maybe I’ll decide to give a big $1,000 check to the charity in December, or maybe I’ll suffer a large realized stock loss I wasn’t anticipating.

These are things that a taxpayer might not realize are going to happen until later in the year.

Strategy Two: Convert IRA Money to a Roth IRA

I think taxes will be higher in the future than they are now.

So when it comes to retirement accounts I prefer paying taxes upfront (when I think they’ll be lower) and then having that money grow tax free over the course of 40-50 years, and then be able to withdraw it tax free.

Thus I prefer a Roth IRA over a traditional IRA (and Roth 401ks over 401ks).

But employer’s tend to do company matching to a 401k which is pre-tax money. I’ve been in several jobs that had a 401k and upon leaving those employers I’ve rolled my 401k money into an IRA.

So if I know I’ve overpaid my taxes I will convert some of my IRA money to a Roth in late December.

This increases taxable income, but one can opt NOT to have taxes withheld during the conversion.

This tax is still owed of course, but the payment can be delayed until later in April.

So if I know I’ll be getting a refund I can use that as an opportunity to convert some of my IRA money to a Roth.

I did this last year. I was working a W2 job for a half a year, and then when my contract was up I had no job. So I’d been overpaying withholding taxes.

So I decided to convert a large portion of IRA funds to a Roth IRA to avoid getting a refund. If I had known I was only going to be working for half a year I would have increased my withholding allowances.

Strategy Three: Realize Some Capital Gains

You want to be smart about this.

I wouldn’t sell a winning investment just to avoid a tax refund, but if you’ve been thinking about getting out of a winning position anyway, doing so will increase your taxable income.

In the US short term gains are currently taxed as ordinary income.

Strategy Four: Give Money to Charity

This strategy doesn’t help avoid a tax refund, but it is invaluable if you have underpaid your taxes too much, because it is a way to avoid penalties (see page 51).

If I realize that I owe more than the penalty-free amount on my taxes, I’ll give some money to charity or make some additional donations or put some money in a Health Savings Account.

These contributions reduce taxable income and can be useful when avoiding penalties that can be assessed if too much tax is owed at the end of the year.

Similar to strategy one, you can also reduce your withholding allowances to have more tax withheld each paycheck, if you realize that you’ll wind up owing too much at the end of the year.

I Hate Tax Refunds

I hate tax refunds because they are an interest free loan to the government and I have better use for my hard earned money than the IRS does.

It’s vitally important to legally pay all taxes due and remain in compliance with all applicable tax laws. It’s just not worth trying to cheat the IRS.

But there are legal ways to reduce your taxable income and avoid getting a tax refund.

Avoiding a tax refund has nothing to do with cheating the IRS or evading taxes.

It’s simply a way to make sure you aren’t paying more than you’re legally required.

It’s also a way to make sure that you don’t pay the taxes you owe earlier than you’re legally required to do so.

The above strategies are merely things I’ve done in the past to manage my tax burden and isn’t advice.

But these ideas could spark some conversation when you speak to your licensed tax advisor and as you make your own tax decisions based on your own unique situation.

I Hate Tax Refunds

I Hate Tax Refunds

I hate tax refunds. Some people think, “I can’t wait for my tax refund so I can do X.” If you really don’t want to wait for your tax refund, take steps so you don’t get one.

See, a tax refund is just that, a refund. It’s not a bonus, new money, or an extra paycheck. An income tax refund is money you could have had earlier in the year, that you overpaid to the government, which is now being returned to you, without any interest.

The United States Tax System

First, a bit of a background on the tax system in the United States.

HowIGrowMyWealth.com has a global audience. I focus on the US with respect to taxes because I am subject to income taxes in the United States and have no experience with taxes outside the US.

While I’m not tax attorney, accountant, CPA or guru, I have been in charge of my own income tax returns since college and I have over 10 years experience doing my own taxes.

There are a myriad of tax situations. I’m just writing about my own experience through 2016 as a W2 income earner.

Income taxes in the United States are imposed at various levels. There are Federal Taxes, State Income Taxes (in most states but not all), and in some cases income taxes on an even more local level.

The US has a pay-as-you-go tax system. That means one is taxed throughout the year at a rate that assumes you’ll make the same amount each pay period.

So if one were to make $4,000 in January, the United States Internal Revenue Service (IRS) assumes you’ll make $48,000 ($4,000 x 12) and taxes will be withheld by one’s employer from each paycheck as if you were going to make $48,000.

But the US tax code is hopelessly complex (you can ask 3 different accountants a tax question and get three different answers all of which could be correct) and tax withholding doesn’t take into account changes in income, deductions, credits, allowances, or capital gains/losses.

As a result one could end up owing more or less in tax at the end of the year, once the myriad of factors that factor into an income tax return are known.

Why I Hate Tax Refunds

Imagine you go to a store and buy a shirt and you pay $100 for it. But the shirt really only cost $50. An honest storekeeper would give you $50 change at the point of sale.

But this store owner holds onto your $100 for over a year and then finally tells you that you overpaid and gives you $50 back.

If you didn’t realize you overpaid you might be glad, “Hey, I’ve got an extra fifty smackers!” But what if you needed that $50 a year ago to pay rent, or buy food, or to buy a pair of pants to go with your shirt, or better yet, save that money and earn interest on it. You’ve lost out on all kinds of opportunities for those funds.

Try to Be Rational

Now I get it, just like if you were to find a $20 bill in your couch that you thought you had lost, there is a certain emotional thrill of getting money back.

I also get that as humans, myself included, we’re very emotional creatures.

Sure, humans have the capacity for reason, but unfortunately and all to often emotion rules the day.

I quote my favorite playwright, Oscar Wilde:

Lord Caversham: No woman, plain or pretty, has any common sense at all, sir. Common sense is the privilege of our sex.
Lord Goring: Quite so. And we men are so self-sacrificing that we never use it, do we, father?

  • An Ideal Husband, Oscar Wilde

In the witty quote above, I think Oscar Wilde is basically saying that too few of us (men and women) use common sense or reason as often as would be ideal.

Rationally it doesn’t make sense to get a tax refund. A tax refund is money that has been overpaid that is being returned much later with no interest.

I strive to be a rational person. Not in the sense of being a robot, but rather having rational thoughts in the driver seat and emotions serving more of a supporting role, rather than using reason to justify my emotions.

It’s much more reasonable to avoid a tax return and be happy that one has the money throughout the year, rather than get the money in April.

My next article will provide ways in which I’ve avoided getting a tax refund in the past, so that I had more money throughout the year and I didn’t give the government an interest free loan.

The Affordable Care Act Made Healthcare Less Affordable For Me

The Affordable Care Act Made Healthcare Less Affordable For Me

With the dawn of the Affordable Care Act (ACA, more often called ObamaCare) individuals are now taxed for NOT buying something.

I encountered this for the first time the 2016 calendar year during my 100 days of unemployment. For for the first six months of 2016 I had what the Affordable Care Act calls “minimum essential coverage” (MEC) through my employer.

Starting in July I no longer had employer provided health insurance.

I hardly considered continuing my employer coverage via COBRA because it’s so expensive.

Even though I’m relatively young and healthy, accidents do happen. The number one cause of bankruptcy in the US is medical bills and I don’t want to be part of that statistic.

I could have signed up for a 2016 ACA plan within 60 days of losing my employer provided coverage but I didn’t think that was a good option.

The Affordable Care Act Made Healthcare Less Affordable For Me

The least expensive plan for me on healthcare.gov was $203.55 per month and had a $6,650 deductible, $40-$80 co-pays and/or 40/60 co-insurance and $6,850 maximum out of pocket.

This ACA health plan would have cost $2,442.60 per year or $1,221.30 for six months.

But even when you pay the premiums one still has to meet the $6,650 deductible.

For those not familiar with insurance jargon, a deductible is an amount that must be paid out of pocket by the insured (in this case me) before the insurance plan will cover anything.

So, in the course of a year you’d have to spend over $9,000 before this plan would kick in and start covering medical bills.

No thank you I’ll find a better plan.

What I Decided to Do for the Second Half of 2016

I purchased a non-MEC health insurance plan for $52 per month. It had a $5,000 deductible 30/70 co-insurance and a maximum out of pocket of $16,666.

I also got an accidental medical expense plan for $57.36 per month with a $250 deductible. I would be paid out up to $10,000 in the event of a disability or cancer/stroke.

So for a little over half the cost I was able to buy what I think is better coverage from both a cost and benefit perspective. My total cost was $656.16 for six months of coverage.

Minimum Essential Coverage

The only problem with the plan I purchased is that it does not fit into the government’s definition of “minimum essential coverage” (MEC).

Not having MEC results in one having to pay the Orwellian “Shared Responsibility Payment” which is $695 in 2016 or 2.5% of Adjusted Gross Income, whichever is higher, prorated for any months in which there was no coverage.

Since I had MEC for 6 months through work, but non-MEC for the 6 month I was unemployed, I would be “responsible” for paying half of the “Shared Responsibility Payment”. This “tax penalty” in 2016 is $695 or $347.5 or 2.5% of my AGI, whichever is higher.

So my total cost for health insurance in the last six months of the year was $1,003.66. Which is still $200 less expensive than if I had gone with the least expensive healthcare.gov plan.

Would I Have Done Anything Differently?

In hindsight I think I would have done the following.

After losing my employer coverage I would have gone without insurance for about 50 days or so (if I had gotten catastrophically ill in that time I would have bought an ACA plan since I would still be within that 60 day window). Then after 50 days of going without insurance I’d sign up for the least expensive ACA plan.

The ACA plan would have cost me $203.55 per month for four months or about $815.

You can go up to 3 months without MEC provided you have MEC for the rest of the time. So I wouldn’t have had to pay the newspeak “Shared Responsibility Payment.”

Lessons

My mistake was not factoring in the “tax penalty”. The health insurance I did buy was less expensive than buying the cheapest ACA plan for four months, but NOT once I factor in having to pay the penalty.

In 2016 I was right in the heart of the people who DON’T benefit from the ACA.

Young healthy single people who don’t need most of the extras health insurance HAS TO HAVE to be considered MEC and thus avoid the “tax penalty”.

At my stage in life I don’t need or want maternity and newborn care or pediatric services. I don’t need or want coverage for rehabilitative services and devices or nursing home care. All things that increase the cost of an insurance plan that MUST be included in an ACA approved plan.

I also was making enough money that I didn’t qualify for any tax subsidy.

Other people my age might opt to go without any health insurance and just pay the fine/tax. That would have been the least expensive option for me in 2016 but not one I was willing to take.

I didn’t want to go without insurance.

I know some people benefit from the Affordable Care Act. However, I was not one of them. The ACA made healthcare more expensive for me and limited my choices.

Three Lessons from Warren Buffett

Three Lessons from Warren Buffett

Warren Buffett is considered to be one of the most successful investors. He’s one of the wealthiest people in the world and he’s also fond of publicity and public appearances.

If you have some humility and don’t get caught up in jealousy you can learn a lot from wealthy and successful people like Warren Buffett.

My own Father is fond of saying that poor people should take rich people out to lunch. The idea being that the wisdom that can be gained from the wealthy is worth more than paying for lunch.

So what lessons can we learn from Warren Buffett?

Do As Warren Buffett Does, Not As He Says

whathedoesThere is an old expression “Do as I say, not as I do.” With Warren Buffett it is “Do as I do, not as I say.”

Warren Buffett talks A LOT and shares a lot of opinions. But you shouldn’t follow what he says as advice because he might actually be doing the opposite of what he is saying.

In order to learn lessons from Buffett one must first filter out a lot of what he says.

There is a quote from Daniel Loeb that summarizes Buffett’s contradictions quite succinctly.

“He criticises hedge funds yet he really had the first hedge fund,” Loeb said. “He criticises activists. He was the first activist. He criticises financial service companies, yet he likes to invest in them. He thinks that we should all pay more taxes but he loves avoiding them himself.”

Source: http://www.smh.com.au/business/warren-buffett-is-full-of-contradictions-hedge-funds-say-20150507-ggwv2o.html

Without further ado here are three lessons we can learn from Warren Buffett.

Lesson 1: Reduce Your Taxes

While publicly discussing how he wants to pay more taxes Warren Buffett has taken extraordinary steps to reduce his taxes.

Source: http://www.nytimes.com/2011/08/15/opinion/stop-coddling-the-super-rich.html

From how he structures his businesses to how he is paid to how he has bequeathed his inheritance Warren Buffett does all he can to reduce his taxes. He gets paid through dividends and long term capital gains rather than ordinary income. He’s also left 99% of his fortune to a private charity to avoid paying inheritance taxes.

Lesson number one from Warren Buffett is Reduce Your Taxes.

There are a variety of ways you can legally reduce your taxes: IRAs, 401ks, FSA, HSAs, charitable contributions, capital gains. I discuss some of them in Five Tax Strategies to Keep More Income.

Real estate is also an excellent way to increase your wealth in a tax advantaged way. BiggerPockets.com is an excellent Real Estate resource.

Lesson 2: Invest in High Quality Companies that are Undervalued

The Intelligent Investor by Benjamin Graham

The Intelligent Investor by Benjamin Graham

Warren Buffett loves great value. Much of his investing philosophy can be traced back to Benjamin Graham, the father of value investing.

According to Investopedia Buffett looks at six criteria for stock investments:

1. Has the company consistently performed well?
2. Has the company avoided excess debt?
3. Are profit margins high? Are they increasing?
4. How long has the company been public?
5. Do the company’s products rely on a commodity?
6. Is the stock selling at a 25% discount to its real value?

Source: http://www.investopedia.com/articles/01/071801.asp

Warren Bueffett is a value investor and I think value investing is an excellent way for the enterprising investor to achieve outsized returns. I’ll be writing more about value investing in future posts.

If you’re interested in reading one of Graham’s seminal works “The Intelligent Investor” use this link to buy it on Amazon and help support this site: The Intelligent Investor by Benjamin Graham. Buffet calls it “the best investing book ever written.”

Lesson 3: Use Derivatives Wisely

buffetoptions
Warren Buffett has written “derivatives are financial weapons of mass destruction.”

Source: http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf

But Buffett has billions in derivatives as pointed out by Kirk DuPlesis of OptionAlpha.com.

Source: https://optionalpha.com/warren-buffett-options-trading-strategy-19655.html

In the article above Kirk talks about two ways Buffett uses derivatives:

1) Uses naked, short puts to lower the cost basis for purchasing stock or target companies that he wants to acquire.

2) Sells short index put options when volatility is at it’s highest, knowing that volatility is the one factor that is overpriced all the time.

I’ve written about trading options and think that done correctly it can be an excellent way to bring in monthly income. I’m interested in utilizing strategy one above more often as I open new stock positions.

Lessons from Warren Buffett

Those are three lessons I’ve learned from looking at what Buffett does, not what he says. Buffett probably gives some advice that is worth following directly but you have listen through a filter and weigh heavily what he actually does over his words.

Personal Finance: Where do I Start? (Part III of III)

Personal Finance: Where do I Start? (Part III of III)

The Building Blocks of Personal Finance

The Building Blocks of Personal Finance

This article is Part III of my three part series of getting started in personal finance. Part I is Stabilization. Part II is Fundamentals. In Part III I discuss investing and advanced investing.

If you haven’t already read parts I and II start there!

I visualize personal finance as building blocks stacked on top of each other (shown to the right).

You must master the lower levels before you can get to the upper levels.

Level 3: Basic Investing

I consider basic investing saving for retirement in a 401k and Individual Retirement Account (IRA) via mutual funds and bonds, and general savings in mutual funds.

Both the 401k and IRA are ways to invest for retirement and get some tax benefits. 401ks are through an employer, and IRAs can be setup through a company like Vanguard, Fidelity, TD Ameritrade, or any number of other firms that act as the “custodian”. I talk about them in a little more detail in my article Five Tax Strategies to Keep More Income under strategies one and two.

Employer Matching 401k

StocksSome employers will match your 401k contributions. As an example lets say your employer matches your contributions up to 5% of your salary. If you make $50,000, and you save $2,500 in your 401k, your employer will add an additional $2,500 to your 401k. I put money in my 401k up to but not beyond the point where I’ve maxed out the match.

I prefer Roth 401ks to 401ks because I believe tax rates are going up in the future. Roth 401ks are more rare but I have had employers who offer them.

The vast majority of the investment options offered by the employers I’ve been at are VERY limited. The easiest option is to go with a target retirement fund. Target retirement funds are basically funds on autopilot, they automatically adjust their asset mixes to become more conservative as investors approach the target retirement date.

If there are more options I avoid bonds and favor international funds but investments depend on your risk tolerance and goals.

Individual Retirement Accounts

IRA’s come in the Roth and Traditional flavor. It all depends if you’d rather pay taxes now, or in retirement. I prefer to pay the taxes up front.

I would open up a Roth IRA and try to max it out ($5,500 in 2016). Another neat trick is that you can contribute to a traditional IRA and then convert contributes to a Roth (you do of course have to pay the taxes though), so if you want to save more than $5,500 in after tax income, that is an option.

One of the things I like about IRAs is that the investment options are much, much more flexible. I think part of the reason employer sponsored 401ks have such limited investment options is because employers are afraid of being sued if an employee makes poor decisions and loses a lot of money, so employers only offer with the most conservative investment options.

If you want to save money and not think about, you’re asking for trouble, but one option is to open up an account at a low cost company like Vanguard (my favorite) or Fidelity. Setup auto-deposit and buy a balanced fund like the Vanguard STAR fund (VGSTX).

You can also buy additional index funds, like the S&P 500 index fund, Nasdaq, large and small cap US funds, etc. These index mutual funds are setup to track the gains and losses of the index they are based on. Again, I think it is good to have money in the emerging markets as well.

Vanguard has investment professionals that will help you decide how to allocate money to different mutuals funds. (Disclosure: I have been a vanguard client for years, but gain no benefit from listing them as an option).

By setting up auto-deposit and auto-invest into Vanguard (or your IRA custodian of choice) from your paycheck you’re dollar cost averaging into the fund and not trying to time the market.

Over time this is a good, conservative strategy, and one discussed by Benjamin Graham in his seminal work “The Intelligent Investor”. Ben Graham was a mentor to Warren Buffet, who you may have heard of, and has done decently well as an investor.

Conventional wisdom is often something like a 40% bonds and 60% stocks (mutual funds) as a conservative approach. Unless you’re retired and relying on your savings for monthly income, I would not buy bonds, but a portfolio that does not include bonds is considered more risky.

You can follow these same investing principles to buy non-retirement mutual funds.

Now I do think that US stocks and bonds are in a bubble. But if the Federal Reserve responds to the bubble bursting as I think they will, stocks and bonds will still go up. I just think there are other asset classes that will go up faster.

Gold MapleConsider Physical Gold

While this could be considered more advanced, I think it is very important to have somewhere around 10% of one’s assets in physical gold and silver bullion. While I don’t give investment recommendations I think that even some of the more conservative and traditional investment advisors would admit this is not a bad idea. I gain no benefit from mentioning them, but I buy bullion from Scotsman Auction house in Saint Louis. They have been in business a long time and have great pricing. I don’t buy numismatics or “rare” coins as an investment. I’m partial to Silver American Eagles and Gold Canadian Maples, but that is just personal preference.

There are lots of gold bullion companies but I would not want to pay more than around 2% over spot price for gold. I avoid numismatics unless they can be acquired at bullion prices.

Level 4: Advanced Investing

NYSEAdvanced Investing techniques are what I’m most passionate about. Examples of what I consider advanced investments are: Investing in individual company stocks, gold mining stocks, peer to peer lending, real estate investments, private equity, foreign stocks, offshore brokerage accounts, options, cryptocurrencies, physical precious metals like gold and silver, and physical gold stored remotely through a Goldmoney personal account.

These techniques are generally considered more risky, although I think that buying US stocks at all time highs and negative yielding bonds is much more risky, even though conventional foolishness wisdom says these are the safe bets.

Get Started!

To get started figure out where you stand in the four phases. Master that phase and work towards the next.

It’s an iterative process once you’re out of stabilization and focusing on the fundamentals and investing. I’m often re-evaluating my fundamentals such as my budget and my goals. I work on my basic investing like maxing out my 401k company match and Roth IRA.

Which phase are you in and what are your savings and investment goals?