This is step 3 in the series: “? Steps to Financial Freedom”. If you are starting here, I invite you to start from the Step 0.
Finally, we talk about investing your money.
So, you followed all the previous steps and now you have a checking account that is full of money. Your credit cards are paid off each month. If you have any debt you have a car payment (pay that off as soon as possible) an/or a Mortgage (15-year fixed rate that you can afford…if possible).
No? Then please go, back and start from Step 0. 🙂
The money you invest in the stock market should be money you don’t need now or for the next 3-5 years. I mean, don’t invest money in the stock market that you need to pay bills.
Ok, enough warnings, there are several types of accounts to invest in. You can get accounts from banks and insurance companies, but I suggest an internet discount broker. I use TDAmeritrade and find them acceptable to good. The advantage with these discount brokerage accounts over the other kinds of “managed” accounts is that you direct where your money is invested. It makes sense then that these accounts are called “self-directed”. It is a fairly straightforward process to setup an account. Just go to the web page, and fill out the online forms, link your checking or savings account to the brokerage account and then “fund” the account with the amount of money you want to invest. The money will show up first as “cash” and the get “swept” into a money market account so you earn a little money with the money that is sitting in your account that is not invested in anything. Also, as you invest in mutual funds, ETFs, and stocks, the investments pay out dividends that are “swept” into your money market account as they wait for you to invest them in more equities.
Types of accounts: Taxable and Tax Advantaged
Before we talk about “what” to invest in, lets talk about what type of accounts should get your money first, second, third, and fourth. Don’t worry you don’t have to do these all at once.
- Roth IRA
- Employer 401k (with match employer funds)
- Traditional IRA
- Employer 401k (without matching funds)
- Self-directed brokerage account
Goal #1 is to maximize your annual contributions to your Roth IRA each year. There are rules about income levels that you need to check before you invest in a Roth IRA. If you are eligible, then this provides the best tax advantage of all these types of accounts. In 2008, a single person can contribute up to $5000. If you are married, both you and your spouse are allowed to contribute up to $5000 to separate Roth IRA accounts. If you can afford to contribute $10,000 per year as a couple (or $5k as a single person) then you should do that. If you need to make automatic deductions from your pay check each month thats cool…when you can save up enough money to make the contributions as a lump sum on the 2 Jan of each year, you are maximizing your investment potential.
Employer 401k (with matching employer funds)
If you still have money after you have maxed out your Roth IRA(s), then the next best type of account is to invest in your employer 401k up to the percentage amount of your salary that your employer will match. I will explain…wait, no time to xplain, I will sum up.
Example: My current employer will match my contributions to my 401k account up to 6% of my annual salary (contributed monthly). So, I setup my 401k to 6% contribution each month to be taken out of my pay check before tax. Your employer (bless them) will then contribute another 6% of your salary (i.e. give you FREE MONEY!!!). Some people will tell you to do this before you do your Roth IRA, and they would not be wrong. If you can only afford one or the other, then you should take the free money first and then start working on your Roth IRA(s).
The traditional IRA is slightly less cool than the Roth IRA. The differences are subtle and interesting…these are subject to change as well but here they are in a nutshell:
- Contributions are tax-deductible–if you need more tax deductions, then this is a reason to contribute some money. The total amount that you contribute counts as a tax deduction for the year you contribute.
- You can “roll over” 401ks into these accounts. When I retired from the Air Force, I had some money in the federal government’s “Thrift Savings Plan” which is like a 401k. I “rolled over” my TSP account into my existing traditional IRA. This way, I can use the money to buy the stocks that other investments I want and I not restricted to what the TSP others in the way of available investments.
Employer 401k (without matching funds)
If you still have money left over (way to go you!), then the last option would be to max out your annual contribution to your employer 401k plan. I don’t do this, because I like to have more control over what I invest in, but if you are just starting out and are ok with the investment options that your 401k offers, this is a sound investment strategy. Tax-advantages are always good.
Taxable: Self-directed brokerage account
Last, but not least, if you still have money left over (WOW!!! you really rock now!), then you should open up a taxable brokerage account. These work the same as a Roth IRA/or Traditional IRA accounts, just you have to pay taxes on all the money that you earn within the account…which is ok. You will pay taxes on dividends and capital gains. Yeah, I will tell you what those are:
- Dividends: Are like “interest” with another name. Periodically, your stock, ETF, or Mutual Fund will pay out a dividend. This is a little chunk of change that will pop into your account like pennies from heaven. It is the company’s way to say “thanks!” for giving them your money.
- Capital Gains: When you sell your investment and you make money, you have to pay taxes on the money that you make. This is important here so take note: You want to do your best to hold an investment for 1 year plus 1 day. This will make the investment a “long-term” investment and you will be taxed at a significantly lower rate than the “short-term” rate.
- Capital Loses: If you sell an equity for a loss (you will…its no big deal) then you don’t pay taxes on the loss. Even better, your losses “offset” your gains within each tax year. Like this see:
- Sold 100 shares of “T” for a Long term gain of $1000
- Sold 5 shares of “UA” for a short term loss of -$1000
- In this situation you pay no capital gains taxes, because the loss completely offset the gain…no tax
The one investment to start with is called “SPY”. It is an Exchange Traded Fund (ETF) that attempts to match the performance of the S&P 500. There are mutual funds like “VFINX” from Vanguard that do the same thing. This is an easy place to start and great place for this post to end.
If you still have money left over…take a trip to Hawaii or buy a Prius or something, you earned it!!! 🙂
Legal disclaimer: This is not financial advice. YooperSmith thinks everyone is responsible for themselves as should take all information from all sources as suspect. Readers are encouraged to seek more information from places like www.fool.com and countless more reputable sites. YooperSmith reserves the right to be wrong and inaccurate as to specifics of all information as things like tax-code and investments options are subject to change. It is hoped readers will be inspired to read further and seek out professional advice and or education before investing any money or opening an accounts. Nuff said? 🙂