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Way back at the end of January (two whole weeks ago), we did a poll on Instagram and found that a lot of you wanted to talk about investing. This is a subject that we have had to take a deep dive into over the past several months, since for the past several years we hadn’t been doing more than the bare minimum. Growing up, neither of us knew ANYTHING about investing. Compound interest is something we were taught and understood the math behind, but we didn’t know how to make that translate to our money working for us, outside the small contributions to our 401K. We figured that if we had that (small amount) of money stashed away, we would work until we were 100 and then have money to hopefully live on until we were dead.
Even after following Dave Ramsey and his Baby Steps to get out of debt, we still weren’t clear on what to do. He doesn’t recommend investing for retirement until Baby Step Four, which is after an emergency fund, paying off all debt except a house, and saving 3-6 months of expenses. Which I agree that those are all good ideas, but don’t agree that investing needs to wait. Also, he recommends investing 15% of your income, which can seem like a lot, until you look at the total numbers and realized that even if you invest that much, especially if you wait that long, it doesn’t provide much wiggle room to retire early. (We still like his debt snowball for paying off debt and a lot of his basics about getting on a budget, but our agreement with his plan ends there. If you need his book to get started, here’s the link.)
So, our goal today is to start the conversation about investing. It won’t be completely comprehensive, just an overview with which to start. We will dive into more details in future posts but thought we could start with some basics.
The first thing you need to decide when you are ready to invest, is not what types of stocks to buy, but what type of account in which to put those funds. Anyone can get onto the Fidelity or Vanguard websites and create an account to buy stocks, but that is not the most effective way to invest for your eventual retirement. One of the most important things I learned is that there are accounts you can use to not just grow your money but also lower your taxable income, which will save you money on your taxes.
Should you use a 401(k), IRA, HSA, 403(b) or a 529? Is your head spinning already? Mine was, and I guess that’s why we paid someone to figure it out for us at first. But as I’ll cover in a future post, paying someone else to invest your money for you is a big mistake. Since we are just getting started with discussing investing here, I decided that rather than go really in depth into each of these retirement accounts right now, I would just give a brief overview of the most common accounts with some recommendations.
The savings account that most people are probably familiar with is the 401(k). A 401(k) allows you to divert part of your salary pre-tax into long term investments. Meaning, the money is taken out of your paycheck even before it is taxed, and sent to an investment account. Employers can also match an employee’s contributions up to a certain amount. If you work for an employer that offers a 401(k) with a match of any kind that should be the first place you put your money. You should never turn down free money. As I mentioned, a 401(k) is funded pretax, which can also save you money by lowering your taxable income. For example, if you make $90k and are married and filing jointly, every dollar you make above $80,251 is taxed at 22%. You can put up to $19,500 into a 401(k) in 2020 ( if you are 50 or older you can add an additional $6,500 per year), so by maxing it out you would reduce your taxable income to $70,500 which would put you in the 12% tax bracket. So now you are saving for your future and saving money on your income taxes.
There are a couple things that you need to consider when signing up for a 401(k). Some employers will offer a variation called a Roth 401(k). The main difference is that with a traditional 401(k) you save on taxes now, but you pay taxes when you withdraw the funds in retirement. With a Roth 401(k) it is the opposite, you pay taxes up front and can withdraw funds tax free later. There is a lot of debate as to which is more advantageous but I prefer to use a traditional 401(k) with the plan of doing a Roth IRA conversion later in life, but that’s a very big and confusing topic for another day.
There are a lot of rules around withdrawing your money without penalties prior to retirement age of 59.5. You can read up on those rules, but I wouldn advise to NOT take loans against your 401(k) or any other withdrawal prior to retirement. Just set it and forget it.
HSA ( Health Savings Account)
The HSA is the ultimate retirement account. The only problem is that it’s not available to everyone. An HSA is a pre-tax savings account only available to people who are enrolled in a high deductible health insurance plan. Do not confuse an HSA with an HRA (Health Reimbursement Account) or FSA (Flexible Spending Account) those accounts have many more limitations and not as many benefits. As the Mad Fientist explains, to put it not-so-simply, with an HSA you can put money in pre-tax, let it grow tax free, and take it out without being taxed. What’s the catch? If you use it before retirement age it needs to be on health related expenses. The amazing thing is that it doesn’t have to be in the same calendar year.
In the year 2020 an individual can contribute $3,550 and a family $7,100 respectively. If you can pay your medical expenses without using that money you can invest it while it sits in your HSA for as long as you want and when you are ready to take you money back you just need to have your receipts from your medical expenses ready. It can be the next year or 20 years down the road, it doesn’t matter. For example, we will be paying for our fertility treatments out of our pocket, and continuing to let our HSA account grow. If while Melissa is on maternity leave, for some reason we feel the need have a little extra cash in our bank account, we can submit the receipts and be reimbursed for those expenses. Cool, huh? Now, what if you don’t have that many medical expenses, or don’t reimburse yourself for things you’ve paid for? If you don’t need to spend that money on medical costs then at age 65 it essentially becomes another traditional IRA, you can start drawing down from it and will just be responsible for the taxes, but have no additional penalties. So after you get your match on your 401(k) the next thing to do is max your HSA.
IRA (individual retirement account)
Here is where things start to get muddy. The two most common type of IRAs are the traditional and Roth IRA. The two accounts have some similarities like a $6000 contribution limit and tax free growth of investments, but they differ in several key ways. Which type you choose is based on your income and whether or not your employer offers retirement plans. If your employer does not offer retirement savings accounts like a 401(k), Simple IRA, or SEP IRA then you want to choose a traditional IRA. If you have access to an employer sponsored retirement account then you want to use the Roth IRA because a traditional will no longer be fully tax deductible. Traditional IRA contributions are tax deductible on both your state and federal taxes, so your tax liability will be when you make your withdrawal. In contrast with the Roth IRA you don’t get tax deductions up front but your withdrawals in retirement will be tax free. The two accounts differ in pre-retirement withdrawals, and distribution rules but we will go into that in a future post. Finally, you need to be aware of the income limits regarding Roth accounts.Just make sure you qualify for the Roth based on your income before contributing.
Even though that is just the tip of the iceberg, it is still a lot of information at once. So for those of you who are new to this, just remember to try to utilize investment accounts in this order:
- Employer matched retirement account (401k) up to match
- Max HSA if available
- Max 401(k)
- Max the IRA that is available to you
- If you have done all of those steps and are ready for a step 5, congrats and stay tuned…