Last Modified: March 30, 2000
If nothing else, read the sections entitled "Bottom Line" and "Conclusions".. I welcome any comments (see bottom of most pages for my email address).
Investing is important because it will make a HUGE financial difference in your future. But this financial advantage is NOT limited to when you're retired. It becomes an advantage fairly quickly, with even better advantages by the time you reach retirement. Let's just say I'm concerned about the financial future of all of you. Enough mumbo jumbo.
What I want you to do is save at least 10% of your income into a tax deferred 401K (if available) or a tax deferred IRA (Individual Retirement Account). If you can afford it, save the maximum allowed. Why? Of course, you're already aware of the benefits at retirement (you'll have a decent nest-egg to live comfortably on when you're older). But you may not be aware of two things: 1. How much this will help, 2. How it can provide quick advantages. Read as much as interests you, ask questions if you like, but DO SAVE!
For further reading I highly recommend Wall Street's Guide to Planning your Financial Future. See Bibliography at end for more.
You already know that you can earn interest and that it adds up to quite a lot of money. But here's how much: Each $10/month for 30 years at 10% yields $22,604.88. Even if you pay in for 10 years, then stop and just let it sit for 20 years, you'd have $15,011.19. The returns become dramatically higher if you're fortunate enough to receive more than 10% returns.
Here's another big part of this puzzle. You're saving pretax dollars. You might think it's not much of an advantage, because when you take the money out (even if after retirement) you still have to pay the taxes. But the big thing to remember is you do not pay taxes on the gains. This money stays in your account and it grows too. For your non-tax-deferred funds, you have to pay taxes on these gains every year. For your tax-deferred funds, this money stays in your account and grows.
Situation 1 (tax deferred investing): Make a one time investment of $1000 in a tax deferred 401K for 14.4 years (footnote 1) at a 10% growth rate. The bottom line is it would turn into about $2800.
(Details: Your amount will then be about $4000. If you were to withdraw this after retirement, you'd pay tax on all $4000, giving you about $2800.)
Situation 2 (after tax investing): Make a one time investment of $700 (approximately your $1000 after tax) in a regular mutual fund (or a non-tax deferred 401K) for 14.4 years at a 10% growth rate. The bottom line is it would turn into about $2170.
(Details: Your amount will then be about $2800. When you withdraw, you do not have to pay tax on the original $700 because you already did before investing. But you'd pay tax on the amount of growth. So $2100 would be taxed. The original $700 is yours, and the $2100 minus tax, or $1470, is yours. So you have: $700 + $1470 = $2170.)
You can see that Situation 1 (investing pretax money) gives you more money. And if you leave it in longer, the pretax savings has even more advantage. I'll refer to this example again. (footnote 4)
What if you need to pull money out in about 15 years? The government will penalize you by 10% if you pull money out of a retirement account before you're 59 1/2. Many people use this as a reason to not invest in a tax deferred savings. First, there are some reasons that the government will allow you to pull money out without penalty. I'm not sure what all of them are, but some are a house, children's tuition, etc. But what if your reason is something that the government does not consider valid, yet you really need the money? Let's use the two situations in the above paragraph to examine this a little more closely. I'll argue that if you will need the money after about 14 years, you're still better off saving in a tax deferred 401K.
Remember that the two situations above are assuming you leave it in for roughly 14.4 years. I'll calculate the two situations again, but for situation 1 (tax deferred) instead of only taking 30% out for taxes, I'll assume 40%. 10% of this is the penalty for early withdrawal; the other 30% is normal taxes. Situation 1 would leave you with $2400 after tax and penalty (footnote 2). Situation 2 (not tax deferred so no early withdrawal penalty) would only leave you with $2170 (footnote 3). It's still better to invest in a tax deferred situation, even knowing you'll be penalized for early withdrawal.
What benefits could you get sooner than that? That depends on the 401K you've invested in, but some let you take the money out with no penalty for certain reasons. I've heard of reasons like 1) buying a house, 2) children's tuition, 3) medical emergencies. If you need the money for one of these "blessed" reasons, then you have come out ahead even the first year.
For ROTH IRA's, you can always withdraw the original amount invested with no penalty. (Any gains must be left in though.)
Some plans allow you to borrow up to 50% of your 401K investment. While you'll have to pay interest, this can sometimes be paid back into your 401K savings, so it's again part of your retirement savings! Let's say the first year you invest $4000. If your 401K allows borrowing up to 50%, then even the first year you could have access to $2000 of that via borrowing.
The closer you are to retirement, the more secure your investments should be. It's true that a high risk 401K (or mutual fund) will increase in value faster than most other investments over the course of many years. But the problem is they fluctuate a lot. They might have a five (or more) year slump. You shouldn't risk this happening just before you withdraw your money.
Also, if you're close to retirement, don't think this doesn't apply to you. See the two situations above again. Once you retire you won't have to pay the penalty on the withdrawals so even if you're retiring in one year, save in a tax deferred investment and you'll have more money at the end of the year.
If you're not close to retirement (15 to 30 years from retirement), these higher risk mutual funds will very likely outpace any other kind of investment before you need to withdraw. So, right now I will put most of my funds in a high growth, "high risk" mutual fund. (Remember, this "risk" is more of a short term description. In the long term, a mutual fund is relatively safe). By the time I'm around 5 years from retiring, I should be putting most of it in less risky investments. (Possibilities include: low risk mutual funds and many types of bonds. There are others but I've not studied them carefully.)
Debts are a bit more sticky and it takes calculating. But paying a debt is more beneficial than it at first appears because you are saving money... and saving money is not taxed like earning money is. If you earn $100, you keep $70 of it after taxes, but if you save $100, you keep ALL $100. Financially, I'd say pay your highest interest debts before your lower ones, regardless of the time left on the loan. But psychologically, it's often better to pay the debt with the smallest amount first and when it's gone, pay that same amount on your next smallest. For most people, I do like this latter approach.
As for paying debts v. investing, it's a tricky question, partially because while some investments are fairly sure, NOTHING is as sure as saving money (paying debts). Once you've saved, that WILL be your money. That's an advantage of paying debts. When comparing interest rates of paying a debt versus investing, be sure you include the fact that paying a 10% debt is like finding a very secure 13% investment because there's no tax on dollars saved. If it gets too complex, I advise talking to a financial counselor.
ROTH IRA's are great deals. Try to max them out every year. You can invest $2000 each year unless you earn over 98k if your single, or over 150k if you're married. You can do this even if you have a 401k already.
I have been in the Janus family of mutual funds for a while now and have been extremely happy with them. You can access the funds via the web, and you can tie it to your checking account. Try hard to save money, and when your account has over a given amount (maybe 3k or 5k) go to their web site (www.janus.com) and transfer the extra to a mutual fund. I treat this like my savings account. There are many very good funds, and many good web sites to learn about them.
I put money into these types of funds, and in this order (maximizing each as I can):
Some good links:
If you are too confused to know what to do, get a financial counselor and just pay the money. Believe me, it will be worth it.
GO INVEST ALL YOU CAN in a tax deferred mutual fund! Most any excuse is NOT GOOD ENOUGH! Remember, each $10 chunk per month invested (for 30 years) yields over $22,000. How many chunks can you save per month?
Very Sincerely, Mark.
1. Why 14.4 years? Because at a 10% growth rate, your money will be multiplied by four (or doubled twice). This can be figured out easily by the "72 rule". If you want to see how long it will take to double your money, divide 72 by the interest rate. In our case, 72 / 10 gives us 7.2. That's the number of years it will take to double your investment. Since I want our money to multiply by four, I have to leave it in for twice that long.. or 14.4 years.
2. The entire portion is taxable and penalized (for withdrawing earlier than 59 1/2 years old) so: $4000 - $1600 (10% penalty + 30% taxes) = $2400
3. The tax (on the part that is taxable: $2100) would be $630 (30% of $2100). (Remember, there is no penalty on this one.) This $630 subtracted from the $2100 would leave you with $1470. Now add back in the already taxed original $700 to give $2170.
4. The break even point for pulling your money out with a penalty, is when your money is multiplied by 1.91. So when it's doubled, you've come out a tiny bit ahead.
Wall Street's Guide to Planning your Financial Future. I can't remember the author(s). But this was very easy to read and is very informative. It's the best "first book" I know of, and you'll do well even if it's the ONLY book. It will give you MANY financial tips including information on wills, estates, trust funds, social security, Keogh plans, etc.
Michael Sivy's Rules for Investing. by Michael Sivy. This is for people who are interested in playing the stock market for themselves in addition to other investments. I'd say be more concerned with mutual funds unless you just want to "play the game" by investing in straight stocks. But this should be done only with money that's OK to loose.
Wall Street Words. by David L. Scott. This is like a dictionary for financial terms.
High Finance on a Low Budget. by Mark Skousen and Jo Ann Skousen.