-if anyone ends up reading this, please consider that this is pretty much unedited stream of thought at this point-
Let’s get one thing straight here from the start. You’re young now and you’re going to really old one day.
You’re going to be tired, sick, and things are going to cost money. You’re going to need money. And whether you get it from your kids, grandkids, the government, or robbing a bank, you’re going to need it.
So, given the simple fact that you know you’re going to need money when you’re older, it’s best to start planning for it now when you’re young. Luckily, saving money isn’t complicated and, if you start when you are young, the money you save will grow on its own.
For example, just saving $5,000 in a index fund over 30 years will give you $34,958.99. And if you add just $100 to it every month for those 30 years you would end up with $145,576.80. And that’s small time! I’m serious. You can do way better. And you can learn how in this article.
WHY we have to save:
Traditionally, savings have been illustrated as a three-legged stool. The legs of this stool are represented by the ways in which you will sustain yourself after you aren’t working.
The first leg is your personal savings. This is the money you’ve saved by yourself in your bank, your IRA, your 401k, and other assets you might acquire during your lifetime i.e. real estate.
The second is social security which all individuals are entitled to after a certain age. The third is pension which is provided by years of hard work at a company that you were loyal to and they sent you off with a big present for retirement.
Remember, I said traditionally. These traditions have changed.
Looking at our stool now, we notice a few differences. The elusive pensions, for one, have all but disappeared and seem to exist only in government jobs. They are like the Florida panther of savings – you might hear about a person who saw one in the wild but you’ve never actually seen one yourself.
Social security is, at best, a questionable form of retirement income for many reasons: discrepancy of those putting in vs. taking out, baby boomers who will deplete the fund, etc. It isn’t something we should depend on for 1/3 of our retirement income.
That leaves one leg left – personal savings.
I want to highlight this fact to emphasize the importance of personal savings. It’s the only thing we can really count on to cover the costs of our old age. We don’t have the luxury of depending on anyone or anything but ourselves to secure our own financial future.
The Math Behind it: Linear vs. Exponential
We’re going to go back to school for this section because we’re going to do some basic graphing. Hah. Remember when they told you that you would need to understand X and Y coordinates and slope when you get older? They were RIGHT! Okay, here we go.
So, I’m going to compare saving money over time in the bank vs. saving money in an index fund. I’m going to give us a hypothetical job and income and, for simplicity’s sake, I’m not going to change the income over 30 years (but in real life, your income will increase over 30 years).
Okay we are a Publix supervisor and we make $45,000 a year. That gets us $3,750 a month and $1,875 every two weeks.
We heard that saving money is important and we want to put aside 10% of our paycheck for savings. 10% of $1,875 is $187.5. So we will save $187.5 each paycheck. Over the course of 30 years we will have saved $67,501. Pretty good, right? Check out the chart here:
Now, we’re going to compare this to saving in an index fund. What is an index fund? It is something you can put your money into that grows on average 5% interest. When you start messing with percents, numbers get bigger when numbers get bigger.
For example, you know how we’re supposed to tip 20% at restaurants? When you have a $100 check, 20% of that is $20, so the final bill is $120. And when you have a $200 check, 20% of that is $40 so the final bill is $240. See what I’m saying? The percents add up to more when your numbers get bigger.
So, now we put our $187.5 in an index fund and it gets 5%. Every paycheck we put $187.5 in the index fund for 30 years and each time we do, 5% interest gets added. Over time, that interest compounds on itself like a coal into a diamond. And it gets bigger over time.
When it starts, you have 5% of 187.5 that is added after the first month, which is only $9.37. But by the end of the year we have $2,303.34. 5% of that is $115.16. Getting bigger; I told you!
So, how much do you save putting $187.5 from every paycheck into an index fund that gains 5% interest over the course of 30 years? $156,052.96.
$156,052.96 vs $67,501.
Basic Portfolio: Risk
Now that we’re talking about index funds, it’s important to keep in understand where this 5% number comes from. Let’s talk about that. An index fund is about the stock market.
Over time, the stock market goes up. Look at this chart of the history of the DOW. You can see the growth since the 1979. It goes up. You see rises and falls within, but, over time, it goes up.
Back to index funds. When you put your money in an index fund, you are buying stock in many different companies. For example, the DOW. There are 30 companies in the DOW which include Apple, Johnson and Johnson, Disney, IBM, Home Depot, etc.
These are large, publicly traded companies. The NASDAQ is another example. SP500 yet another.
So, when you buy into an index fund, you’re buying a little stock in a lot of large companies. The value of index funds rise and fall with the economy. When the economy is doing well, the price is up.
And when the economy is doing poorly, the price is low. Remember when the great recession hit and people were talking about the DOW falling so much?
The large companies in the DOW lost a lot of money and it affected the DOW index fund price. A lot of people like you and me lost their savings when that happened.
Naturally, this brings us to a conversation about how to avoid that happening to us. When you start saving, you’re making a portfolio.
Your portfolio is your collection of things that you own (also called assets): your index funds, your house, money in the bank, etc. Have you ever noticed that the value of some of the things that you own changes over time?
For example, a house will typically increase value in time. A house that cost $200k ten years ago might cost $250k today. Except sometimes when there’s a housing bubble or a housing crisis. But, generally speaking, houses are a safe bet. I’d rate them just a little risky.
Buying collectibles like baseball cards or Funko Pop toys are another thing that changes value in time. Once in a while, one can be sold for a lot of money. But, generally, their value doesn’t increase in time. I’d rate this as very risky.
Index funds rise and fall but generally increase in value over time. I’d rate these as moderately risky.
There is another type of investment that we haven’t talked about yet which are called bonds. Bonds are like the index funds in that you buy them and you own them. But they are different in the amount that they rise and fall in value.
Over time, they generally just increase a small amount. I would rate these as very low risk. Even less so than the house.
Okay, now that we’ve talk a bit about risk, we know what to do with our portfolio over time. For sure, we don’t want a lot of risk when we’re about ready to retire. We don’t want to be that person who lost all their savings in the recession.
But where does that leave us now? What should our portfolio look like now? Here comes the golden rule about investment portfolios: Don’t put all your eggs in one basket. While I’m telling you to invest in index funds, don’t invest it all in index funds. Put some into bonds.
Here’s what this looks like:
So, when you’re young, you can handle a certain amount of risk. You have a lifetime to account for it. If you have a bunch of money in index funds and the market crashes in your 30’s, it’s no sweat.
The market will likely recover and, 5-10 years later, you’ll probably get it all back. So, it’s okay for your portfolio to have mostly index funds when you’re young because you’ve got time.
I can hear a question coming on, “Why not just go with bonds from the start and take on very little risk the whole time?”. Keep in mind that bonds don’t grow very much and that index funds do.
If you go with bonds the whole time, you money will be safe, yes, but you won’t be getting 5% interest on it. Bonds have an interest rate of 2-3%. As as I said before, it adds up over time.
I’m going to wrap all this up with a very simple rule regarding your portfolio over time. In the beginning, your portfolio will be mostly risky investments (80/20) and in the end, your portfolio will be mostly non-risky investments (20/80).
At some point, like when you’re in your 40s or 50s you may go 50/50 or 60/40, whatever you’re comfortable with.
Where we save: IRA and 401k
Now that we’ve covered the basic concepts of what we’re doing, we can now get into the good stuff. This section is all about how to get around taxes in order to maximize your savings.
Did you know that if you went out today and bought a bunch of stock in an index fund that you would have to pay tax on it at the end of the year? Remember that 5% interest that you gained? TAXED. You just got taxed.
This isn’t right because this is our savings! Why should I be taxed on savings? Well, the good news is that programs exist already that can help you avoid tax on any money that you save for retirement.
The first one we’ll talk about is called an individual retirement account or IRA.
IRA is the place where you have all your index funds and bonds. Think of it like a wallet. It is a wallet with all those index funds and bonds that you bought.
You make an IRA with investment companies like Fidelity or Vanguard. You can do this on their website or over the phone. They link to your bank account and you just put the money in.
You add money to it over many years and then you take it out when you’re old. It’s that simple. I’ll go over how to actually buy the index funds and bonds later in the article.
The other important thing to know about IRA is that, when you reach age 70.5 (yes it is exactly 70 and one half), you MUST take money out of your IRA. This is a government thing. More on this later.
As of right now (March, 2018), you can save up to $6,000 tax free per year. You should definitely try to do this every year. There are a lot of benefits to saving in your IRA but my favorite is that you save on your taxes each year.
I’ll explain using our hypothetical Publix supervisor job.
Remember that we make $45,000 a year. And remember that we are trying to maximize our savings for IRA this year which is $6,000. If we maximize our IRA savings, we can take that off our taxable income when we pay our taxes.
For example, if we didn’t use IRA, we would be taxed on an income of $45,000. But when we use IRA, we get taxed on our income minus the amount we did in IRA savings. That would be $45,000 – $6,000 = $39,000.
When we pay taxes on that $39,000, we pay less than we would if we had paid tax on $45,000. That means a bigger tax refund!
Take a moment and digest that. When you save money in IRA, you get a tax break. We’ve talked about IRA in the traditional sense.
This IRA works great for people in certain tax brackets, but, understand that you will pay taxes on this money at some point. When you take the money our of your IRA when you’re old Another type of IRA emerged in the nineties called a Roth IRA.
You also get a tax break with Roth IRA but it’s different.
Remember I told you that, for simplicity’s sake, I’ll keep our hypothetical Publix supervisor’s salary the same for 30 years? That isn’t real life.
People don’t stay at the same salary for their entire life. Typically, their salary increases over time. Our Publix supervisor, loyal as he/she is to Publix, will one day be store manager and he/she will make like $100k a year.
$100k a year is a different tax bracket. If our store manager is making $100k by the time he/she must take money out of his/her IRA, then they will pay taxes on the amount of that tax bracket.
The amount of tax in higher tax brackets is more than ones in the lower tax brackets. This is where the Roth IRA comes in.
With a Roth IRA, you pay the taxes on your savings now because you expect that you will be in a higher tax bracket in the future. Then, when you take the money out at 70.5, you pay no taxes.
So, if our Publix supervisor’s dream is to be store manager, then they will choose the Roth IRA over the Traditional IRA because they expect to make more money at the age of retirement.
Next, we talk about 401k. When you work for a company, they will sometimes offer a 401k (sometimes 403b) program that helps you save for retirement. The way it works is the company you work for partners with an investment company and make some agreement.
Then, you agree to put in a percentage of your paycheck to go straight into an index fund. This money isn’t taxed until you take it out for retirement.
You will always see 401k information when you begin working for the company (if they offer it) and typically every year after that. What’s the difference between 401k and the IRAs we just talked about? Not much, actually, but there are two really important differences.
They are alike in the way that you’re putting money aside for retirement and it isn’t taxed until you take it out. They are both managed by investment companies like Fidelity or Vanguard.
But here’s one big difference. Some companies will match the money that you put in your 401k. In my experience, the most common percentage that companies will match is 4% of your paycheck. THIS IS A HUGE INCENTIVE.
When a company matches your money, they are giving you a dollar for every dollar you put in. You are doubling your money. Where else can you hold out twenty bucks and have it turn into forty bucks? Nowhere! You just doubled your money!
You can’t even get those odds in Las Vegas!
I’m highlighting this fact to emphasize the importance of contributing to your 401k. Even if you do no other type of savings, you should do this. I’m going to elaborate a bit more with our hypothetical Publix supervisor just to illustrate a more clear real world picture.
So, remember that our Publix supervisor makes $1,875 on his/her paycheck every two weeks. And Publix matches up to 4% of his/her paycheck. 4% of $1875 is $75. He/she puts that $75 straight from their paycheck into their 401k and Publix matches it; $75 times 2 is $150.
$150 for only 75 bucks! Do you see what I’m saying? That’s the best deal around! Our Publix supervisor can elect to put more than 4% of his/her paycheck if they want.
But, at bare minimum, one should ALWAYS put aside the maximum amount that a company will match on 401k. Remember that I said this, we will discuss this again later in our discussion about debt.
There’s another thing about 401ks that we will talk about. Anyone who has ever had one will understand the moment when they were given the booklet. The booklet has all the investment information and it lists all the mutual funds that are available to you.
Someone looking at this for the first time will be immediately turned off from the whole process of saving for retirement. How can you know which fund to choose? On to the next section about choosing a fund.
Which Fund do I Choose for my IRA? Actively Managed Funds vs. Index Funds
This section will serve as a guide on how to choose a mutual fund that will have the lowest fees. Over time, the fees will eat into your savings. I will show you how to avoid that.
As I mentioned before, when you get a job at a company, they may offer you a 401k. If they do, you will receive a booklet and it in you will find a page that looks like this:
At first glance, it is daunting. But, I will help you to understand. Let’s break this down. Take a look at it again now that I’ve circled some of the important items.
“Fund” is circled. That one’s easy – its the name of the fund. In that column, I double underlined some of the fund names. Take a look at what’s in there. It’s bonds, right?
Remember we talked about those? They are the ones that we should have 20% of in our portfolio because they are low risk.
“Ticker” is circled. You can use google that to find out the history of that fund. You can plug it into your phone and get notifications on it daily. So you can see if it’s going up or down.
And then all the way to the right is “Net Exp.” which stands for net expenses. And under it are circled some decimal numbers. These numbers are very important. They represent the FEES that the investment company will charge you to keep your money in there.
They justify it because they are “actively managed”.
We don’t want to keep our money in there because, over time, those fees will eat into our savings. Take a look at this graph comparing index funds to actively managed funds:
Actively managed funds cost more to own because their fee is higher. And because of that fee, you lose out on a lot of money over time. Don’t make this mistake. How? Choose the mutual fund with the lowest expense ratio.
Go back to the chart and take a look at all the circled expense ratios. Which is the one with the lowest one? I’ll wait for you..
Correct! The lowest one is 0.05. And what is the fund name? INDEX FUND! See? I’m not lying to you! So, those are bonds, let’s take a look at the large cap funds – that means large companies.
Now, remember that 80% of your portfolio should be more risky. These large cap funds follow the economy and you can expect a 5% interest return on your investment over time.
Same as last time, take a look at the expense ratios. Which one is the lowest?
Yes! 0.03 at BlackRock Equity Index Fund! You are awesome at this!
Debt: What to do?
What to save: index funds comparison
Review: Big Picture
(optional) Budgeting: discretionary vs. mandatory
(optional) Depreciating assets