I’ve been getting a lot of questions recently from people who are getting to the point in life when they are ready to start investing. They understand the basics, but don’t know where to begin. That’s where this quick guide will hopefully come into play.
This is by no means the only way to invest, but is the best way that I have found to maximize the return on my investments while minimizing the cost of my time. All while not needing to pay a financial advisor a cent of my hard earned money.
So let’s begin.
Invest in Your Company’s 401k Plan Up Until the Employer Match
If your company matches 1%, you invest 1%. If they match 5%, you invest 5%. If they match 10%, you invest 10%. ALWAYS invest as much as your company is willing to match, otherwise you are throwing away free money.
They planned on paying you that amount of money, by not taking it, you are allowing your company to make even more money on you.
So this is always the first step to investing, even before an emergency fund or paying off your debt. Later we will talk about how to invest this money in your 401k plan.
Start an Emergency Fund
Most people recommend 3-6 months worth of expenses. This should be kept somewhere that you can access easily in case of an emergency such as a broken down car, lost job, etc. You need money to keep the lights on and avoid dangerous high interest debt in case the worst happens.
Most recommend keeping this money in your savings account. I personally recommend a high yield savings account or your brokerage account but this requires a higher risk tolerance. I keep half of mine in a high yield savings account and the rest I keep invested in my brokerage account. We will discuss how to invest in a brokerage account later.
I choose a brokerage account as it has no early withdrawal penalty and can be accessed fairly quickly. I can put any emergency expense on my credit card until I am able to access the money in my brokerage account to pay off the charge. The only risk is that if an emergency happens in a down market, it will require me to sell low, but that is the risk I allow myself to take.
So if you are more risk averse, there is nothing wrong with keeping this fund in a high yield savings account.
Pay Off Your Debt
I am not a Dave Ramsey zealot, so I don’t think you need to pay off all of your debt before you begin investing. However, you should pay off the high interest debts. So likely all credit card debt, most student loans, and some auto loans. Most home mortgages have fairly low interest rates, so I don’t always feel the need to pay them off before investing.
We can assume that if we invest in the market that will see a conservative return of 7% annually. So right away, any debt with an interest rate higher than 7% is going to eat away more money than you will be making by investing. So you should pay this debt off first.
However, because I am a little more conservative with debt than others, I recommend 5% as my cut off. Meaning I will pay off any debt that is over a 5% interest rate before I begin investing. This leaves me a little bigger buffer to ensure that I am always getting a solid return on my money.
Max Out Your HSA
I have an entire post as to why an HSA is the best investment account, but to summarize, an HSA is the best because it is tax free on the way in, has tax free growth, and is tax free on the way out. Meaning basically no taxes!!
An HSA is only allowed for someone with a high deductible health insurance plan, which is most people as more employers continue to offer trash insurance.
In 2020, we are allowed to contribute $3,550 dollars to our HSA. Many companies with high deductibles will offer an HSA plan, and some even contribute to it. However, for those of us that don’t have a plan through work, I recommend signing up for an HSA through a low fee company.
I recommend Fidelity which is who I have my HSA plan through. From there, I have all of my HSA invested in FSKAX which is the Fidelity Total Stock Market Index. The Fidelity version of VTSAX which we will get to later.
Next is where it gets a little grey
The Grey
This is where our investment guide splits because it begins to depend on what tax bracket you are in. For simplicity, if you are in a high tax bracket, it likely will be better for you to max out your pre-tax investments first, meaning your 401k and traditional IRA. However, if you are currently in a low tax bracket it may make more sense to invest in your Roth IRA, a post-tax investment.
Basically, if we are in a low tax bracket now, but expect to be in a higher tax bracket later in life due to promotions, job changes etc, it would be best to contribute to a post-tax investment vehicle like our Roth IRA. That way when we are drawing down from our portfolio later in life we already paid the taxes when we were in a lower tax bracket.
If we are in a high tax bracket now, and believe we will be in a lower tax bracket later when we are drawing down from our portfolio, then it is best to contribute to our pre-tax investments such as our 401k and traditional IRA. This way we can maximize the money we are able to contribute now and then pay taxes on that money later when we will be paying much less in taxes.
Max Out Your 401k
We have already been contributing to our 401k to get our company match, but now that our emergency fund is in place and our debts are paid off or at least manageable, we can begin to go all in on our 401k plan.
In 2020, we are allowed to contribute $19,500 annually to this plan. This investment is a pre-tax investment, which means that it is invested before Uncle Sam can take his cut of your money out in the form of taxes.
This means that your taxable income will now drop almost $20,000 which will likely put you in a lower taxable income bracket.
Meaning that if you were an unmarried individual whose current taxable income was $55,000, by maxing out your 401k plan, it would drop your taxable income down to $35,500. Which would change your tax bracket from 22% to 12%, allowing you to pay much less money in taxes that year.
Since we don’t get to pick who our 401k plan is through, my best recommendations for what to invest in for your plan, is to find an index fund with a very low expense ratio. One that isn’t actively managed, and that follows the S&P 500, or the total stock market index. Most company plans should have something at least similar to this.
It likely won’t be perfect, but it’s better than investing in a fund with high fees that the “advisor” for your company suggests as they likely get commission for getting people to invest in that fund.
If you really don’t have a fund like this, it may be time to advocate for yourself and colleagues to have your employer think about bringing in some better options. But this is a discussion for another time.
Max Out Your Traditional IRA
A Traditional IRA is a pre-tax investment vehicle just like your 401k. This means that you are avoiding paying taxes upfront which lowers your taxable income and allows your money to grow tax free. However, you will have to pay taxes on this money once you withdraw it.
We would choose this account over maxing out our 401k in the instance that our 401k plan has high fees that are unavoidable. This is because both are pre-tax investment vehicles, so both lower our taxable income. So if our 401k has high fees, it may make more sense to first max out our traditional IRA before our 401k plan because we are able to choose where our traditional IRA is held.
For your traditional IRA, in 2020, the max contribution is $6,000. I recommend creating your account with Vanguard due to their extremely low fees and then investing primarily in their index fund VTSAX or their ETF with the ticker VTI. Both are the same fund, but for some investing, Vanguard will require you buy VTI first until you meet a minimum threshold.
If you were to max out your HSA, 401k, and traditional IRA, you would be able to decrease your taxable income by $29,050.
Why VTSAX and VTI?
VTSAX and VTI are Vanguard’s Total Stock Market Funds. The expense ratios are 0.04% and 0.03% respectively, so you are paying very minimal in fees. The funds have both returned roughly 9% annually since inception. If you want to read more about why these are the safest and least time consuming investments to reach FI, I suggest checking out the book “The Simple Path to Wealth” by JL Collins.
Max Out Your Roth IRA
A Roth IRA is a post-tax investment vehicle, meaning you are paying taxes upfront so that you can allow your money to grow and be withdrawn tax free. We would choose this account over maxing out our 401k in the instance that we are in a lower tax bracket.
For your Roth IRA, in 2020, the max contribution is $6,000. Note: If you contribute to a Roth IRA, you will be unable to contribute to your traditional IRA and vice versa.
Again, I recommend creating your Roth IRA account with Vanguard due to their extremely low fees and then investing primarily in their index fund VTSAX or their ETF with the ticker VTI. Both are the same fund, but for some investing, Vanguard will require you buy VTI first until you meet a minimum threshold.
Invest in Your Brokerage Account
After you have maxed out all of the above accounts, the final place to invest in is your brokerage account. A brokerage account is an investment vehicle that doesn’t offer any tax benefits but allows you to invest post-tax dollars without any limitations.
With a brokerage account, you have full control over what you invest in, how much you invest annually, and when you can withdraw from your account.
Again, I recommend creating your brokerage account with Vanguard due to their extremely low fees and then investing primarily in their index fund VTSAX or their ETF with the ticker VTI. Both are the same fund, but for some investing, Vanguard will require you buy VTI first until you meet a minimum threshold.
Summary
There are thousands and thousands of investment plans out there, some that work and many that don’t. This plan requires very minimal effort and researching. It doesn’t try to guess the market, buy at the right time, sell at the right time, nor rotate between sectors, cap sizes, or emerging markets.
It simply follows the above progression of investment vehicles to maximize tax benefits and invests in low cost index funds which track the United States Total Stock Market. It’s conservatively returned 7-10% annually since the beginning of time and takes me 5 minutes per week to mange. (Even less if I would automate my investments)
It’s not the only way to invest but it’s the way that has worked for me and has allowed me to stay on track to reach financial independence well before the normal retirement.
Investing is confusing, but it really doesn’t need to be. Hopefully the above helps to simplify the process if you are just starting out.
Feel free to share this post to whoever may need some gentle guidance with their investing.
If you have any other questions, feel free to comment below or email me directly at fiscaltherapist1@gmail.com
