Whether you’re a twenty-something who has just gotten your first job or you’ve been out in the world of work for decades, here is how to start investing.
First of all, good for you! The earlier you start saving, no matter how much it is, the more money you will have later. And if you’re behind the sooner you try to get caught up the better.
There are three reasons to save money. These are not in order of importance:
- To have money available if an emergency arises such as you lose your job or have large medical bills.
- To make a large purchase in the future.
- To prepare for retirement when your income will be greatly reduced.
Whether you’re very young or in catch-up mode, you need to have money invested in the stock market. Over time the stock market yields the highest returns over other investment types such as bonds and savings accounts. For this article, we will only address only stocks, and the best place to start investing in the stock market is with mutual funds.
What is a mutual fund?
A mutual fund is a collection of securities. Mutual funds are very diverse, typically owning hundreds of different stocks. This means that your risk is spread out. With a mutual fund, if one stock within the fund loses value, it won’t necessarily tank your entire portfolio.
Not all mutual funds are created equal
All mutual funds charge fees. Some fund companies charge very high fees. The lower the fund’s expense ratio, the more money you get to keep and the more money you will have in the future.
One of the best type of low-cost mutual fund investments for the average investor is a low-cost index fund. An index fund is a type of mutual fund that is pegged to a specific market index. The mutual fund company purchases all the stocks in the index. As the index moves up and down, so does your investment.
The two companies that offer the lowest cost index funds are Vanguard and Fidelity.
Both Vanguard and Fidelity offer low cost S&P 500 and Total Stock Market index funds. S&P 500 mutual funds contain a weighted average of around 500 U.S. stocks. A Total Stock Market index is just what is sounds like — every stock in the U.S. stock market. Over the long term, the stock market goes up 5 percent to 10 percent or more annually, depending on which metric you look at.
What is a 401(k) and what are the advantages?
A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a portion of their paycheck, up to a specified amount each year, before taxes are taken out. Taxes aren’t paid on the investment or any growth in the investment until it is withdrawn from the account, many years later when you retire. That is, the taxes are deferred until you start making withdrawals.
All employers will offer you some or many mutual funds options that you can invest in through their plan. If you’re lucky, they may offer Vanguard and Fidelity and the indexes mentioned above. If they offer different fund families, look for the lowest cost index fund. If you can’t find the expense ratio, contact your human resources department or call the fund company directly and give them your employers plan number.
Many employers will match a certain amount of your annual contribution to your 401(k). An example: If they match up to 2% of your gross income or the amount your contribute annually, if your income is $30,000 they will add $600 to your account every year that you contribute 2% of your gross income. The advantage of many 401(k)s is that they offer a match, which is free money.
If you are employed you should contact your human resources department and get the information about your 401(k). At the minimum you should always contribute enough to the plan to get the annual match (the free money).
What is an Individual Retirement Account (IRA)?
An Individual Retirement Account (IRA) is an investment account that an individual sets up at a financial institution that allows an individual to save for retirement and that offers the tax advantages of tax-free growth on a tax-deferred basis or entirely tax-free growth and withdrawals in the future. The two different types of IRAs to be discussed here are the Traditional and Roth IRAs.
What is a Traditional IRA and what are the advantages?
A Traditional IRA is an investment account that an individual sets up at a financial institution. Taxes aren’t paid on the investment or any growth in the investment until it is withdrawn from the account when you retire. That is, the taxes are deferred until you start making withdrawals. The money you contribute to a Traditional IRA is tax-deductible (up to specified amount and certain income limits) similar to a 401(k) plan but you will take the deduction for the IRA contribution when you file your tax return. However, there is no match on a Traditional IRA since you are contributing the funds on your own.
A Traditional IRA may be a good option if your employer doesn’t offer a 401(k) plan.
Many mutual funds have a minimum investment requirement to open a regular (non-IRA) account. Both Vanguard and Fidelity will waive the minimum investment requirement for many index funds if you open a Traditional IRA.
What is a Roth IRA and what are the advantages?
A Roth IRA an individual retirement account allowing a person to set aside after-tax income up to a specified amount and subject to income limits each year. All withdrawals from the account after age 59½ are tax-free.
The advantage of a Roth IRA is if you need the money before you are 59 1/2 you can take out your original investment (not the earnings) tax-free. This makes a Roth IRA a good option as an emergency fund.
Many mutual funds have a minimum investment requirement to open a regular (non-IRA) account. Both Vanguard and Fidelity will waive the minimum investment requirement for many index funds if you open a Roth IRA.
Self-employed people have additional retirement savings options.
Where do savings accounts fit into the mix?
Savings accounts are currently paying virtually no interest. However, if you are saving up for something specific such as the new iPhone, a television or a down payment for a home this is where your money should go.
If you’ve been following the stock market lately it has been all over the map since the beginning of the year. If you are saving money that you will need in the short term, you may want to invest it into something that won’t fluctuate.
A savings account is probably a more appropriate place to save for your emergency fund. An emergency fund should cover six to eight months of your expenses in the event that you lose your job. You may need a large emergency fund if you feel that your job is not secure.
If you are saving for something short-term (or your emergency fund) open up an online savings account that is FDIC insured and have the money swept out of your checking account every pay period.
If your employer offers a 401(k) plan enroll and invest at least enough to get the whole match. These funds will come out automatically every paycheck.
If you have any additional funds after investing in your 401(k) then open up a Roth IRA at either Vanguard or Fidelity and have the money swept out of your checking account every pay period.
Bonus: Where to find the money to save
Many people, of all ages, are always telling me that they do not have any money to save. If you look at your budget honestly there is money to be found if you work hard and cut back. The best place to start to look for ideas is through your local Living on the Cheap website.
Other places to “find” money:
- Cell phone. Get out of your traditional plan and get a low cost prepaid phone. Even after buying the phone up front you can save 50 percent. Don’t replace your phone every two years unless it’s broken.
- Get rid of your cable or reduce it to basic.
- Scrutinize your utility use. Use power strips and turn off everything as you exit rooms. Turn down the thermostat or use a fan.
- Walk, ride your bike or organize trips in your car. Don’t just drive to the store to buy five things.
- Go through your closet and wear everything before buying any new clothing.
- Don’t take an expensive vacation this year.
- Get organized and buy most of your groceries when they are on sale. Spend two weeks or more “eating” from your pantry and freezer. Go through your kitchen and eat all the stored and frozen food before shopping for more.
- Try a “no-spend month” or two. Vow to spend a whole month eating from your food stockpiles but extend the no spending from groceries to everything else. Don’t go out to eat or spend money on other entertainment. Don’t buy any clothes, cups of coffee or anything else. The exceptions would be medical and emergencies.
- If you want to eat out, use coupons, turn happy hour deals into a meal or split a meal with your dining companion.
- Go through your bills and make sure you’re getting the best deal. Review your gas, electric, landline, Internet, cellphone, cable, auto insurance and homeowners insurance bills. Determine whether you’re getting the best deal for each.
- Cancel all unused services and memberships. Health clubs, magazines, Netflix, Hulu, cable — pick one.
- Cancel or downgrade unused credit cards with an annual fee.
- Go through your home and look for things you can sell.
- Cash out your vacation time/paid time off if your company allows it.
- Work overtime, get a second job or do temporary work. If your job offers overtime pay, volunteer to work as many extra hours as it will give you. Get a second job to take up the time usually spent watching cable. Or take a week of vacation and work a temp assignment.