Best Way to Start Investing
You have a job, you make more money than you spend. You have about four months worth of expenses put away for emergencies. You have divided it between a no-fee savings account at a local credit union and a no-fee, interest bearing checking account at an Internet bank.
The next step depends on
- How much money you are making.
- The kind of benefits your employer offers, if any.
- Why you are saving. What will it be used for and most importantly, when.
The amount of money you are making determines your tax bracket. This is important because one of the largest expenses you will have over your lifetime will probably be taxes, so it makes sense to pay attention to that.
Saving vs. Investing
Before we get into that, though, let us remind ourselves of the difference between saving and investing. While you were building your emergency fund, you were saving. Your primary concern was to have a stash of extra money you could access any time just in case. Getting a return on your money was the least of your concerns. In fact, you willingly accepted that you are guaranteed to lose money because of taxes and inflation. When you are putting money away for a short-term goal like a vacation, new car or even a house, you are saving.
Investing on the other hand is when your primary concern is to generate a return on your money, to make it grow. Technically, your savings account is an investment because it does pay you interest, but it is a very poor one because it does not grow nearly fast enough to even keep up with inflation and taxes.
You could simply continue to keep saving the same way you have been, but it will be a losing game because you will constantly have to overcome the impact of taxes and inflation just to get ahead.
Some Basic Definitions
The government does want you to pay taxes, let there be no doubt about that, but it also wants you to save, so a number of rules have been made to encourage you to do just that. In order to make the most of it, let us begin with understanding tax brackets and some other tax related concepts.
To make informed decisions, you will need to get a handle on some important terms like:
- Gross income
- Taxable income
- Marginal tax rate
- Effective tax rate
For the sake of simplicity, we will assume that you are single and have no children. You can easily find the information you need at irs.gov if you are married or head of household.
Gross income is what you get when you add up all your sources of income from wages or salary, and interest from your savings accounts.
The government allows you to exclude some of your income from taxation. Those exclusions are listed at the bottom of page one and the top of page two of Form 1040. Get a copy of Form 1040 and learn what they are. Your taxable income is what is left after you have deducted all the exclusions from your gross income. This is what determines your tax bracket and consequently your marginal tax rate.
The marginal tax rate is the rate applied to the last dollar you make. Not all taxable income is created equal. For 2016, you pay
10% on the first $9,275,
15% on everything between $9,276 and $37,650,
25% on everything between $37,651 and $91,150,
28% on everything between $91,151 and $190,150 and so on.
The highest rate is 39.6% on everything over $415,051.
Therefore, if your taxable income is $35,000, you are in the 15% tax bracket. You do not pay 15% on all of it, just on the portion between $9,276 and $35,000. The first $9,275 is taxed at just 10%. Your marginal tax rate is 15% because the next dollar you make will be taxed at that rate.
Can you see that there is a big jump, 10%, from 15% to 25%. All other jumps are either 3% or 5%, so it pays off the most when you go out of your way to avoid having income in the 25% tax bracket or higher.
The effective tax rate is when you add up all your taxes from the various tax brackets and calculate the percentage of your income you paid in taxes. It is less important for our purposes here. I just want you to understand that it is different from the marginal tax rate. You just want it to be as low as possible while still working within the rules.
Employee Benefits Fundamentals
The other thing you want to consider when you make your investment decisions are employer provided benefits. Employers are required to provide certain benefits, but they may also offer voluntary benefits. Some employers offer pension plans for their employees. Pension plans allow employees to save money by having it deducted from their paycheck without paying taxes on it. The money is deposited into the employee's retirement account. The employee owns, manages and controls the account and no taxes are due until he or she withdraw . Employer sponsored retirement accounts are called 401k plans named after the tax code that governs them.
Some employers even match some of your 401k contributions with as much as 50% or more. This is the best deal anywhere. It is like getting a 50% return on your investment. Some say that this is so good that, if this is available to you, you might even want to borrow money to fully exploit it if necessary. Only you know how disciplined you are, so do this at your own discretion.
Employer Plan Alternatives
If your employer does not offer a retirement plan, all is not lost. An Individual Retirement Account (IRA) is another way you can exclude income from taxation. There are two kinds, the traditional IRA and the Roth IRA. The traditional IRA works in a way similar to the 401k plan. You pay taxes when you take your money out, not when you put it in. It works best when you are in the higher tax brackets because your contributions reduce your taxable income. Remember your marginal tax rate depends on your taxable income. The Roth IRA does the opposite. You pay tax on your contributions when you put it in, but no tax on any of the earnings when you take it out. This works best while you are in the lower tax brackets.
So how does this help you if you still have to pay the taxes when you take the money out, you ask. It helps you because you do not have to take any money out each year to pay the taxes on the earnings. We say that you have deferred the taxes. All of the earnings will be available to earn additional returns perhaps for decades to come. For example, if you earned $10 in interest from a regular account, you would have to take $2.50 out to pay tax assuming you are in the 25% tax bracket. That means only $7.50 will be available to invest for the next year. In a 401k or IRA the entire $10 will remain in the account and earn more interest. Interest earned on interest is called compound interest.
After all that, I still have not explained how you should start to invest. All we have talked about so far are some ways to save. Saving is only the first step. Without savings you can not make investments. Remember, the goal of investing is to generate a return on your money first of all to beat the impact of taxes and inflation, but also to generate income you can actually spend at some future point in time.
That brings us to my next point. When do you want to spend the money? You invested your emergency fund in a savings account because you need it all to be there tomorrow and the next day and the next. In order to earn a higher return than the savings account, you will need to take some risk. You will have to accept that the investment might decrease in value in the short term, but increase over the longer term. For the really short term, like one to three years, CDs and money market accounts are good choices. Safety is good, but the return is still dismal. I want you to consider mutual funds.
Mutual funds pool investors' money and buy stocks, bonds and sometimes other kinds of investments. At the end of the year, they distribute the earnings to the investors. But mutual funds can lose money, you say. Yes, they can, but because they spread that risk over many different kinds of assets, the possibility that they will go completely bust is remote. Some of the underlying securities will have gained in value while others have lost.
According to Ric Edelman, the stock market in general has made money 70% of all the years since 1926 when they started recording these things. It has made money 90% of every five-year period imaginable and 100% of every 15-year period. What does that tell you? It tells you that if your time horizon is less than about 15 years, you need to have at least some other type of funds in addition to your stock mutual funds. Bond funds serve that purpose nicely. Over long periods of time, they also earn respectable returns in their own right, but more importantly, they tend to zig when stock funds zag. If your horizon is short, say, three to five years, you will have more bonds and less stocks than when your horizon is longer, say, ten to 15 years.
What I am trying to tell you here is that you reduce risk by spreading your investments over a large number of different asset classes such as stocks and bonds. Ric Edelman recommends more than half a dozen different kinds of investments. The point is simple. You need to diversify and not rely on a single kind of investment. It may seem counter-intuitive, but introducing some risk can actually make your overall investment safer.
Getting Started is Key
That is good and dandy, you say, but you have only a few hundred dollars to invest. That is not a problem. IRAs usually have lower minimums than regular taxable accounts. 401k plans may not have a minimum at all. All of the discount brokers have online guides to select funds for just about any situation imaginable so lack of funds should not stop you from getting started. Getting started early is key. You remember what I said about compound interest earlier, right?
While I cannot recommend any funds in particular, I will say that I am a big fan of index funds for several reasons. First, they are passively managed. Nobody needs to be paid to select stocks or bonds to invest in. That is all on autopilot. They are very tax efficient which is important especially outside tax deferred retirement accounts. Because they only need to trade when the index changes, they rarely sell any securities which might trigger taxable capital gains. They tend to spread a wide net to include a large number and variety of securities. There are even funds that invest in other funds to cover as much of the market as possible. One fund like that may be all you need. The best reason of all is that they also beat most actively managed funds most of the time.
If your funds are limited, another option is a so-called target date fund. This is a good choice if you have a particular purpose in mind such as buying a house. All you have to do is decide when you want to do it and the fund will automatically adjust its mix of securities to match your time frame.
Finally, look for funds with "balanced" in their names. Balanced funds typically invest in several asset classes. They often generate respectable, but rarely spectacular returns.
I have already mentioned overhead and management costs as a factor when you select funds. You want the net expense rate to be as low as possible, definitely less than 1%. Also look at the 10-year return. The funds would prefer you look at the best performance, but that is a mistake. Spectacular returns in a single year or two are irrelevant. You want consistency year after year. The 10-year return tells you more about that than any other number you can find. Extraordinary short-term performance is often an indication that the fund is about to peak. Then it is too late to get in. Focus on long-term performance.
As always, feel free to ask questions or post comments below and I will try to find answers for you.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.