So, you are a new graduate who followed my advice and took the month of July to get your finances in order. Now you’re wondering where to start investing. Here are five easy rules of thumb to get you started.
First, let’s recap what you should be doing in July: Figure out your expenses, build an emergency fund, buy disability and life insurance, and start saving.
Congrats if you are thinking about saving and investing this early on in your career. As I showed last month, starting early gives you tremendous opportunity to let compound interest work for you. So let’s concentrate on where, and in what order, you should invest your money.
1. Start with your 401k or 403b
If you are an employee of a private group, hospital, or academic institution, you should place as much as you can into your group’s 401k retirement plan especially if you have an employer match. There are two general types of 401k plans: traditional 401k plans where you make all the contributions, and profit sharing 401k plans where your employer contributes on your behalf and you contribute. For traditional 401k plans you’re limited to contributing $16,500 this year, although this number goes up with inflation every few years. For profit sharing plans your combined employer and employee contributions are limited to $49,000, of which $16,500 comes from your contribution.
It is particularly important for you to contribute to the plan if your employer provides a match for your contributions. Check the formula that your employer uses for the match. Usually it’s a certain percentage match on the first few percent of your income and then goes down from there.
So, why do all of this? First, placing money in a 401k reduces your taxable income so you pay less taxes. Second, there are restrictions and penalties for withdrawing money from a 401k, so it removes the temptation to take it out and spend it.
2. Set up your own retirement plan
For EPs who are independent contractors, the choices are more flexible and simplified. The easiest way to get started is to set up a Simplified Employee Pension (SEP) IRA. As the name implies, this is incredibly easy to do and should take you one day to set up. You basically fill out a SEP IRA agreement at a brokerage firm or bank, sign the one page IRS tax form, open a SEP account and you’re ready to go. Just like a profit sharing 401k, you can potentially contribute the max of $49,000 this year but you have to make a minimum of $245,000 to do so. Any less income limits the contribution amount to about 20% of your compensation. Just like a 401k, contributing to a SEP IRA reduces your income tax liability.
However, for a bit more effort you can set up a solo 401k plan, which is just like an employer 401k except that you are the only employee. There are two main advantages to a solo 401k over the SEP IRA. First, you can contribute more money to a solo 401k at lower income levels than you can with a SEP. For example, if your income is $200,000, the SEP limits your contribution to $40,000, but with a solo 401k you can contribute the full $49,000 ($32,500 is classified as an employer contribution and $16,500 is an employee contribution). The second advantage is that your $16,500 deferral can be classified as a Roth 401k contribution if your plan allows it. What this means is that you will not get a tax deduction now for that amount, but your earnings will grow tax free and withdrawals during retirement will be tax free. The downside to all of this is that there are far greater administrative headaches to a solo 401k.
3. Fund an Individual Retirement Account (IRA)
If you have a traditional 401k and max out your $16,500 contribution, or you max out your SEP IRA or solo 401k, then consider funding an IRA. Contrary to popular belief, you are allowed to contribute to an IRA regardless of income level, but you probably won’t be able to take a tax deduction for it because of your income. This strategy allows you to grow the earnings tax deferred until withdrawal. Another advantage starting this year is the ability for you to convert a regular IRA to a Roth IRA regardless of income. This means that you can grow earnings tax free and withdraw money tax free during retirement.
4. Open a taxable account
Still want to invest more or want total flexibility? Then consider a taxable brokerage account (non-retirement account). If you are an extreme saver, or don’t know how much you have to spare in a 401k or IRA, then simply invest money in a regular brokerage account. Unlike the 401k and SEP IRA, you won’t receive a tax deduction, and when you sell investments for a gain you will pay income tax on the gain. But this approach provides you with complete control over your money. Generally retirement accounts like 401ks and SEPs have penalties on early withdrawals, but with a nonretirement account no such restriction exists. So if you think you will need this money in the next few years a nonretirement account is for you.
5. Keep it simple
Once you’ve organized your accounts, it’s time to invest the money. One of the biggest mistakes you can make early in your career is to make this far more complex than it is. I know you can probably intubate with your eyes closed by now, but being cavalier about investing will only get you in trouble later on. So where should your first hard earned dollars go? Stick with one or two low cost, diversified mutual funds. A great way to begin is to use the Vanguard Total Stock Market Index Fund (ticker VTSMX). In this one fund you own all of the great American companies for a really low cost. Later on as your portfolio grows you can add other investments to compliment this core investment to potentially enhance your returns and lower risk.
Setu Mazumdar, MD practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA www.lotuswealthsolutions.com