So you want to learn how to start investing.
And can I just say, I’m so excited! This is gonna be great!
Let’s get right to it.
When you first start investing, you want to be debt-free and have a full emergency fund of 3-6 months-worth of expenses.
The first thing to do is identify the purpose of your investment, and the first priority is retirement.
The reason for this is that there’s an 87% chance that someone in their 20s will live to be at least 67. And if you live to be 67, you have a very high probability of living into your eighties or nineties.
Point is, you’re probably going to live beyond your physical capability to work, so you need to have a good chunk of money to live on in your non-working years.
To phrase it in a more positive light, 🙂 you have the chance NOW to invest wisely so that the last ⅓ (and possibly more if you can retire early) of your life is full of choice and freedom of time, instead of struggling to make ends meet.
The first step is to figure out a ballpark amount for your retirement savings goal. Do you need $2 million or $200 million to retire? Or is it somewhere in between?
A million dollars doesn’t go as far as it used to. In today’s dollars, a $1,000,000 nest egg will provide $40,000 a year of income (using the 4% rule). It’s certainly enough to get by, but it’s not a “millionaire lifestyle” when we think of having seven figures in the bank.
And 20 years from now, $1,000,000 won’t be worth what is is now due to inflation.
It’s safe to say you’re going to need more than $1,000,000 to retire decently.
But I’m not here to overwhelm you, I just want you to be aware of the factors that play into the “magic number” for retirement.
So, I made a retirement goal planning worksheet that walks you through figuring out what this number is in four easy steps (and it only takes a few minutes to complete).
Don’t get analysis paralysis with figuring out this number. It’s fine to get a ballpark estimate, especially when you’re 20-plus years out from your projected retirement date.
Just take a few minutes to go through the worksheet and move on (you can always adjust your goal number).
The second step is to decide what kind of retirement plans you want to invest your retirement dollars in.
When you invest for retirement, you can put your money in tax-advantaged plans.
A loud HOORAY!!! is in order any time you read “tax-advantaged.”
You’re probably familiar with these types of plans: 401K (or 403B for non-profits), Traditional IRA, and Roth IRA. Those are the most common ones.
(Side note: you can contribute a maximum of $5,500 per person to IRAs per year.)
These are nothing more than tax shelters for your investments. They aren’t an investment type. (Don’t worry, we’ll get there!) They’re shells to protect your precious investment from being taxed.
If you see the word “Roth” in front of it, that means you invest after-tax money, and when you withdraw the money in retirement, all of the money- including the interest earned- is tax-free.
If you do NOT see the word “Roth” or if you see “traditional,” that means you get a tax deduction on the amount you contribute to the account in that tax year.
However, ALL the money- including the interest- is taxed upon withdrawal.
In a perfect world, we would be able to predict what the tax laws will be at retirement. Unfortunately, we can’t, so all we can do is give it our best guess.
If you think you’re going to be in a higher upper marginal tax bracket when you retire, then a Roth is a better option for you.
Your upper marginal tax bracket is the highest percentage that you pay on taxes. Here’s a chart showing the federal tax brackets.
So let’s say your upper marginal tax bracket is 25% right now, and if tax laws remain the same, you anticipate being taxed on retirement withdrawals at 40%.
Better to pay less in taxes now and no income tax later with a Roth IRA and Roth 401k if your company makes that an option.
But if your upper marginal tax bracket is 40% and you expect to be in the 25% bracket in retirement, then taking the tax deduction now through a traditional IRA or 401K is going to save you more money in taxes overall.
A third option is to have BOTH Roth and Traditional plans. So perhaps you have a traditional 401K at work and you open a Roth IRA.
You get a tax deduction now on the amount that you contribute to the 401K, and you put after-tax dollars into the Roth IRA.
When you retire, you can look at the tax brackets and leverage it to your advantage.
Let’s suppose you take $77,000 a year out of your Roth IRA, which cannot be taxed, and then you take another $8,000 out of your traditional 401K, for a total of $85,000.
You aren’t going to be taxed at the upper marginal tax bracket for $85,000. You only pay taxes on the $8,000, so your tax bracket stays low.
Both Roth and traditional are good because they’re both tax-advantaged.
Look at what your upper marginal tax bracket is now, make some estimations about what your upper marginal tax bracket might be in retirement, and then decide which combination of Roth/Traditional plans are right for you.
If you want more specific guidance, you can also work with your tax professional or investment advisor to strategize what’s most advantageous for you situation.
Those are the first two steps to getting started with retirement: set your goal, and then decide whether Roth, traditional, or a combination is your best option.
Stay tuned for the next step!
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