Earlier this month, I shared a new financial framework I’ve been developing, one that stresses earning, spending, and saving as the building blocks of personal finance.
Two weeks ago, I elaborated by sharing how I make money. Last week, I turned to the other half of the basic personal-finance equation: I shared how I spend money. (Or, more precisely, the ways in which I try not to spend money.)
Today, I’ll share the ways I save money. But because many folks found the term “save” confusing in this context, let’s call it the ways I invest money instead. Whichever word we use, I’m talking about how I put the surplus — the difference between what I earn and what I spend — to work so that it provides for my future.
Saving
My monthly surplus is used for two purposes: saving and investing. Some of the money is set aside for near-future use, such as buying a new car or taking vacations. Here, for example, are my targeted savings accounts at ING Direct:
But while these accounts were created by saving the surplus between what I earn and what I spend, I don’t really think of them as being part of the “saving” (or “investment”) building block. This is money that will be spent eventually. It’s sitting in an account that, at best, keeps pace with inflation. It’s not money I’m trying to grow.
Investing
The cash I have in my savings accounts represents money I’ve already harvested. The money I have in my Roth IRA, my 401(k), and my reguar investment accounts represents the funds I’m trying to grow.
Clumsy metaphors aside, your skill at investing comes from how you’re able to make your surplus grow. If you hide your money under a rock, your investing skill isn’t particularly good. Although you might think you’re protecting what you’ve saved, you’re actually losing money to inflation.
Skill at investing comes from learning everything you can about increasing your wealth. It comes from creating a plan and sticking to it, from making logical decisions (instead of emotional ones), from avoiding fads, and from understanding the fundamentals of investing, including diversification and asset allocation.
Of the three basic building blocks of personal finance, investing is the last one to be put into place. As a result, many people never master it. I’m just a novice investor; I have a grasp of earning and spending, but I’m new to investing, and still struggling to put theory into practice. (My ongoing series about rebalancing is an attempt to document part of this learning process.)
How do I invest?
- I contribute the maximum to my Roth IRA (or traditional IRA, if I don’t qualify for a Roth in a given year).
- I contribute the maximum to my self-employed 401(k).
- With any leftover money, I contribute to regular, taxable investment accounts.
When I say that I contribute “the maximum” to my tax-advantaged accounts every year, I mean the most I’m able to based on the law. Each account has different contribution limits. Sometimes these are confusing. For instance, the amount I can contribute to my 401(k) depends on how much my business earns in any given year. The more I earn, the more I can contribute. So, I contribute as much as I’m legally allowed. (How this works in reality: After doing my taxes, my accountant says, “Okay, J.D., you can put $XXX into your 401(k) for last year.” And I do it.)
Putting my surplus into investment accounts is only half the battle. I also have to decide what to invest in — and why. This is the part that’s especially tough for me right now. I feel like I have just enough knowledge to be dangerous. I have to force myself to make smart decisions. Even then, I come up short a lot of the time. My current series on rebalancing my portfolio describes which funds I invest in and why. If you read the first part, you know I have 18% of my investments in an energy mutual fund. This is silly.
So, while I seem to be doing well with the earning and spending building blocks, I haven’t yet mastered investing. My returns have been good, it’s true, but that’s mostly due to pure chance. I think it’ll take me several years to get more than a theoretical understanding of how investing works.
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JD -
What are your taxable accounts, if you are willing to share? Do you have investment accounts, savings, etc?
I was reading “Boggleheads’s Guide to Investing” and they make a good point about taxes. Any taxable account’s dividend distribution, even if you reinvest it by buying more of that stock, is taxable. Same thing with CDs and it’s interest earnings…
So now, I am concerned that my returns are much lower after taking into account the taxes that need to be paid.
My question to you is: How do you take taxes into account with regards to taxable accounts? And is it even worth opening these accounts given the tax implication?
Currently I contribute to a Vanguard personal account, invested in the STAR fund and Balanced Index Fund. And now am thinking maybe I shouldn’t?
On a side note, I do not qualify for Roth IRA due to income restrictions (my DH and I do make more than the annual limit). This is why I opened a taxable investment account. Also, my thought was one disadvantage of retirement accounts is that you cannot access them before a certain age… So I needed something that earned more than a savings account that I can access.
Your thoughts are appreciated!
Thanks JD!
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The real issue is that I haven’t taking taxes into consideration before now. It was only after meeting with my guy at Fidelity recently that this became a concern for me. He pointed out that in order to rebalance, I’m going to have to sell some stuff. And since the stuff that’s overvalued right now is the stuff in my taxable accounts, I’m screwed. I’m going to be losing some of my gains to taxes.
He also re-iterated something that may be of use to you (based on your “is it even worth it?” question. He noted that you shouldn’t make investment decisions solely based on the tax consequences. This is true in all areas of personal finance, actually. I’ve heard of people doing some pretty dumb stuff to avoid paying taxes. Taxes are a pain, but it’s best to consider them the price you pay for doing the right thing. Does that make sense? In other words, yes you should still put money in taxable accounts, especially if that’s your only option. But you should be smart about it — which I haven’t been.
One thing you may want to do is be certain you’re taking advantage of all tax-advantaged accounts available to you. You may not qualify for a Roth IRA, but you may be able to make non-exempt contributions to a traditional IRA (which may or may not be convertible to a Roth). If I had questions about this, I’d ask my financial adviser or accountant. You might want to do the same. (Or maybe one of the GRS readers who knows this stuff will come along and give you some concrete numbers.)
So, I think it’s good to have money invested, even if it’s only in taxable accounts. You need some money in a savings account, true, but you also need money to grow if you want to ever retire.
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If you ever start charitable giving, donating those appreciated stocks to a non-profit is a fantastic way to deal with the gains in a tax-preferred manner.
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Yes, I acknowledge that estate tax may be a factor. However let’s not forget that there is a $5 million exemption, and less than 1% of the population will be subject to this.
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I also do not qualify to make Roth IRA contributions, however you can do what J.D. recommends: make non-deductible/post-tax contributions to a Traditional IRA, and then convert (called recharacterizing) to a Roth IRA.
Generally when you convert from a pre-tax Traditional IRA to Roth IRA, you have to pay taxes on it.
With the non-deductible Traditional IRA, you only pay taxes on the gains.
So essentially, you have contributed to a Roth IRA, it’s just an extra step.
As JD says, check with your financial adviser or accountant.
I proposed the above to my CPA and she said that was the way to go for what I wanted to do (contributed to Roth while being over the income limit).
Cheers!
Allen
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Allen, I’ve been wanting to do this but am stumped. How and where can I open a non-deductible Traditional IRA. (Right now I have a 401k through work – max $17,000 contribution allowed, a Rollover IRA at Schwab, but those were pre-tax dollars, and a Roth with a very tiny amount in it, started last year, but I make too much to contribute to it.). I really really would like to do this non-deductible traditional thing and convert to my Roth, but I’m confused (and the Schwab representative I spoke with didn’t seem to have a clue as to what I was talking about when I brought this up). Would appreciate ANY suggestions or guidance you can offer.
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When you’ve maxed out your 401K and Roth IRA, what’s the next best place to invest in?
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I like I-bonds. $5000 per person ($10K if you also buy paper bonds). Interest grows tax free (also tax-free for education). In May it looks like they will pay 4.6% interest.
See this: http://www.mymoneyblog.com/savings-i-bonds-march-2011-cpi-update-4-60-variable-rate-up-to-2-51-11-month-investment.html
For stocks, go with a S&P 500 index fund (or ETF) in a taxable account.
If you have children also think about 529′s for college savings.
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If you want to re-balance your taxable accounts, but don’t want to get hit too hard by taxes, just make sure you don’t sell anything until it’s been held for over a year. That way, you take advantage of long-term capital gains tax rather than being taken advantage of by short-term capital gains tax.
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You can contribute to a Roth IRA when you’re beyond the income limits by doing a non-deductible IRA contribution (which has no income limits) and then converting it to a Roth. This is known as the backdoor Roth. See this link for much more detail on how to do such a maneuver:
http://thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html
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You may not qualify for direct Roth IRA contributions, but you qualify for non-deductible Traditional IRA contributions. And in 2010, they removed the income cap on converting from a Roth IRA to a Traditional IRA.
I would take a gander at this page on the Bogleheads wiki: http://www.bogleheads.org/wiki/Backdoor_Roth_IRA
If you’re with Vanguard, you can actually convert from Traditional IRA to Roth IRA using the “Exchange funds” pages.
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Real growth = nominal/quoted growth minus fees minus inflation minus tax
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J.D. I think your’re well beyond a novice investor. The Roth concentration will be particularly beneficial if you plan on maintaining your capital base through retirement, and bequething your remainder. The Roth can be passed on outside of probate, is free of required minimum distributions during your lifetime, is not taxed at your death, and continues to grow tax free for your beneficiaries. It truly is the holy grail of retirement savings vehicles.
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While I wholeheartedly agree that a Roth is a good thing, let’s be clear on one of the comments here — a Roth IRA or 401k is subject to estate tax just like anything else at your death. However, it’s not subject to income tax, whether you or your heirs withdraw the money.
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Yes, I acknowledge that estate tax may be a factor. However let’s not forget that there is a $5 million exemption, and less than 1% of the population will be subject to this.
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“I think it’ll take me several years to get more than a theoretical understanding of how investing works.”
For what it’s worth, I don’t think that sort of understanding is actually possible, not really. I think the best you can do is find yourself comfortable with some sort of investment strategy. But can anyone really, truly understand investing? I don’t think even the experts do!
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You are using some bond funds, which are ok, but..
(and from the other post…
>>37.39% in various bonds and bond funds)
When interest rates start to climb, Bond Funds will decline in value. You may want to think through what to do here. (I am not advocating dropping bonds and funds, just mentioning this…)
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I think it’s cool that you’re sharing all this info J.D.
Whenever I hear someone say they’ve “maxed out” a 401k, I assume they mean they contributed $16,500 to it, and likewise $5,000 for an IRA. Maybe we should just stop talking about “maxing out” retirement accounts since that’s confusing and doesn’t mean anything in particular.
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That’s a good point, Tyler. I’m not sure how else to phrase it. Maybe this?
“I’ve contributed as much as I’m allowed to my Roth IRA/401k for the year.”
Okay, I’ve got to quit reading/replying to comments now. I have a presentation on budgeting tomorrow night, and I need to prepare for it!
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Hi there…..you hit the nail on the head with “Putting my surplus into investment accounts is only half the battle. I also have to decide what to invest in — and why. This is the part that’s especially tough for me right now.”
All my friends (people in their 20′s and 30′s) are scared of losing their shirts after going through the crisis. Saving seems to be the easy part for most, it’s putting the money to work (in the market) where most hit a brick wall.
Your returns look pretty great to me! Why do you think you need to “master” investing? Unless you want to be the next Warren Buffet, why sweat it? Proper diversification and rebalancing will get you there.
And, the fact that your returns are so good isn’t by “chance”…. you deliberately put your money in the market when a lot are sitting on the side lines, that’s a bold move in itself after the volatility/uncertainty we’ve had over the last few years
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Quick question, I was under the impression that 401k/403b had to contributed to during the year you are counting the contribution, unlike IRAs. When does your accountant let you know what you can deposit?
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I sure hope not, or I’ve been doing things wrong for the past few years.
This year, for instance, my accountant told me what I could contribute on April 12th. I made the contribution on April 13th. And Fidelity seems to be fine with this when I tell them it’s for 2010.
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I believe April 15th is the deadline. I don’t know if that varies for years on which the 15th is a weekend like taxes do.
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For a SEP you can definitely contribute up until April 15th (the tax deadline) of the following year. I can not comment on the 401k, etc.
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I definitely think investing is important, but right now I view it as more of a set-and-forget type of thing.
Maybe this is good, maybe not. But I guess I see it like this- if you use your time to build a solid business, it will have much higher ROIs in the long run.
I know some guys make a killing in investing, I just personally don’t know if it’s the best way for me to build wealth.
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I like the idea of compartmentalizing things. That way, you know where your money is, and how to spend it or save it.
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I just finished reading Bernstein’s Investor’s Manifesto. Very good reading, and reassured me that I am on track. He mentions that you should only rebalance every year or two, which I thought was quite interesting, and not what I had been hearing. I have neither the interest nor the inclination to spend a lot of time learning the finer points of investing, so I plan to stick with a few basic index funds and let it ride.
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The question is, where will it ride to?
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Ray Lucia’s “Buckets of Money” has a pretty good breakdown of tax consequences of investing and, more importantly, withdrawal from your investments in retirement. It doesn’t make sense to accumulate a ton of money during your working life only to let the Gov’t swoop in and take obscene amounts of it when you need it the most because you planned poorly.
By the way, JD, those numbers are looking pretty stout! Do you still contribute to your emergency fund or do you just sit back and let the interest build up?
Also, which site is that screen shot that has your investment account returns on it? It looks pretty efficient to be able to see your returns in one location.
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I love you honesty in this post and how you want to continually learn more and grow. However, I’m not sure anyone will figure out how investing works entirely. The markets are always changing and demanding of continuous study. We will never get to a point where we’ve “made it” and don’t need to learn more. Good luck!
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Politely pointing out a typo:
“but that’s mostly do to pure chance”
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If there were an Olympic event in homonyms, I’d be a gold medalist. They’re the bane of my existence.
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One of the best things you can do tax-wise is max out you 401K or IRA contributions. If you’re in the 25% tax bracket, each $1000 you contribute saves you $250 in taxes that year. Plus the money in the account grows tax free. Come up your own tax-estimating spreadsheet and see what works best.
For non-retirement savings, look into I-bonds. The interest grows tax-free (and may be completed tax-free if used for education). Also, the May I-bond rates will likely be ~4.6%.
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Bogleheads’ Guide to Investing….nuff said.
Jack Bogle:Investing::Dave Ramsey:Debt repayment
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Out of curiosity why do you have a solo 401k instead of a sep?
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Higher contribution limits.
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What is the “Holding Account” for on your ING list? Is it an Electric Orange or a Savings account?
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If it’s the same as what we do, it’s an Electric Orange Checking account, to bypass the savings account withdrawal limits. We have one EOC account where my paycheck gets direct deposited every other Friday. The following Monday we have anywhere from 8-12 transfers – moving money to various subaccounts, investments, etc. Since the limit on savings accounts is 6 withdrawals per month, we had to get the EO checking as a ‘buffer’ account. Other than the couple days a month immediately after I get paid, there’s never more than $10 in this account.
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Since you have substantial gains in a taxable account, may I suggest a donating that stock to a donor advised fund. Donate the appreciated stock to the foundation in 2011 (get a big tax break) and then you can distribute it to charities over time. I’m very happy with the Fidelity Charitable Gift Fund.
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You’ve been publishing some decent posts about investing lately and I’ve found that refreshing and interesting, but I feel like it lacks a direction for those looking to invest now. You may not want to get into investing ‘advice’, but I think it is a major topic that hasn’t been directly confronted here.
Perhaps it isn’t your cup of team – but providing some general ideas such as index investing, diversification, and rebalancing as a unified article might be helpful for folks. In part two you could talk more about smaller asset classes, tilting, and more of a slice and dice approach.
Doing some searches it looks like individual topics have been covered, but a unifying post may be missing. Or perhaps I’m just no good at searching.
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I don’t think there’s ever been a unifying post. The closest I’ve come is the investing chapter in my book. I do try to steer clear of investment advice because I feel unqualified to give it. But I could certainly try to summarize some general themes and recommendations.
I’ve thought a lot about my investment future today, and a commenter in the other thread made a great point: I need to slow down. There’s no reason I need to decide my new asset allocation by Monday. When I meet with my Fidelity guy, he and I can outline the steps I need to take. Number one should be to develop an Investment Policy Statement.
As I take each step — carefully, being sure to do things right — I can document the process here on GRS. This won’t give you a unifying post, but it’ll help document how somebody goes about doing this, yes?
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You are doing quite well VS SP500 index so you must be doing something right.
I think it’s great to see how you invest your money. It’s from a regular guy point of view and that’s more interesting than the usual financial adviser point of view.
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J.D., you say you need to slow down and that you’re a novice investor, but I think you’ve done quite well already by simply doing something.
It’s so easy to sit on your hard-earned cash and feel like you have complete control over it, instead of risking it in complicated investments that have lots to do with very big, intimidating concepts.
Getting in the game is more than half the battle.
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How did you get that performance tab? I don’t get that when I log in, I only get the other 5 tabs.
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I’d lie to know the answer to this too, I can’t seem to find it on my fidelity account.
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JD,
Thanks for tackling the investing stuff on the blog. It’s nice to see your actual thought process. I’m also glad you’re tackling topics at all ranges of the PF real. Budgeting isn’t an interesting topic for me anymore (I have one and stick to it most of the time). Neither is debt payoff (no credit card debt, but my student loans will be with me until I die, albeit at really low rates). I’m at the third and fourth stages — saving for a house (live in DC, it’s a non-trivial endeavor) and planning for retirement.
So thanks again for keeping this interesting beyond the basics.
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nice E/F
i had original mini for 3 years—bright orange–great fun to drive.wish i kept it
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Yay for MINI! i have my second one – red with white stripes – and i love it. Words of warning though – I originally had a 2006 automatic mini cooper. After 65,000 miles, the transmission blew. It was only 10,000 miles out of warranty, and even though this was a known flaw, there was never a recall. It would have cost $6500 to replace, minimum. More than I owed on the car. After a good amount of arguing, negotiating, and research, I got the best of the not so desireable outcomes – they let me trade it in as if it were working fine. They fixed the problem in 2007 models, but if you plan on buying used, do a great bit of research before you buy! The new one is a 2011, and so far so good, but I am still a bit sour on the situation.
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JD, great to see more articles about investing and asset allocation. After lots of research I reached the conclusion that keeping it simple is the best bet. I settled on the three-fund approach suggested by the Bogleheads, with annual asset allocation adjustments. I prefer to make adjustments by funneling more money into under performing asset classes rather than selling/buying/exchanging.
http://www.bogleheads.org/wiki/Three-fund_portfolio
I’m curious why you are investing with actively managed mutual funds rather than all index funds? My decision to go with all index funds was based on John Bogle’s below quote:
“If you go back to 1970, there were only 355 equity funds. Only 169 of them survive today, so right away you are dramatically skewing the numbers by not counting the losers. Of those 169 survivors, only nine beat the S&P 500 through 1999. Three by 1 percent to 2 percent per year, four by 2 percent to 3 percent, and only two by more than that. I would say that 2 percent isn’t really statistically significant, but let’s leave that aside. Then there’s taxes. After tax, maybe only those top two truly beat the market. That means it’s just a game of chance and a bad one at that.” –John Bogle
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I felt guilty for hoarding a lot of cash and not dumping it into the market until I met with a financial adviser last week and he said and I agree that we’ll see a lot of volatility until the Fed decides what to do about QE3, so I’m going to wait until after summer to invest.
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Awesome post, it’s cool to see that we do some of the same things (I have multiple ING accounts for various goals), AND that there are still things you are unsure of.
Though from where I stand, you seem pretty damn informed about investing to me.
I just got married a month ago today, and we’ve both altered our W4s to reflect our status (after talking to our tax guy), and I just paid off what was left of wedding expenses. We’ve got a list of goals, and a decent emergency fund that we’re still contributing to. I feel pretty good considering my husband and I both went to art school and are in careers that don’t pull in six-figures.
I always look forward to reading your posts, keep up the good work!
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@brooklyn mone – Don’t try to time the market. I would be cautious of any adviser suggesting that is what you should do that.
If you are invested for the long term, then I would start taking a position now. If you are uncomfortable with a lump sum, you could take a dollar cost averaging approach in which you minimize risk by investing the same amounts in set intervals.
Also, as JD suggests, you must fight the urge to sell stocks when they are under performing. Many people made the huge mistake of selling when the market bottomed out in March 2009 and missed the ridiculous Bull run that followed and nearly doubled the value of investments. Everyone knows its logical to buy low and sell high, but surprisingly few actually are disciplined enough to stick to it.
It takes a lot of guts to increase your % investment contribution when the market is crashing and pull back when its booming. However, you must realize that waiting for QE3 is like waiting for a store’s sale to end and prices to go way back up, and THEN buying.
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Hi, Can you tell us what software you are using to track your investments? It looks very good and my brokerage never shows me ROR like that.
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Is JD planning on working until retirement age? This plan of “maxing” the Roth and the personal IRA means he’s potentially investing well over 50k/year into tax deferred accounts, which is all well and good if you’re absolutely sure you’re going to work until full retirement age but kind of a bummer for anyone considering early retirement.
In order to have funds available before you turn 59.5, you need to have some of those funds invested in taxable accounts. Considering even modest support from social security and any other potential retirement income sources like a pension, suddenly the savvy investor needs to have a significant portion of total savings in taxable accounts. If you want to retire at 40 and have income until 60 to last until 80, then you need well over half (due to compounding) of your total nest egg outside of retirement tax shelters.
I’m certainly not opposed to working until 60 or later. But investing 50k+ per year provides a pretty comfortable life in retirement and not much freedom before that. If the point of prudent investing is to give yourself options for the future, doesn’t it make more sense to put some significant portion of that annual contribution into taxable accounts where it’s available earlier in life?
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Love these posts on investing, JD. I run into these same questions, even though I have an investing plan or policy, whatever you want to call it. I just think since there is so much uncertainty it is only natural to question yourself. Like someone above said, you are probably ahead of 80% or more of people just by doing something.
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I just thought of something…you maybe related to the guy that created the Roth IRA LOL
Jokes aside. You are doing a great job saving
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I never understood the point of creating separate “targeted savings accounts” for specific purposes. If you’re disciplined enough to look at that list and not say “Screw it, I really want the Mini Cooper now, I’ll just ‘borrow’ $10,000 from my emeergency fund” then you should be disciplined enough to have one account for all short term savings and spend from it responsibly. Unless you have accounts with separate investments for different timeframes (car next year vs. retirement in 30 years) keeping separate accounts just makes it all more complicated to manage.
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I like using separate targeted savings accounts so I can see how far I am to my goal. It is completely a visual/psychological thing. I’m not going to borrow the money from another savings account, but seeing them all lined up shows how much I’ve saved towards that goal. Honestly, I find it easier to manage separate accounts for this purpose than one single one, as I know the purpose of every single dollar and penny in that account.
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