This section of the course is a little different. These three lessons focus on a sample plan for first-time investors starting at three different spots: under $10,000 to invest, under $100,000 to invest, and anyone over $100,000.
What’s great is that the basics of investing for all three groups are going to be the same! In all cases, we’ll use what we’ve learned in previous courses to do the same thing: invest in diversified, low-fee index funds.
The main difference is what problems each group encounters. The more you invest, there is more emphasis on taxes, and which accounts you can use. Taxes become a pretty big headache at first, so it’s nice to have a plan from the get-go. Once you understand them and have a plan for how to properly manage them, that plan becomes a tactful ally helping you keep more of your hard-earned money!
We’ll have a plan for that in all cases. In fact, each of these three articles is going to be very similar. If you just want to skip to the one that fits your investment level, go for it!
Starting Point for Our Under $10,000 Plan
Let’s take a look at the starting point for our investor with under $10,000. This is what their finances will look like when they are taking the steps to make their first investment:
Who?
Meet Stacy. She’s 26 years old, working her first job out of college – which she considers to be a very stable position. She’s making $45,000 a year – $40,000 a year after taxes – and spends about $30,000 of that right now – leaving her with $10,000 extra at the end of each year. This was only after she aggressively analyzed her spending and cut down some expenses that weren’t bringing her enough value to keep spending on them. Her company offers a 401(k) with “a 50% match up to 6%” – whatever that means.
Debts?
Stacy has used her income so far to pay off credit card debt she racked up in college (good job paying that off!). She purchased a used car and has a 5-year auto loan she’s still paying off. She also has around $50,000 in student loans at 4.5% that she’s paying $300 each month towards, which is included in her $30,000 spending. She’s paying the minimum on her auto loan and her student loans but pays off her credit cards in full every month. She has no plans for any large upcoming purchases.
Assets?
Stacy has taken the idea of an emergency fund to heart and saved up $15,000 in her savings account. This is the account she uses to pay all her bills, her student loan, and auto loan. Since her expenses are about $2,500 a month, she has about 6 months of savings.
Our Problem: What does Stacy do with her $15,000 in her checking account and the extra $10,000 each year? Does she pay off student loans? Pay off her auto loan? Invest it? Save it? Spend it? Let’s make a plan for how to use it.
Making A Plan for Stacy
Stacy is in a pretty good position. She has some debt, but it’s all low interest (under 7%).
If she didn’t have extra income, or she was still paying off her credit card debt, she’d want to wait to invest for now and focus on that first.
She also has taken the huge first step of creating a 6-month emergency fund. 6 months in an emergency fund is amazing – and may even be more than she needs since she considers her job stable. If Stacy believes she could quickly replace her income if she lost her job, then 3 months may be enough.
This is my go-to graphic to help people figure out what to do next. Let’s take a look and see how it helps Stacy.
Let’s take these one by one.
Emergency Fund. Stacy has 6 months in an emergency fund in a checking account. This is a liquid account, which means she could quickly use it at any time.
Recommendations: Given her situation, 6 months might be overkill, and might give some room for investing. She’ll want to keep at least $7,500 in an emergency fund though! Her cash is in a checking account which provides nearly no interest. If she opened at a high-interest savings account at her same bank and moved most of this money into that, she could make another $150-$300 a year (assuming a 2% interest rate).
Stacy has about $10,000/yr, or $833 a month, to fill up the remaining buckets.
Company 401(k) up to the company match. Stacy’s job offers a 401(k) with “a 50% match up to 6%”. The way 401(k) matching is stated is always like this – a complete nightmare of math and grammar. Let’s break that statement down to what it actually means:
Stacy’s company pays her $45,000 a year. 6% of that is $2,700. If Stacy sets her 401(k) at 6%/$2,700 a year, then her company will match her investment with 50% of $2,700 – or $1,350 each year. If she invested $2,000, the company would match with $1,000 (50% of it). If she went over and invested $5,000, the company would still match at $1,350, since it would match for the first 6% then stop there.
A 401(k) company match is without a doubt the best investment Stacy can make. For every $1 she invests up to $2,700, it immediately increases in value by 50% with the match!
Recommendation: Stacy should without a doubt open a 401(k) with her employer and set it to at least 6%/$2,700 a year. This will cost her about $225 a month, lowering her available money to about $650/month. Within her 401(k) she can split her investments between US Stocks, Intl Stocks, and Bonds.
Debt. Stacy has no credit card, but she does have student loans and an auto loan. This brings up a huge question – should she pay these off first, or invest first?
This is both a math question and a personal happiness question. Stacy would be much happier not having any student loan debt. Since she’s paying $300 towards her loan right now, it’ll take about 16 years to pay it off – making her 40 by the time it’s done. Or she could choose to attack it first with everything she’s got and put in $10,000 a year for about 5.5 years. The downside here is that she’d be 30 years old with $0 in savings but with a clean slate.
My personal recommendation here is always to invest sooner than later. If Stacy aggressively paid off her student loan then began investing $10,000 + 300/month, then by age 40, she’d have about $188,000 in savings when she reaches 40. That’s assuming her income stayed the same too – it’d be much higher if she also saved her raises.
But what if she started investing $10,000 each year today and kept paying the minimum on her student loan? In that case, she’d have over $250,000 in savings! The difference in those additional 5 years investing is massive.
There’s a middle ground too: she could chip in a bit more each month to her student loan to pay it off sooner. Paying an extra $300 each month would lower the loan term by half – from 15 years to 8 years. In that case, she’d have about $200,000 by age 40 – still a lot less than if she had invested it, but more than if she paid it all off right away.
I’d leave her auto loan alone right now and just keep paying the minimum there. It’ll be paid off in 5 years anyway.
Recommendation: Stacy has a lot of options! Assuming the market rises more than the interest of her student loans, investing is the best solution. There’s no way of knowing that in the short term though. What she can do is split the difference and invest a bit extra each month and try to halve the number of years needed to pay off her loans. Mathematically it may make sense to go all-in on investing, and physiological it may “feel” better to have the loans paid off, but by doing some of both she’ll be able to take advantage of known rates (her loan rate) and unknown rates (future market growth). She can leave her auto loan alone for now too. Let’s assume she puts another $250/month into her student loan – lowering her student loan duration from 15 years down to 8 years. This will cost her about $250 a month, lowering her available money to about $400/month.
Roth IRA / Traditional IRA. IRA accounts, or individual retirement accounts, are opened by you and not your company – hence the “individual” part. Stacy can create a new account at Vanguard (or any brokerage firm) and invest there whenever she wants.
Since Stacy has another $400 each month to “spend” investing, her next choice would be the decision between a Roth IRA and a Traditional IRA. The income limits for these accounts change every year. Given Stacy’s income is $45,000 a year she can use either account.
If she chooses a Roth IRA, she’ll pay taxes now and be able to invest $400 each paycheck. When she withdraws money in retirement it’ll be tax-free.
If she chooses a Traditional IRA, she’ll be contributing with pre-tax money, allowing her to contribute a slight bit more. Since she’s in the 12% tax bracket, she’d actually contribute $448 each month and it would cost her the same amount.
The question of Roth IRA vs Traditional IRA is honestly sooo confusing. I’ve been reading and writing about it for a decade and still don’t have a great answer for it. Here’s how I determine which to recommend to people:
Choose a Roth IRA if you believe you’ll make over $124,000 a year later in your life if you want to retire early and have increased flexibility in your drawdown or you like to keep things simple.
Choose a Traditional IRA if your 401(k) only has high-fee options, you plan to retire at a normal age (60+) and you don’t plan to use a “Backdoor Roth IRA” technique later in life.
Like I said, it’s tough to know which to use. Most of those questions assume you know what’ll happen 10 or 20 years from today! My personal recommendation is to only use a Roth IRA. Sure, you won’t get the tax benefit today, and your account won’t be able to grow with the extra deposits from the tax deduction, but you’ll be able to withdraw from the Roth IRA anytime, you’ll be able to do a “Backdoor Roth IRA Contribution” later in life if your income grows and you’ll have more options to save on taxes later.
Traditional IRAs are also taxed at your normal tax rate in retirement, which can be a lot.
Recommendation: Since Stacy has 6 months of expenses in her checking account, she could take some of that out, say $3,000 and open a Roth IRA at Vanguard. The 2020 Roth IRA contribution limit is $6,000 a year. If she puts in another $250/month she’ll max it out. That leaves her with another $150 left!
Company 401(k) Up to the max. Stacy’s can use her last $150 to increase her 401(k) contribution even more – up to $375 a month total.
Recap
Ok, let’s look at where I recommend Stacy’s money should go.
- Savings Account: Reduce her $15,000 in savings down to $12,000, and use $3,000 to open a Roth IRA at Vanguard.
- 401(k): By setting her 401(k) to $375/month, Stacy is getting the full company match each month, and even putting more in – $4,500 in total or $5,850 each year after her company match!
- Roth IRA: Stacy will aim to max out her Roth IRA this year. By putting in $3,000 to start, then another $250/month, she’ll max it out this year.
- Debt: In order to pay off her student loans faster, Stacy is putting $250/month extra towards them – an extra $3,000 a year. This will cut the time needed to pay it off in half.
At the end of just the first year doing this, Stacy will have put $11,850 into the stock market! That’s huge!
Investments
Ok, the last step – what should she invest in? She’s young, so let’s assume her ideal asset allocation looks like this:
- 60% US Equity Index Fund ($VTSAX)
- 30% International Equities Index Fund ($VTIAX)
- 10% Bond Index Fund ($VBTLX)
She has two accounts – a 401(k) and a Roth IRA. Looking back at How Taxes Eat Into Growth, we can see that each account has an “order of funds”.
For the 401(k), the best funds would be Bonds, then Intl, then the US. For the Roth IRA, it would be US, Intl, then Bonds.
That makes it a little easier to split the accounts:
Roth IRA: 100% of it would be in a US Equity fund like $VTSAX.
401(k): This account would be split between all 3 – which is somewhat confusing. In order to meet the asset allocation, Stacy would want to set her contributions to be about 20% bonds, 60% International and 20% US. Yes, this means holding US stocks in both accounts – but that’s what’s needed to reach her asset allocation.
Another, more simple solution would be for both accounts to invest in a target-date retirement fund for a far-future year, like 2060. This works well for her at this age where Stacy can exchange the funds in both accounts later and not need to pay taxes. For most people getting started, I’d go with this route to start, then revisit this in 5 years when they have more money saved up.
Next steps
At the end of the first year, she’ll probably want to make some changes. In order to keep maxing out her Roth IRA, she’ll want to lower her 401(k) contribution back down to 6% and then raise her Roth IRA contribution up to $500/month.
Any money that she wants to save from future raises would then go into increasing her 401(k) contribution.
She’ll also want to tweak the percentages in her 401(k) every once and while to rebalance her portfolio and make sure her actual asset allocation is in line with her target asset allocation. She would only need to do this about once a year.
Stacy is an amazing spot. On paper, she’s $35,000 in debt, but she’s on track to have a lot saved up by the time she’s 30! Don’t let student debt hold you back from investing now. Those additional years in the market can make a huge difference in how much you have saved up over the long run.