Today I have a guest post from The Early Retirement Engineer, a 22 year old lover of life with a mission to reach early retirement by the age of 30!
For those of you who still working hard to decrease those numbers in the debt category, keep up the great work! Reaching zero and then watching the positive numbers get larger is a rewarding experience.
But what’s next after you reach a positive net worth? Chances are, if you’ve been following Amanda’s wonderfully wise words, you’ve likely been enjoying spending significantly less than the level that brought upon any debt in the first place. Now that it’s gone but your spending isn’t substantially increasing, where do you put those excess rivers of income?
Sure, you could stash it all away in a simple savings account. The problem is most accounts have negligible interest rates. My credit union’s savings account rate is .03%, meaning I’ll earn $0.03 per year for every $100 in my account. Factoring in inflation, any money I save there today will be worth roughly half as much 35 years from now. Not a great incentive to save.
Here’s where the stock market comes to the rescue. It’s a scary topic for many people, but it’s actually not very difficult to navigate. The easiest way to invest is through Vanguard index funds. They track the overall market, have amazingly low fees, and are as close to ‘invest and forget’ as you can get. Over time you’ll likely see 6-8% annual gains after inflation, meaning your money will roughly double ever 10 years! But that’s not the focus of this article.
Right now, we’re going to discuss three main investment buckets that you can put excess money to save for retirement (or early retirement). Not only will you see your money grow exponentially in the long run, the three accounts covered will return 30% or more in the first year because you won’t pay income tax up front!
Tax Advantaged Accounts
Most employers offer 401k’s (Thrift Savings Plan for government employees), and many will match a certain percentage of your income that you contribute. Let’s pretend you have a $60,000 salary and your employer matches 5%. Essentially, your employer is paying you, dollar for dollar, to invest up to $3,000 of your income.
If you don’t save another additional penny, you absolutely must contribute at least the amount of your employer’s match or you’re essentially throwing away, in this example, $3,000 of income. It’s actually greater than that, because by the time you use that money, it will likely have doubled multiple times. Even if you have credit card debt at 25% interest, you’re still coming out ahead by earning the 401k match before paying off the debt.
If you are still weighed down with debt, I’d recommend contributing only enough to your 401k for the full benefit of your employer match. Every other spare cent should be going towards eliminating those ugly red numbers.
If you happen have extra income though, you can contribute up to $18,000 in 2016 (plus an extra $6,000 if you’re over 50). That number also scales every year for inflation.
In addition to maximizing your salary with a 401k match, you also won’t pay income tax (federal or state) on any money you contribute to a tradition 401k. If you’re in the 25% federal tax bracket and you have a state income tax, contributing $3,000 means you’re saving around $900. Maxing out at $18,000 saves about $5,400
While an employer match is wonderful, the biggest downside of the 401k is your investment options are limited by what your employer offers.
If you don’t already contribute to your 401k, go talk to your employer yesterday about starting! I don’t know anybody that would throw away free money.
IRA (Individual Retirement Account)
On top of an employer-based retirement account, you can contribute up to $5,500 in 2016 to your own retirement account ($6,500 if you’re 50 or over). The same tax incentives apply for an IRA. The greatest benefit over the 401k is you have much greater control on where your money is invested!
Again, while exact investing strategies would take many thousand-word articles to discuss, typically the best and easiest route to go is a Vanguard index fund, such as VTI. Because index funds are a massive conglomeration of stocks, they perform similar to the S&P 500.
Yes, you may lose some money tomorrow, but you don’t care at all what your shares are worth until the day you sell them. In fact, until you retire and begin to sell, you like it when the market is down because it means stocks are on sale and you should buy more!
The volatility of the market is the number one factor that scares people away from investing. But because you’re investing for 10, 20, or 50 years down the road, daily fluctuations shouldn’t bother you.
I opened my IRA in 2008, literally days before the first big crash of the Great Recession. It was only a few thousand dollars, but that was most of the money I’d ever earned at 14 years old. If a freshly-minted high schooler can make it unscathed through such a traumatic experience and still be confident about continuing to make retirement contributions, you can do it too!
“Alright, no taxes, employer contributions, free money; So what’s the catch?”
Unfortunately, there are a couple downsides, but with the correct planning, they can be minimized. Both the 401k and IRA are not taxed when you contribute, nor do you pay taxes on any market gains while that money is invested. However, you will be taxed when you take any money out after you retire.
The idea though, (besides more money earning investment gains) is you’ll be in a lower tax bracket when you retire. With a frugal lifestyle, you’ll likely be close to the zero percent tax bracket!
The other catch is, once you put money into a traditional retirement account, you can’t withdraw any of that money before 59 1/2 unless you’re okay paying a penalty. There are a few ways around this, but it’s probably better to not need that money and you’ll never have to worry!
Health Savings Account (HSA)
The most underutilized (and potentially most helpful) type of tax-advantaged account is the health savings account (HSA). To have an HSA, you must be enrolled in a high-deductible health insurance, but unless you’re way riskier than your insurance company believes, statistically you’re losing money if you’re not!
An HSA can be thought of as a personal insurance plan with a massive discount. Each year you can contribute $3,350 for an individual ($6,750 for a family). While IRA and 401k contributions are subject to the 7.65% FICA taxation, HSA contributions are 100% tax free. Your HSA can be invested just like other accounts, and the gains are likewise untaxed.
The rules are set up to allow you to reimburse yourself for any medical expenses from this account, but also gives you significant flexibility. There is no timeframe in which you have to reimburse yourself (keep records!), and if you have money remaining after 65, that money can be withdrawn for absolutely anything, penalty free! (Medical expenses are still withdrawn tax-free but general purchases are not.)
Order of contributions
If you happen to have an extra $27,000 of disposable income, great! Why not max out every account?
If not, where should your money go first? Here’s the order that I’d suggest and why.
1. Contribute to your 401k up to the employee match. Again, you’ll essentially be increasing your salary by 3-6% depending on the policy. Don’t contribute more yet though, unless your employer offers an amazing investment portfolio.
2. Max out your HSA. Not only do you not pay FICA taxes, you can pull money out at any time for qualifying medical expenses. Added flexibility for free is always a good thing. And after 65, it basically turns into an IRA.
3. Max out your IRA. You have the same tax benefits as a 401k, but more flexibility for where you invest the money.
4. Max out your 401k.
Again, this money should NOT be something you plan on needing in the next 5 years. It’s long term savings. But if it would be sitting in the bank anyway, why not put it to use while decreasing your tax burden?
Speaking of tax savings, how much can you actually save? Here’s a fictional example of a single person living in California, earning $70,000 per year with no special tax deductions. For this exercise, I’m using an online tax calculator.
If this fictional person needed every cent of their take-home pay and thus didn’t invest anything, they would pay $19,655 in income taxes. On paper they’re getting paid $70,000 but, in reality, their true salary is only $50,345.
Instead, say our character lives on much less than their take-home per year and maxes out their contributions in all three accounts. The tax bill now comes to only $12,542. Not too shabby. They’ve already increased their salary by $7,113!*
But let’s go back to the 401k employer match at 5%. Adding another $3,500 brings the total saved to $10,613! Of course not everybody is able to save $27,000 of their salary every year, but no matter what you’re able to afford, the benefits of saving for the future are vastly underrated in today’s society.
Where to Invest
For full disclosure, while I’ve done substantial research, I am not a financial professional. Please do not take anything written here as official professional advice. However, luckily you don’t need the help of a professional to start investing. A little online research should be plenty to get you on the right track.
Again, if you’re an absolute beginner, I’d recommend checking out Vanguard.com. A short Google spree will reveal it’s an industry favorite for individual investors.
If you’re looking for guidance from a professional advisor, you’re welcome to contact me at theearlyretirementengineer @ gmail.com and I can help point you in the right direction.
Happy saving for your future!
The Early Retirement Engineer is an electrical engineer by trade but is mostly invested in making the world a happier, richer, and better place. For some unknown reason, he’s long been able to see past the consumeristic group-think that grips Western society and leads to over-taxing the world’s natural resources while leaving us all struggling under mountains of stress-inducing debt. His philosophy is focusing on maximizing happiness rather than buying a ton of stuff because his neighbors do. The result is the ability to retire after an incredibly short forced career of under 10 years, and permanent extreme happiness! He shares his insight on his blog at www.theearlyretirementengineer.com.
*The Early Retirement Engineer and I found online tax calculators aren’t created equally. Please note that there may be slightly different results with each calculator. The point is contributing to the tax advantaged accounts can save you thousands in income taxes each year!