Posts Tagged ‘Investment Basics’

Employer retirement savings and benefit plans

Chances are, you came here because your employer offers some sort of retirement savings plan, specifically a 401k, and you’re simply uncertain as to what to do or how to invest. Therefore, it may be beneficial for you to understand the several different types of savings plans offered by various employers; These plans can be split into a couple of different major categories – Defined Contributions and Defined Benefits. Defined contributions are things such as your 401k, where you are responsible for managing how your money is invested. Defined benefits are like pension plans, where your employer guarantees you a set amount of money upon retirement, to be paid in fixed increments (similar to social security, but this is managed privately instead of by the government) and managed by the employer. Defined benefit plans, or pension plans, have been disappearing over the years, and in fact, very few employers offer these types of benefits any longer. This means, it’s your responsibility to ensure you set money aside and invest it to ensure you have money for retirement. Or you could just work until you’re 80, it’s your choice.

Other defined contribution plans include 403(b)s (similar to 401(k)s, however, these are only used by non-profit orgainzations), 457 plans (available to state and municipal empoyees and similar to 401(k)s and 403(b)s, however these allow larger catch-up adjustments), and SIMPLEs (Savings Incentive Match Plans for Employees for organizations with less than 100 employees).

Some employers do not offer any of the above, in which many people choose to “create their own” by using IRAs (individual retirement accounts). You can invest in a “Traditional IRA”(pre-tax dollars) or a “Roth IRA” (invest with after tax dollars). Here is a great article on Traditional IRAs. I will expand upon this subject in my later lessons.

The important thing to take away from this lesson is that pension plans have been replaced by 401k plans and similar, companies are no longer doing the investing for you, it’s in your hands now. You better know what you’re doing or you could end up losing money for no reason.

Keep going, you’re nearly 1/3 the way through this mini-series! Next, Learn about the different types of investments you can buy (stocks, bonds, cash, real estate, etc.).

Don’t have time to carry on now? Come back at your leisure, but don’t wait too long, every dollar wasted is a dollar not working for you. Also, consider signing up for my daily updates sent right to your in-box. Don’t worry, I hate spammers too.

What is a 401k plan?

Very simply put, a 401k plan is a company sponsored retirement tool. More or less, your company will allow you to deduct a portion of your wages to be invested. More important, your company will match a portion of what you invest and this is free money to you.

Let me show you a quick example of why pays to invest, rather than just save money: Below, I will talk about two brothers, one whom chooses not to invest through his 401k plan, rather into savings after he gets his paycheck – and the other whom knows he will have more money than his brother at the end of the day by investing pre-tax:

Billy Bob makes $30,000 a year, but invests no money, rather he saves about $1,500 a year from his paychecks. His taxable income would be $30,000. Let’s say his tax rate is 25%. He would pay about $7,500 in taxes, and his take home pay for the year would be $22,500 (30,000 X .25 = 7,500 and 30,000 – 7,500 = 22,500). Billy Bob then puts aside 1,500 in savings, for a net of $21,000 for living expenses at the end of the year.

Freddy, Billy Bob’s brother, makes the same amount of $30,000 per year, however, Freddy participates in his companies’ 401k plan, and he contributes 5% of his wages to be invested. So, Freddy’s taxable income would be $30,000 less 5% or $1,500 (30,000 x.05 = 1,500 and 30,000 – 1,500 = 28,500) or $28,500. Taxed at the same 25%, Freddy would pay $7,125 in taxes (28,500 X .25 = 7,125). Freddy’s net pay for the year after investing would be $21,375.

The two brothers would have both set aside the same amount, however, Freddy would actually have $375 more in his pocket at the end of the year than Billy Bob (not to mention whatever amount his company matched in addition to what he invested! Billy Bob thought he was doing fine saving on his own, but actually he was hurting himself!

Do you believe me now? It truly pays to invest, especially when your company matches what you put in for FREE!

Now, some are still wondering or swearing at me: “What about the taxes on the 401k investments?” Yes, it is true you will have to pay these taxes some day. The above example shows the man chose to have his money deducted from his pay and invested pre-tax (in other words, the IRS will allow you the option, pay taxes now or later). The key here is, for most, you would rather pay taxes later when your income is much lower (as it is when you retire), because you will be in a much lower tax bracket by then because you will be living off of investment income. Not to mention – you get the benefit of having all of those dollars you invested making you money instead of making the government money. If given the option however, and say your investing through an IRA, you’re better off choosing a Roth IRA, and investing after tax dollars. I’ll explain that later, don’t worry.

Another important point and reason to invest pretax is that there is the potential that by investing you would even lower the tax bracket you are in, according to your taxable income, further raising your take home pay.

Per Wikipedia, The term “401(k)” has no intrinsic meaning; it is a reference to a specific provision of the U.S. Internal Revenue Code section 401. However the term has become so well-known (it is almost a “brand”) that some other nations use it as a generic term to describe analogous legislation. E.g., in October 2001, Japan adopted legislation allowing the creation of “Japan-version 401(k)” accounts even though no provision of the relevant Japanese codes is in fact called “section 401(k).” India, Hong Kong, and Singapore refer to their equivalents of the U.S. 401(k) plan as Provident Funds. Egypt and Lebanon have a similarly structured retirement fund, and Israel has its own retirement fund.

Now, hopefully you see the benefits of investing versus saving, but that’s just the tip of the iceberg. Continue on with the lessons and you’ll be repeating my mantra by the end, “Would you rather work for money, or have money work for you?” I’m not sure where I heard that or who said it, but it’s certainly something to ponder. Some people just want to work til they’re 80, I on the other hand don’t and won’t. By preparing for my future and teaching you, you can join the folks who work hard and retire early by simply retirement planning and investing. Check out all of my lessons and articles for help in making sense of setting up your investments and help in selecting what investments are best for you.

The next lesson is “Learn about the importance of Compound Interest and how it can make you money, click here to move on.”

Don’t have time to carry on now? Come back at your leisure, but don’t wait too long, every dollar wasted is a dollar not working for you.  Also, consider signing up for my daily updates sent right to your in-box. Don’t worry, I hate spammers too.

Calculating your retirement needs and risk tolerance

I just started a new job, please help me setup my portfolio!For the majority of people investing in their companies’ 401K plan or similar, few have a clue as to what they are doing or for what reasons.

Rather than asking a neighbor, or your distant cousin – you have decided to take this chore upon yourself. First, let me congratulate you on taking some time to try and understand this sometimes complex task. Now that’s out of the way, let’s move on to making some sense of this mess.

Just like selecting a healthy diet, defining what is healthy or acceptable to you or me may not be true for the other guy. Your diet, like your investment plan, should change over time to accommodate your health (or wealth). Not too many young people care what fast food they stuff in their mouth, but as they get older – those same foods do different things to your body – leaving you no other choice but to eat what your body will allow you. Younger people can afford to be riskier, they have time to correct mistakes as they get older. However, as those kids get older -they must be more careful how risky they are with their money, as they have much less time to make up for mistakes.

Keeping this in mind, allow us to start our first, and potentially most important lesson for the beginning investor- Calculating your retirement needs and understanding your risk tolerance: Basically, the younger you are the riskier you should be, as you get older your investment portfolio should change to protect your newly accumulated wealth and you should move your investments into less risky options. Pretty basic huh? Yes, I would agree – however too many people skip this first step all together and or don’t understand it at all.

Let’s shed some further light on exactly what this means by looking at an example of how two different aged people, starting investing and retirement planning at different times in their lives should go about retirement planning. I’ll take a look at a mother and daughter and compare what their investment strategies should be. The first investor, Mother, just turned 50 years old and has been investing now for about 10 years. The Mother’s daughter, whom just turned 30, has been investing for almost 10 years now too. These two people have very different objectives and goals to achieve from their investments, even though they started at the same time.

When Mother started to dabble in investing – she was 40, and she wanted to retire in about 25 years, and have the ability to support herself for 20 years without working. Mother knows this is a lofty goal but thinks there will surely be increases in life expectancy – so she wants to cover herself for as long as possible. She estimates she will have her home paid off by the time she is 60, and the only other income she will need to support herself will be for living expenses of which she estimates however many dollars per year she will need. She estimates those dollars to be 10,000 per year for 20 years – So, by the time she hits 65 she wants to have $200,000 in savings. Even though Mother could potentially make a bunch of money by investing in riskier stocks, she could potentially lose everything – thus preventing her from doing anything other than selecting a mix in her portfolio that will guarantee the outcome she wants. So, Mother picks mutual funds that guarantee a certain level of return with a certain level of risk.

So, Mother did the following:

1. She estimated when she could retire based upon when all of her major bills would be paid (cars, homes, credit cards,etc.) off.
2. She estimated how much money she would need to maintain a comfortable lifestyle for the remainder of her life after retirement.
3. She then set her investment goals to obtain and protect the amount of money she will need at retirement (We will get into further detail later as to what types of mutual funds would best fit her needs).

Now, her daughter on the other hand has nearly 35 years until she will ever consider the possibility of retiring as she is only 30. Her daughter started investing much earlier than her mother and has very different objectives and goals. Her daughter determined that she will have her house paid off by the time she is 50 and that she wants to live modest now in hopes of a fun life of travel during retirement. Her needs though come at a price, unlike her mother, the daughter will want $50,000 a year for the 25 years she expects to spend in retirement, or $1.25 Million dollars – so she can see all the things her mother didn’t get to and so her children can come along too. Not to mention, her daughter has to plan for her children’s college needs. Since the daughter began investing at such and early age, and has the ability to stay in the market for the long term, she has chosen an option that will make her much more money in the long run – however, it is much riskier. However, the Daughter understands, as she get’s older she will simply change her investment strategies to protect her money as needed.

Let’s summarize the Daughter’s plan:

1. She calculated when she wanted to retire and how much money she would need to maintain the lifestyle she wants after retirement. She figured out how much money it would take to pay off all of her bills and fund her children’s tuition needs.
2. She then set out to find a portfolio that matches her age and risk tolerance. She knows, as she accumulates more and more wealth and get’s older and older, she will have to sell off the riskier stocks and bonds for one’s with more certain returns and less risk.

The above Mother and Daughter example shows you how two different people correctly go about gauging their retirement needs and start thinking about their abilities to take on risk. Riskier investments = higher returns, safer investments = lower returns.

This is the extreme basics of retirement planning, we will build upon this knowledge going forward.

In addition, I have a Retirement Calculator that will help you figure out what your needs will be when it comes time to retire.

Please move on to the next lesson at your own pace, but don’t wait too long – or it may cost you! Learn the difference between retirement savings and benefit plans and the different investment types available to different types of workers (government, private companies, individuals not being offered a 401k by their employer, etc.)

Don’t have time to carry on now? Come back at your leisure, but don’t wait too long, every dollar wasted is a dollar not working for you. Also, consider signing up for my daily updates sent right to your in-box. Don’t worry, I hate spammers too.

Diversification is the key for the young and the old

What does diversification mean and why did my finance professors stress this word so much? I’m certain you have heard of diversity by now, as it is stressed in most every company. Well, diversity in your stock portfolio is extremely important too. Essentially, diversification means don’t put all your eggs in one basket. Now before you run off and claim you understand, let me further explain this important point: Diversification is just as important for the old as it is for the young. For example, just because you are young and wanting to take risks, you shouldn’t take all of the risks with one company or mutual fund or whatever your investment may entail, rather, spread those risks over several funds or investments. If I invest in one risky company, I could make a ton of money – however, I could lose it all too at any time. How can you combat that? Well, try investing in several different “risky” stocks, young buck.

You can accomplish this task by spreading your risks against multiple types of investments: Stocks, bonds, mutual funds, and money markets for example.

Furthermore, within the mutual fund field (for 401k investors) you have the ability to build a diversified portfolio of different types of funds; Such as value or growth funds, index funds, large and small cap funds and various other types of funds (I will later explain what these different types of funds are).

The key here is, if one is losing, chances are another will win – offsetting the chances of large losses.

Finally, diversify your security holdings by industries or geography. It is important to invest in several different types of companies across various regions to diversify your portfolio. If I were to show you a quick snapshot of my portfolio, you would see a portion of my assets are allocated across the world, to combat the falling dollar. International markets are a great way to combat local issues or currency problems. This was further evidenced in this past recession. In general, you should have around 25% of your portfolio allocated to international funds. Some people have a good argument in saying 25% is not enough, you need more exposure to international markets. Regardless, you should probably stay below 50% of your portfolio being invested in international funds.

Next up: Learn about how to make a retirement plan for yourself and family, and how to determine what your risk tolerance is and what approach you will need to take in investing. Determine how much money you will need for retirement.

Don’t have time to carry on now? Come back at your leisure, but don’t wait too long, every dollar wasted is a dollar not working for you. Also, consider signing up for my daily updates sent right to your in-box. Don’t worry, I hate spammers too.