Lately I have been thinking more about personal finance matters. A few of my friends start making money and, needing to make set themselves up for the future, finding themselves befudded by the immense amount of information and choices out there. For some reason they figure that I might be a good resource for advice on this matter. I am not registered or anything, but I figure that I can point some people in the right direction.

Let me first make clear, though. The money you make in your twenties is a pittance compared to the money you make later. You make like $100 and you’re like OMG that’s so much. By your 30s that’s nothing. The disparity is so large that I wish I spent a WHOLE lot more when I was younger, spending money to experience more cool things and trying out new opportunities. It is for that reason a lot of people in my college (unpaid) internships told me, “Jonathan don’t worry about the money. Just worry about finding a job you are good at and can enjoy.” The rest takes care of itself.

Because of the above, I think what’s more important is building the good financial habits that really pay off in the long run. Right out of college, I quit my accounting job because I hated it so much but found myself making $15 an hour doing freelance work for startups. I made nearly nothing but saved like $100-150 a month. Tiny but once I started making decent money in a full time (which by the way, was NOT a big improvement), I saw my savings zoom up and then the cash flow I had for hitting debt or adding to savings rose.

With all that being said, it is never too early to start setting things up even if you think there have no money to invest. This means stuff that might seem confusing like 401Ks and IRAs and brokerage accounts and such. I am going to try to explain what these things are on a basic level. You gotta do the rest yourself!

IRAS/401Ks

An IRA/401K is a tax sheltered brokerage account. A brokerage account is an account that you can log in on with and buy stocks. Practically the only difference between an IRA/401K and a regular brokerage account is that you can put only a limited amount of money into the IRA/401K. The regular brokerage account can be funded to your heart’s content. But the cool thing about the IRA/401K is that the money you have funded into the IRA is “tax sheltered”. What does that mean? We can talk about that later. Just keep that phrase in mind.

You buy stocks in the IRA just like you do with the brokerage account and then those stocks grow. At a certain age (59.5 years) hopefully the account has grown in value and you can withdraw the money for use in retirement. I generally recommend Fidelity or Charles Schwab for an IRA. The reason is because their fees are super low. Olivia has an IRA with Fidelity and it just sits there. There is no annual fee or opening cost. You pay for trades and $50 for closing the account. That’s it. Also the Fidelity iPhone app is really nice.

IRAs and 401Ks exist because they let you manipulate how much you pay in taxes for your invested savings - remember what I said about the ‘tax shelter’ phrase? For some types of these accounts you can put them off into the future - meaning that you don’t pay taxes for the $2000 of income you put into the account but you DO pay taxes for it when you eventually take it out for retirement (after you turn 59.5). But hopefully by then the $2000 or so has grown to a big amount by then.

What’s the Difference between them?

A 401K is opened with an employer and you can contribute up to a certain amount to the 401K. You invest in stuff and then the investment gains are not taxed until you finally take it out. A 401K is sponsored by an employer so it is not particularly easy to open for yourself. It is different from an IRA because you can fund it with more money than you can for an IRA.

The money that you contribute to a 401K is deducted from your taxable income (which is called, AGI, recall the passage from your notes). So if I open a 401 and then put $5,000 into it then at the end of the year I get to take $5,000 out of my AGI (annual gross income). So when I calculate my taxes I multiply a percent (20% for those who make about $60K or so annually) by my AGI to get the taxes I need to pay. Now I have saved $5,000 x 20% ($1K) from the taxes I need to pay!

The best thing about a 401K is that when you contribute to a 401K, sometimes the employer does a match, meaning if you add $500 they add $500 (usually not 1 for 1, usually a percentage). If your employer offers that you should do it. It is free money.

An IRA is more personal. The limits to contribute are smaller. There are generally two types of IRAs. A traditional IRA works very similar to the 401K. You put money into it and you get to subtract that amount from your AGI. A Roth IRA is cool because it works in the reverse. You DO NOT take the money out of your AGI, but as a result when you finally withdraw it later it is tax-free. It is not really a freebie because you already paid taxes on it back when you contributed.

Note that almost in all cases you cannot really take that money back out without paying a tax penalty (that 20% or so, it is calculated in a specific way). There are a few exceptions to that rule - usually involving money for a house down payment or a medical emergency.

Since an employer sponsors a 401K, what happens when you leave that employer? What happens to the money in it? There are a number of different things, most of them involving a phrase called “rolling over” which is a way to transfer the money out without incurring tax penalties. There are some finicky ways of getting these things to roll over with rules but I think the rules make intuitive sense. You cannot roll over a 401K to a Roth IRA because if the government allowed that then people would not be paying taxes at all. A 401K lets you put off taxes into the future. A Roth IRA lets you to pay taxes now. That won’t work without tax penalties. But you can roll over to a traditional IRA and that’s tax-free. Check out this link for more info (https://investor.vanguard.com/401k-rollover/options). You can definitely roll it into a traditional IRA so I would recommend that.

What Needs to be Done

So what are the decisions you should have to make besides, “Hi I want to open a Roth IRA?”. What about what to invest in? Do I need to check in with the accounts or can I assume that me putting money into it is all I need to do?

Choosing what to invest in is usually pretty simple. I actually wrote a blog post with an ETF/investment that I think would work well for pretty much everyone, VYM. You pick to match up with the stock market as a whole. Fidelity is cool because they have a number of broad funds that match the stock market and they don’t charge you a dollar to buy them (https://www.fidelity.com/etfs/ishares). Schwab also has their own set of ETFs that you can buy for free too. They are all good choices but a decent combo would be:

50% US stock (ITOT or VYM) 30% International stock (IXUS) 20% Bonds (AGG)

Once you buy the stock (usually to the amount of the cash you have invested into the IRA or 401K), there is little else that you need to do. You need to reinvest dividends (dividends are cash payments paid out ever so often. They can be deposited to your account or made to be reinvested. You should reinvest them).

But after that once you buy and deposit up until the limit you don’t need to do anything. Check it once a year and that’s about it.

Life Goals

If you invest $5,500 (the maximum Roth IRA allowable) annually and it grows at 6-7% a year for 40 years then you will have $1.1M at the end of the time period. That being said, once your household starts making an AGI of a certain amount (currently at $117K) then you cannot make that much of a contribution. And also as I note, we can’t presume that we will get 6-7% anymore. More like 4%, which translates to $500K. This means we need to save more in our non-tax protected accounts.

However in today’s market environment we don’t get 6% yields anymore. More like 2-4% so that is about $20-40K. That is not the end of the world, because you can sell part of that $1M to reach your financial goal but that also lowers the annual yield. Adding to that again though is the fact that the 2-4% assumes that we are taking a lower amount of risk. If we are willing to take more risk then we can raise that amount of yield. But taking more risk means that the $1M is more likely to take more losses when we get into a market crash (and there is always going to be a market crash).

Not only that, I think what is going to be important in the future is that we are going to need a lot of money in the coming years. $1.1M is frankly not enough. Today people live to about 90-100 years, which means 30 years of retirement if we retire at 60 (most people won’t. We should expect to work until 70). And not only that there is the cost of kids ($1M per child when including college) and a home ($1M+ on the West Coast) to live in. I think the IRA is good but the next step is to start building good financial habits, saving more and keeping costs low (but don’t go crazy).

Build these financial habits now and it’ll pay off itself more than any IRA or investment. It is indeed confusing but having it set up is going to help because once you start learning good financial habits, they stick with you even as your income goes up. So don’t worry about the numbers or whether or not they are pennies or such. You are learning habits. Live within your means, don’t buy a Ferrari when a Toyota can do, and things will be alright.