“I’d like to learn how to invest.” This is something I hear a lot from friends and prospective clients. If you want to learn about money investing for beginners then read on.
When I was in college, I was jealous of my classmate James who had a portfolio of stocks he would check during class. I didn’t know anything about investing back then (I was a biology major), and although I wanted to, it seemed out of reach. Perhaps you feel that way too. When would you want to contribute to a Roth 401(k), instead of the traditional pre-tax option? What is the right combination of stocks and bonds? Should I only invest in US stock funds? We will discuss money investing for beginners strategies and more below.
Most of us already have investments through our employer-sponsored 401(k)s. You may have randomly chosen several funds to put your contributions in or sought advice from your smart uncle or co-worker. But regardless, your 401(k) savings are invested in either stocks or bonds. Let me explain.
If Elon Musk wanted to borrow money from you, would you lend to him?
If you lent Elon Musk $10,000 to help him produce a Tesla car, and he promises to pay you back in 5 years plus 4% interest, then you’ve bought a bond. Most bond funds contain bonds issued by the U.S. government and top-notch U.S. companies which will very likely pay their obligations, so this is considered a conservative investment.
If you gave Elon Musk $10,000 in return for being a part-owner of Tesla, then you’ve bought a stock. If Tesla wins big, you win big. But if it goes bankrupt, you lose all your money. It’s high risk/high reward.
You can eliminate the risk of being exposed to just one or a few companies by buying into a stock fund that invests in several hundred companies. There are plenty of stock funds to choose from in your 401(k).
What’s the right combination of stocks and bonds?
It depends on: 1) how long before you need the money, and 2) will you panic and sell all your investments when you see a CNN headline that reads, “DOW DROPS BY 800 POINTS!”
If you’re saving for retirement and it’s about 30 years away, and you believe you can remain steadfast during the next recession and just continue with your monthly contributions, then you probably can invest more aggressively.
If you’re saving for a house down payment 5 years from now, then you probably should invest more conservatively. Stocks can make us a lot of money over long periods of time, but no one knows what it will do over the next few years, since the true value of stocks is masked in the short-term by human emotions—namely fear of losing your money and fear of missing out.
Diversify, diversify, diversify
Question: If you choose 5 U.S. stock funds in your 401(k), are you properly diversified? What about 10 funds?
Answer: If they’re all in U.S. stock funds, then it’s invested in just one type of investment.
We intuitively know we should not put all our eggs in one basket. But true diversification means your 401(k) or IRA portfolio is invested in several different types of investments, which may include international stocks, stocks in developing economies, small company stocks, and emerging market bonds.
If you work with a credentialed investment advisor, s/he can explain in greater detail the differences between investments you can make in your 401(k) and IRA. S/he can help you choose which ones make sense to invest in, based on the current risk/reward profiles.
Choose the best investment vehicle for you
Next, we discuss how to choose from different investment vehicles (Roth IRA, Roth 401(k), Traditional IRA, brokerage account). We will also discuss the impact of fees in your 401(k) and IRA (Hint: It’s in the magnitude of tens of thousands of dollars).
You are contributing to your 401(k) to get the full company match. Because you live beneath your means, you are still generating excess cash each month and would like to invest it. Where is the best place to do so?
Option 1: Roth IRA
While a 401(k) is set up through your employer, an IRA is a retirement account that you’ll have to open by yourself through a financial institution. It stands for Individual Retirement Account. An IRA allows us to make additional investments in a tax-advantaged way. A contribution to a traditional IRA can be tax-deductible and will grow tax-deferred. Meaning, you don’t pay taxes on the money you make while it’s inside the IRA, but you’ll have to pay taxes once you withdraw it.
A Roth IRA is another type of IRA. It is one of the best places to invest your savings, because your future earnings will be tax-free! Let’s say you invest $5,000 a year in a stock mutual fund through a Roth IRA that generates an average annual return of 6%. In 30 years, you will generate about $250,000 in earnings – all tax-free!
Not everyone is eligible to contribute to a Roth IRA. You can contribute the full amount ($6,500) in 2023 if:
- You have earned income (you receive at least $6,500 in wages via W2 or 1099); and
- Your adjusted gross income is less than $153,000 if you file your taxes as single, or less than $228,000 if you file married filing jointly.
Option 2: Roth 401(k)
If you have excess cash to invest, you can increase your contributions to your 401(k) up to the maximum allowed by law ($22,500 in 2023).
Better yet, think about contributing to the Roth portion of your 401(k) plan, if it’s available.
There are no income eligibility requirements for a Roth 401(k). Meaning if you’re single and make $154,000, you are not eligible for a Roth IRA, but you are allowed to contribute to a Roth 401(k) via your employer’s 401k plan (if your employer makes it available).
Question: When would you want to contribute to a Roth 401(k), instead of the traditional pre-tax option?
Navigating the complicated income tax code can make deciding between a Roth vs. traditional 401(k) seem complicated. In simple terms, it all depends on if you want to pay taxes now (Roth) or at the time you withdraw the money (traditional). If you are in the lower income tax bracket, then the Roth option is probably best. However, if you are in your peak earning years and near retirement, then you probably want to take the tax breaks today and contribute to a pre-tax traditional 401 (k). This means that you will pay income taxes at a lower tax bracket during retirement rather than during your high-income years. Here are the tax brackets for 2023.
Option 3: Taxable Brokerage Account
If you’re maxing out your 401(k) and IRA contributions and still have excess cash to invest, you can create an individual or joint taxable brokerage account. You will get a 1099 each year on the dividends that you will earn and you will include this in your tax return. You may also have to pay capital gains tax each time you sell a fund that has risen in value.
The upside is, there are no withdrawal restrictions.
Are there termites in your investment funds?
Each fund in your 401(k) or IRA charges a fee, mostly to cover hiring & overhead costs of running the fund. It’s called Expense Ratio. It typically ranges from 0.03% to 2%.
Question: How much difference does it make if we invest in a U.S. stock fund that charges 0.2% versus another U.S. stock fund that charges 1.2%?
Answer: A whole lot! In the graph below, we can see that we lose more than $30,000 to fees in the higher-cost fund, given a $10,000 investment that makes an average annual return of 6% (before fees) over 40 years.
Within each investment category, look for a fund that has low fees. If you see the word “index” in the name of the fund, that usually indicates lower fees. That’s because their hiring costs are lower. Studies consistently show that over Studies consistently show that over 90% of these lower-cost funds outperform their expensive counterparts over a 20-year time horizon.
Money investing for beginners is like gardening.
It takes a lot of patience and due diligence. You need to choose the right type of seed (asset class) and soil (tax-advantaged vehicle). You plant a seed (initial investment), water it frequently (monthly contributions), and you’ll be rewarded to see it grow over time.
More financial advice blogs that may interest you:
Tax Free Investment Options for YouTubers
Three Biggest 401k Mistakes
Legal Roth Hack
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.
