With the steady decline of late-stage capitalism, money management is a popular topic these days. It’s no longer enough to have a job in a “stable” industry. There are hundreds of websites, books, and podcasts offering tips, techniques, and tricks on how to make your money make money.
But what if good enough is all you want? Navigating the terrain of financial topics when you’re content with just getting by is nigh impossible. There are a lot of strange terms to understand, and often someone is trying to sell you something to help them, not you.
This website will give a very direct introduction on how to handle your money. It’s not going to teach you how to be rich or how to budget your expenditures. It will instead guide you on the types of accounts you should have for intermediate and long-term saving goals. (It should be noted that most of the advice here is directed at individuals with accounts in the USA.)
Let’s start by defining the most important term when it comes to personal finance.
Claimed to be “the most powerful force in the universe,” compound interest is fundamental to understanding how money works in this world. Ancient Romans reviled the idea as an immoral loan that benefited the lender, but Western society warmed up to the concept by the 17th century. Compound interest is just a percentage amount that is applied to a chunk of money, usually monthly or annually. It can work for and against you.
Consider this: you have $10,000 in an online savings account. The bank offers you 1% interest over a year, which means that, if you kept the money in there without touching it, you should have an additional $100 after one year. Now, why do banks do this? Is it out of the goodness of their hearts? Not at all. While you park your money within a bank, the bank is, at the same time, loaning that money to additional customers. Your money is always “there,” but it’s not always yours. To “thank” you for keeping your money in the account (and allowing them to use it), banks offer an interest rate to incentivize you to keep your money with them (as opposed to under your mattress). If you keep that $10,100 in the account and continue leaving it alone, in another year’s time you should have $10,201. Thus, the longer you hold on to your money, the more it grows.
Similarly, assume you buy something worth $10,000 using a credit card. You have been loaned that amount of money by a loan shark; you must pay it back. To “incentivize” you to pay it as quickly as possible, the credit card company places a 25% monthly interest fee on anything you owe. Which means, if you don’t repay the full $10,000 that you borrowed in a month, the credit card company will expect $12,500 the next month. If you don’t pay back that $12,500, you will owe $15,625 the month after. (Note that credit card companies don’t actually want you to pay this back as quickly as possible; the longer you wait, the more you owe them.)
That’s the power of compound interest. Over a set amount of time, money grows by a repeating percentage. The more money you start with, the greater the amounts returned.
Let’s introduce two more terms.
You’re might already be familiar with what stocks are: a financial activity primarily dominated by men with very little melanin. Buying a stock grants you ownership of a company. When a business is just starting, they want as many investors as possible, so that they can have money to operate. After a while, their business grows and makes money on its own. Strong stock growth is indicative of a healthy business.
Stocks are traded on the stock market. After you buy a stock, if that company succeeds, you are paid dividends four times a year as a “thank you” for your investment. (This is essentially similar to how a bank operates: in exchange for giving your trust vis-à-vis an investment, you are rewarded as the business grows.) The more stocks you own, the more dividends you receive. If the company fails, however, you do not recuperate any of the money you spent on stocks. (Unless you happen to be an executive at that company.) Stocks are high risk, because you don’t know if a business will succeed or fail, but they are also high reward, because their growth has the potential to pay high dividends.
The best way to describe a bond is to think of it as yet another loan, except you yourself are the bank. When you buy a bond, what you’re actually doing is loaning money, either to your city, state, or national government. They in turn promise to pay you back, with regular interest payments. Bonds may be used to do anything from fund local transit projects to covering budget deficits.
Bonds are considered low risk, because governments typically pay back their creditors. (If a government collapses and is unable to make a repayment, there are far worse problems at stake.) Although you are paid back some percentage of interest, it’s a relatively low reward for the amount of risk you’re taking. Still, the interest returned from a bond is often greater than the interest returned by a bank, so they’re more financially sound for growing money long-term.
A reasonable balance of owning stocks and bonds, along with the power of compound interest, is fundamental in growing your assets.
With all of that understood, let’s look at some things you can do with your money, in order.
Step 1: Pay off all your debt
No one is saying that this first step is easy, but it is undoubtedly the most important move to make: pay off any debt you hold immediately.
As suggested by the section on compound interest above, credit card companies charge astronomically high interest rates. That $10,000 purchase you made could cost you an additional $2,500 at best if you don’t pay it back on time. The easiest way to not owe additional money is to not spend money that you don’t have. Of course, sometimes this is inevitable. You may need to borrow money to go to school, or to purchase a car that you need in order to commute to work. Sometimes, this is called “good debt,” because the theory is that these “purchases” will lead to better opportunities for more revenue. For example, by going to school, you’ll be able to land a high-paying job you couldn’t get otherwise; or, with a new car, you’ll get better gas mileage and be able to afford to commute further for work.
While incurring debt in order to make money is a reasonable thing to do (“You’ve got to spend money to make money”), there is no such thing as “good debt.” Having student loan payments to make does not place you in a better financial position. You will continue to pay extra money for a decision you made several years ago, for no reason, other than a lopsided capitalist system that seeks to punish you for attempting to advance yourself with higher education. Again, this kind of debt is often inevitable. But you should always focus on paying it down as soon as possible, by meeting or exceeding your minimum payment accounts, any way you can. Why should you pay an extra $20,000 on something that already cost $100,000?
It should go without saying: once you’re out of debt, don’t get back into it. Deeply consider whether a purchase that sends you back into debt will be a wise investment.
Step 2: Maximize 401(k) contributions
With debt out of the way (hooray!), it’s time to introduce a few more terms:
These are accounts which are taxed every year at tax season. They include savings accounts, stock market funds, and so on. Every year, when your accounts grow due to interest, you must pay taxes on that profit.
These are accounts most commonly associated with retirement plans with difficult names such as 401(k) or IRA. Every year, when these accounts grow due to interest, you do not pay taxes on that profit. However, when it is time for you to retire, and you begin to withdraw funds from these accounts, you must pay taxes on the amount you withdraw.
These are accounts which are almost exclusively for a special kind of retirement account called a Roth IRA. However, every year, when these accounts grow due to interest, you do not pay taxes on that profit.
When it comes to taxes, an extremely simplified summation of these three accounts would be:
- With taxable accounts, taxes are paid on the interest every year.
- With tax-deferred accounts, taxes are paid on the interest at a later date.
- With tax-free account, taxes are never paid on the interest.
At this point, you might think that that tax-free bucket seems pretty tempting! After all, your money can grow over time and you don’t have to pay any taxes on that profit. But, as with all things, there’s a catch, and we’ll get to that later. For right now, let’s talk about tax-deferred accounts.
Some places of employment offer a 401(k) plan. Assuming you are fortunate enough to be offered this, you should take advantage of it. But what is it?
A 401(k) plan is a type of tax-deferred account primarily associated with retirement. Crucially, a 401(k) account is funded pre-tax. Every month, your employer taxes a percentage of your gross pay and places it into your 401(k) plan. Often, they will also offer a “match”: for every amount you put in, the employer will also contribute some set percentage of your contribution. This is basically free money. The beauty of a pre-tax tax-deferred account is that you can save quite a lot of money with very little effort.
For example, let’s say you make $3,000 a month, before taxes. You decide to contribute 10% of your paycheck each month into your 401(k). Your employer also decides to contribute 1% of any contribution you make into your 401(k). In one month, you will contribute $300; your employer will also contribute $3. $303 may not seem like much, but with compound interest, the bigger the number, the more you end up with.
What if pre-tax dollars weren’t considered? After taxes, that $3,000 is actually going to be closer to $2,550 every month. If you contributed 10% of your after-tax pay, that contribution would amount to $255; your employer will also contribute $2.55.
Not only does paying into a 401(k) before taxes provide a greater contribution, it also provides a higher employer match as well. The money in this account will grow without tax consequences, so it makes the most sense to fund this bucket as early and as quickly as possible.
However, there is a limit to the amount of money you can save in a 401(k) plan. In 2019, the maximum contribution for a 401(k) plan is $19,000. This maximum tends to change every few years by about $500, so if you’re reading this some time in the future, be sure to check what your upper limit is!
Step 3: Maximize your savings
You have no debt and you’ve started some basic saving for retirement. Now it’s time to build up your emergency account.
This account should only be used for unexpected expenditures, such as repairs to a bicycle, medical bills, or if you suddenly find yourself unemployed. A good rule of thumb is to save about six to twelve months of your monthly gross income. For example, if every month you spend $3,000, have an account somewhere with at least $18,000 stored in it. Tilt towards the higher end of the “six to twelve” rule if you’re either particularly nervous or your job situation is unstable.
Keep in mind that if you’re having trouble funding your savings account, you shouldn’t send money in other purchases or frivolous investments in bitcoin. The good news is that once you’ve hit your number, you won’t have to keep adding funds in here. In fact—don’t. There’s no advantage to saving more, and you could get that money working in smarter ways.
Step 4: Maximize IRA contributions
With your 401(k) steadily growing, you might think you’re all set for retirement.
But you’re not! Saving for retirement is just about the best thing you can do, because you never know what the future will hold. Because of the magic power of compound interest, the more you save (and the earlier you save it), the more money you can expect to collect when you need to.
To that end, once you’ve set up a savings account, you can start funding an IRA. There are two kinds to consider:
- A traditional IRA (tIRA). The amount you fund into a tIRA can be tax deductible, but ultimately, any earnings in a tIRA is considered to be tax-deferred–you’ll pay taxes when you withdraw later.
- A Roth IRA is a tax-free account. Any contribution you add grows without any tax consequences.
In 2019, the maximum IRA contribution limit is $6,000. Unlike a 401(k), both IRA types are funded with after-tax money, presumably because the government would prefer that you continue working well past retirement.
If you’ve been following along, you would correctly believe that the Roth IRA is way better than the traditional IRA. But here’s where another tax-free “gotcha” kicks in: since a tax-free account is so appealing, not everyone can contribute to them. If your income level exceeds a certain amount, you are forbidden by law from contributing to a Roth. In 2019, for example, if you’re single and make over $137,000 a year, you cannot contribute to a Roth IRA. Check the federal “MAGI” laws for more information.
Step 5: Contribute to other taxable accounts
If, and only if, you’ve completed all the other steps, you’ve somehow achieved the near-impossible, and you can begin to consider contributing to other accounts. Growth on these sorts of accounts are taxed every year, but, unlike retirement accounts, you can use that money whenever you want, not just when you retire.
What other types of investments are there? Plenty. Although you could choose to invest in individual stocks, a much more sound financial strategy would involve investing in “a stock of stocks,” or a mutual fund. Just as buying a single share grants you a single sliver of ownership in a single company, buying a share in a mutual fund grants you a silver of ownership across whatever companies the mutual fund tracks.
Stock growth in a single company may be astronomical, but they are also more risky as they are much more susceptible to fall. A popular mutual fund option is ownership in the S&P 500, which tracks the top 500 U.S. companies. As businesses succeed and decline, a mutual fund tracking the S&P 500 will adjust its holdings accordingly. Thus, by definition, you are always guaranteed ownership in the most successful companies. This doesn’t mean you’ll always be making money, but you do beat holding individual stocks in one key difference: the market always goes up.
Although daily, weekly, and monthly fluctuations in the market occur all the time, the only true statement that can be made is that, over enough years, the market always trends up. A crash in the market may take two (or five, or more) years to recover, but it does recover. If a company flounders and fails, there’s no guarantee that it will recover.
If you do invest in stocks, don’t even think about selling them until at least five to ten years. The market will go down and up and down again, and if you buy a stock at $100 a share, and watch it fall to $75, you might be tempted to sell in order to prevent further loses.
Don’t. You cannot time the market. No one can. Who’s to say that that $75 won’t become $110 in another few months? As the chart above shows, with enough time, you are likely to come out on top. Invest in taxable accounts only if you’re certain you won’t need that money in the near future.
For a great read on how “staying in the market” can benefit you, read “What if You Only Invested at Market Peaks?”, which uses math and actual stock trends over the last forty years to demonstrate the above points.
Addendum I: What do I invest in, and how much?
Up until now, we’ve discussed what sort of accounts you should have, but we haven’t talked about where you should put your money. That’s because this is entirely based on personal choices. There’s no one-size-fits-all solution. The advice above is good information to guide you towards your goals, but only you know what those goals are. The savings plans for a twenty-two year old might not be the same plans for a fifty-five year old who is much closer to retirement!
Still, there’s a general balance that can be struck for your asset allocation between stocks and bonds. You want to own stocks because, over time, they will grow; and you want to own bonds because you are much less likely to lose money with them. A reasonable suggestion is to hold a percentage of “120 minus your age” in stocks, and the rest in bonds. For example, if you are 35, you could have 85% of your assets in stocks, and 15% in bonds. As you grow older, you are less likely to take on the risk of losing money, and so you need to rebalance your holdings to ensure that more of it goes out of stock holdings and into bonds.
If you don’t want to constantly rebalance (and no one will blame you), Vanguard has Target Retirement Funds to make the process much easier. The funds are named based on your age of retirement, and the holdings are automatically adjusted as time goes on. For example, the 2030 fund has a 70⁄30 stock/bond mix, while the 2065 fund has a 90⁄10 split.
If you’re able to take on more risk, or simply want your own custom ratios, that’s totally fine! You could take a look at holding stock in VTSAX or VFIAX mutual funds. Both track the entire stock market. The former tracks companies of many different sizes, while the latter only tracks the aforementioned S&P 500.
Addendum II: Additional resources
If you’ve read through all of this and are still eager for more information: relax. Everything after this point are either citations for everything described above, or, crazy minutiae when dealing with asset holdings. After getting yourself out of debt, remember that there’s more to life than worrying about money. Don’t deny your inner self!
JLCollin’s stock series breaks down strategies for handling your assets into digestable chunks. It’s very highly recommended.
The Bogleheads forum is an essential place for more information on the content described above. The Bogleheads are extremely welcoming to new and advanced investors alike. Some of the material on this site can be visualized over at the “Tax-efficient fund placement” article on the Bogleheads wiki.
Earlier statements on after-tax contributions are slightly oversimplified: there are ways to get around Roth limitations, but they depend heavily on your personal circumstances. For more information on that, check The Mad Fientist’s post on “After-tax Contributions”.