Making Sense of Investing

Disclaimer: The statements made in this post are the opinion of the author. They should not be viewed as financial advice. Please consult with a financial specialist before making any financial decisions.
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This post will be the last in the first string of “Money Basics” posts. If someone read only these posts, and did nothing but the bare minimum recommended in each of them, they would, in time, become financially free. The way to financial freedom varies considerably, but the most common involves good old fashioned investing. This is a topic that everyone knows a little about and that everyone knows they should know more about it, but everyone takes one look at the charts, options, graphs, jargon, and junk presented at various HR meetings and they decide to ignore it.

So here it goes: investing 100.5 (because 101 just seems too confusing).

What does investing mean?

Investing is simply giving an entity (or an individual) money whether in the form of stocks (a portion of ownership in the entity), bonds (glorified I Owe Yous), or buying any other type of asset in hopes of getting more money back in the form of interest. This post will focus mostly on investing in stocks and bonds because that is where most people do majority of their investing without even thinking about it.

Stocks and Bonds investing is what you are most likely doing if you have any kind of job that has any kind of retirement plan. What these plans are range greatly, but regardless of what your plan is, if you have a retirement account, then you are investing in Stocks and Bonds (almost) guaranteed. This is where it can become confusing.

What options do I have when investing?

Unfortunately, the answer to this question depends greatly on how you are employed, if you are employed, where you are employed, by whom you are employed, and so many other factors it is mind boggling. So instead of telling you how you can invest, I will briefly cover all the ways people can invest, then I’ll give you homework to find out which of these options are available to you. (Yes, I said homework, I’m a teacher, so get over it).

401(K) The most common option is the 401(K). A 401(K) is available through your employer (most likely). How it works is any money you put in is NOT taxed that year. Employers also often give an employer match (read free money) on however much you put in up to a certain percentage. That money is used to buy stocks and bonds, which is usually handled by a third party investing firm, and it grows tax free until you reach retirement age. I won’t even bother with retirement age because it is becoming a moving target. Once you’ve reached retirement age, you can pull that money out at which point it is taxed. If you pull it out early then you have to pay a penalty, so make sure any money that goes in you can afford to keep there until retirement age.

403(B) The 403(B) is another common retirement investing option. The only substantial difference between a 401(K) and a 403(B) is that a 403(B) is generally offered to government employees (or non-profit organizations) and a 401(K) isn’t. The employer match can be offered for this as well.

IRA This stands for Individual Retirement Account and the only difference between an IRA and 401(K) is that an IRA is opened up by an individual and is not offered through your employer. Since it isn’t offered through an employer there is not match offered.

457 A 457 is an AWESOME account, but sadly it is only available to government employees and occassionaly non-profit employees. The 457 acts like a 401(K), but what makes the 457 special is that whenever you stop working for that employer you can start to withdraw those funds (taxable of course) so this is great for anyone that wants to retire early or wants a runway built up tax free to tap into between careers. Employer matches can happen here, but it is highly unlikely.

Roth Accounts All of the above accounts have their alter-ego: the ROTH account. To understand what a ROTH account is, just insert the sentence “this money is taxed BEFORE it goes into the account and NOT after it comes out” into the definitions above.

Other Vehicles for Investing

HSA The Health Savings Account (HSA) is a powerful tool to consider, but it has a lot of guidelines you have to follow. First, as a Health Savings Accounts it is meant to be used for medical purposes. This is how it works. You put TAX FREE money into your HSA that YOU own, then if you need the money for medical expenses you pull out the money TAX FREE and use it. Second, this option isn’t available to everyone, the main requirement is that you generally need to have a high deductible insurance plan. So if you don’t have that, you can probably disregard this paragraph for now. Third, not every HSA provider allows you to invest the money (did I mention tax free) so you need to do your research to choose a company that allows that. There are many more benefits to an HSA we can’t discuss in investing 100.5, but my last piece of good news for the HSA is that once you hit retirement age you can use the money in an HSA like any other retirement account.

Taxable Brokerage Accounts The problem with all of the above options is they are very restricted. All of the traditional retirement accounts listed above have certain restrictions on how much money you can put into them each year. If you are like most Americans, contributing up to the limit of $19,500 (in 2020) into your 401(K) seems like a pipe dream. But as you spend less than you earn and increase your income, that will become more obtainable to you. After that, or whatever you decide to do, you may want to start investing elsewhere. A taxable brokerage account doesn’t have the tax benefits that the previously listed accounts do, but you can pull out the money at anytime. So if you plan on living off of your investments before retirement age and you don’t want to pay a penalty, then you will need a taxable brokerage account.

Retirement Vehicles that are NOT Investing

Social Security Benefits The Social Security Benefit is not an investment because you have no control over it. You could get the same amount that your parents get, you could get substantially less, or you could end up getting way more (but I doubt that). The point is that there is nothing within your control when it comes to Social Security. The wise financial person will realize this and NOT calculate social security into their retirement and just be pleasantly surprised when/if they get it.

Pension Plans If you are part of the quickly dying breed of employees that work for a company with a pension plan, then you are lucky–especially if you are close to retirement. I work for the state, and therefore I have a pension plan, but I can tell you right now it is broken. They have complex systems of tiers, years, and averages that will make anybody’s head spin and the only thing it comes down to is they are giving away less and less money every year because they just can’t afford it. So if you have a pension plan, my advice is the same as the Social Security Benefit, DON’T plan on it, but enjoy it if it is there.

Conclusion

That is the break down of the different types of investing. I realize that even at the 100.5 level it can be incredibly confusing. That is why I have created the table below to help breakdown the different elements in a simple graphic manner. Also, every type of investment account listed above is defined on my Running List of Definitions post for your reference. I hope you can tangle through all of these crazy letter and number coded retirement accounts to choose the best option for you.

Retirement Accounts Simplified Graphic

For those that have been following along at home, you are tracking your spending, spending less than you earn, and building your emergency fund. Once your emergency fund is satisfactory, then what? Then it is time to invest. Max out any retirement account you feel is best to get the maximum tax advantage, or contribute to your taxable brokerage account to have additional income, or put money in your HSA for medical expenses and retirement; it depends on what works best for you. Regardless of what you choose though, starting is always better than waiting on the sidelines. So start investing today!

Which retirement vehicles are you using? What questions do you have about choosing a retirement vehicle? What advice do you have for retirement investing. Tell me about it in the comments below.

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Definitions

Financially Free (See Financial Freedom): Being able to cover all of your expenses each month without having to work. This doesn’t mean you don’t work, and it comes in a variety of ways from investing in stocks to real estate to businesses, etc. Your path to financial freedom is your own.

Investing: Giving an entity (or an individual) money whether in the form of stocks, bonds, or buying any other type of asset in hopes of getting more money back in the form of interest.

Stocks: Buying a certain percentage of ownership or “shares” in a company. The company uses the money received from selling shares to grow the company then pay back the owners of shares in the company with interest.

Bonds: To raise funds for a project an entity (usually a government) will sell bonds or certificates saying that if you pay X amount now you will get X back with interest later. This gives them the money they need now and gives the investor interest on their original investment later.

Assets: Things that put money into your pocket every month (or year). Sometimes equity in your house is also included as an asset, but I prefer not to include it. A car loses value every year (depreciates) so it is NOT an asset.

Interest (Investing): Money returned on top of the original amount of money invested. For a very simplified example, if I invest $1,000 at a %10 interest rate than I can expect to receive $1,1000 back.

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