Investing in the stock market doesn’t have to be hard or time consuming. This guide is intended to provide an approach that takes minimal time and can get you decent returns over the long term if you’re investing for multiple decades. Once you learn how and start, continuing is relatively easy. This is a complete guide to getting started.
Investing in stocks you heard a “tip” on is a great way to lose money. It’s important to understand what you’re investing in, why, and what the expectations are. This strategy is a long term approach to slowly grow wealth over time with minimal effort as you focus your time and attention of building bigger income streams in your work life. Ultimately investing is a balance of risk and reward where the risk includes time you could have spent doing other things. This is why we propose a simple approach so that you make money over the long term and spend minimal time doing so.
If you live outside of the United States, most of these principles still apply, but the brokerages account types, numbers, and funds may be different.
Disclaimer: This is not investment advice, but rather a description of a general simple investing approach. Ensure you have an emergency fund covering at least 3-6 months of expenses in a liquid account (e.g. savings account) and no high interest debts before investing. Investments can make or lose money. Do your own research to determine the best investing path for you.
The inflation rate is typically around 2% which means if you hold cash you lose approximately 2% in purchasing power every year. The stock market averaged around a 10% return over the last century. The gains you make compound, which means if you’re invested the gains you make will also gain additional money. The stock market has made less and more over shorter time frames, which is why we invest for the long term. For example, if we look at the best and worst 10 year returns for the stock market, it’s -3% and 20% respectively. However, if we look at the best and worst for a 20 year period, it’s 6.4% and 18%. From this we can learn that by buying and holding for a long period of time, we have great odds of success at ending up with significantly more money than we invested.
As an example, if we assume we earn 7% (10% average minus 2% for inflation and a 1% margin of safety) and invest $2,000/mo over 15 years on average we’ll end up with $603,096.53. Uninvested, this would have been been $360,000 ($294,146.21 after expected inflation). By investing in this scenario we’d end up with an extra $308,950.32 after inflation. Can you invest more or less? Will you income grow over time so that you can invest more? By following a simple investing strategy, you’ll have more time to focus on growing your income. Here’s a few more examples starting at $0 with a 7% expected return:
|Amount invested per month||Contribution period||Account balance at end of time period @ 7%|
Keep in mind these averages are not guaranteed, but rather a general estimate of how the investments might perform.
Where does the money come from?
In this guide we’ll talk about stocks and bonds. When you buy a stock, you’re buying a percentage of a company. You can receive money in the form of dividends, which are regular payments from the company to you. Like a personal budget, companies have income and expenses. Companies can can use their money for a variety of things like dividends, stock buybacks, and investing in their business. Each individual company decides when, if, and how much dividends to issue. You can also receive money from stock price appreciation. The stock price can appreciate for a variety of reasons. With stock buybacks, a company buys back it’s own stock in order to reduce the number of outstanding shares. This typically increases the value of your shares because there’s less of them now. Additionally, if a business invests in itself, grows, and starts earning more money the company becomes more valuable because stocks are typically priced in terms of how much the company makes and what their expected growth trajectory is.
With bonds, you’re investing in government or corporate debt. This means the government or company promises to pay you back at a predetermined date and interest rate. Additionally since you can buy/sell bonds, they go up in price if the federal interest rates fall and down in price if the federal interest rates rise. An example is if you buy a government bond for 7 years at 3%. The government promises to repay you at 3%, so if interest rates down, the federal government will then lower the interest rate for their bonds. If someone can buy a 2% bond on the open market, your 3% bond is more valuable. Likewise if interest rates go up and the federal government starts issuing bonds at 4%, your 3% bond is less valuable.
Choosing individual stocks and bonds that perform well requires in depth knowledge and research. For this reason, a long term investing approach with index funds allows us to invest in a collection of stocks and bonds to get the average return of the market with minimal effort. An index fund is simply a pre-determined basket of stocks and/or bonds, so we’ll be buying hundreds to thousands of stocks with a single index. This also simplifies managing the account. Examples of Total Market U.S. Index Funds include FSKAX for Fidelity or VTSAX for Vanguard.
What if the stock market goes down?
If the stock market goes down over a period of months or years and you’re still investing, you’ll be investing at discounted prices. The stock market is always in one of two conditions: all time highs or drawdowns (when the market goes down). Based on the last century of data, it has always gone up over the long term (20+ years), so if you continue to hold and invest, it will likely go back up. Selling when the stock market is down is typically a bad idea because you’re losing money. If you know it’s very likely to go back up in the future, holding onto the investment will help you still make money without worrying too much or trying to time economic conditions.
How much to invest?
First, save for any short term goals you have. Investing is for a long term horizon (more than 5-10 years). These short term goals could be things like saving up an emergency fund, paying off debts, saving up for a down payment on a house, etc. Once you have met all of these goals, investing as much as possible regularly every month will help your investments grow faster.
How to invest more
- Work for a promotion at your current job. Ask your boss what levels there are and what you need to do to get to the next level.
- Apply for higher paying jobs. In some industries you can get 20%-100% raises just by switching jobs.
- Learn new skills to apply for higher paying jobs. Read books and watch videos before or after work, go to college for a new career or take classes onlike like Coursera.
- Work a side hustle like your own side business, contracts for your skills on the side, gig economy jobs, etc.
- Cut expenses ruthlessly: sell a fancy car with monthly payments and drive a beater you can buy cheap in cash, find roommates, do work on your house yourself instead of hiring it out, examine and reduce recurring expenses, etc.
- Save on investing fees and taxes with some of the strategies below.
This simple approach is provided so that anyone can manage their own investments. Using an investment professional can allow someone to guide you in creating a more complete picture of your own personal situation, but typically comes at a high cost. There are two main types of financial advisors: fee based and asset based. With fee based you pay directly for services as you need them. With asset based the fees are more hidden in that they charge you a percent of your invested assets and take the money out of your account behind the scenes. If you must go with a financial advisor, strongly consider the fee based approach so that it’s more clear to you what you’re paying for the service.
Here’s a few reasons to learn to manage your own account rather than have someone handle it for you:
- No one has your best interests in mind more than yourself.
- Asset based advisors can be very expensive. For example, if you save and invest $1 million and they charge 1%, you’ll be paying $10,000 every year, or $833 per month. If you kept this money invested, you’ll build a larger investment and be able to withdraw more.
- Financial advisors typically try to sell you products like life insurance, annuities, etc because they earn commissions when they sell you these products. Annuities are known for having high fees and separate life insurance may not be necessary if your job already provides it or you already have a large nest egg to leave your family.
- Advisors can be incentivized to buy funds that earn them commissions, but may not be the best investment for you. For example, they may buy a load mutual fund with a sales commission or a mutual fund with a high expense ratio that costs you money every year for owning it. We’ll talk more about how to minimize these things later.
Primary account types
Most people have 401k plans available from their employers and employers typically match a small amount of money contributed. For example, if your company matches dollar-for-dollar up to 6% and you invest 6% you’d double your money immediately. If you don’t have a 401k plan there are alternatives for government/non-profit employees, self-employed, etc such as a 401(a) plan, SIMPLE IRA, etc. A 401k plan is a great place to start investing assuming your employer has a good selection of funds (we’ll describe how to select funds further down) and doesn’t charge high fees. A 401k is tax-advantaged in that money can be contributed pre-tax. This allows the money to grow quickly and you don’t have to pay income tax on it until you withdraw the money. The main downside of a 401k is that you cannot withdraw the money until age 59.5 without penalties. This means you’ll need to save enough to cover expenses until then in other account types if you plan to retire before 59.5. There’s typically a limit in how much you can contribute to a 401k. In 2021 it’s $19,500 if you’re under age 50 and $26,000 if you’re over age 50. Once you fill the pre-tax portion of your 401k, some plans have an after-tax portion that can be used for additional tax savings, but they’re more complex.
An Individual or Joint Brokerage account allows you to invest money you’ve already paid taxes on. It’s a “taxable” account which means you’ll be taxed on dividends and gains when you sell. For this reason it’s not the most tax efficient account, but has fewer rules and restrictions than some of the other account types.
A lot of people use IRAs (Individual Retirement Account) and they have a lot of rules around how they’re used, so for the simple approach we’ll start with a 401k and a taxable brokerage account. Once you have mastered those, moving onto IRAs, 529s, HSAs, etc. can help you reduce your taxes, but your account management will get more complex over time as you expand to more account types.
Simplify, simplify, simplify
As you start investing, it may seem small to add another account, but as you continue on throughout your life you’ll keep opening new accounts for one thing or another.
When choosing your brokerage, try to use a broker you already have. For example, if your company 401k is with Fidelity then investing with Fidelity will help you maintain less account logins, remember less websites layouts, and deal with less places to login for tax forms at the end of the year.
When you first get started, starting with a 401k and Individual Brokerage and a basic set of funds is a good start. As you get more practice you can start adding other account types and funds to save money on taxes. It makes it easier to master the basics first before setting up a lot of account types with complex rules.
Don’t try to time or beat the market
If you want to spend as little time as possible and get comparatively good returns, get the average of the market by using passive total market index funds. You’ll be buying hundreds to thousands of stocks at once with a single ticker. If the stock market goes up, that’s great because you have more money! If it goes down, that’s great too because you can keep buying stocks at a discount!
You can generally identify passive funds by looking for a low Expense Ratio (less than 0.1% for domestic and slightly higher for international funds). A passive fund simply invests in a pre-determined list of stocks. Total market index funds typically invest in a couple thousand of the biggest stocks in the stock market. They’re typically “market cap” weighted, which means you’ll be investing the most in the largest stocks.
Why not buy individual stocks?
Succeeding in purchasing individual stocks takes an extraordinary amount of time and effort. By purchasing an index fund and averaging the market return, we gain diversification and don’t have to spend a lot of time doing research or monitoring the market. This frees up our time to earn more money in other ways. It also helps prevent major mistakes where you’d lose money if something went wrong with one of the companies for the stocks you picked.
Suppose you purchase a single stock and news comes out that the company you purchased didn’t meet expectations for their financials. That stock would fall and you’d lose money. This can happen to individual companies, sectors, or even the entire stock market. By diversifying across companies, sectors, asset classes, countries, and time we can mitigate this and lower our risk. Here’s a few examples:
- Diversify across companies: Index funds purchase hundreds to thousands of companies.
- Diversify across sectors: Total market index funds purchasing hundreds to thousands of companies are across all major economic sectors, e.g. tech, healthcare, etc
- Diversify across asset classes: With the simple approach we diversify by purchasing stocks and bonds. Some people like to purchase REITs and/or commodities (e.g. gold) to diversify more, but for the most simple approach we just stick to stocks and bonds. Real assets like REITs and Commodities can help reduce the amount your portfolio goes down if stocks crash at the cost of additional complexity in managing your account and potentially lower returns over a long time frame.
- Diversify across countries: By investing in domestic and international stocks, if the international market outperforms the U.S. it’ll help keep our portfolio balanced and reduce our risk of the domestic market underperforming for long periods of time.
- Diversify across time: By investing over a long enough time period, we will continue contributing as much as we can over time. This means if the market goes up or down instead of buying all of our stocks/bonds at once, we’ll be buying over time and will average the ups and downs of the market. We pay a closer to average price for the stocks instead of over or under paying. This is called Dollar Cost Averaging.
Typically 20-30% of your portfolio is recommended to be invested internationally. This helps lower your overall risk in the long term. Investing internationally has increased costs and are less tax efficient than investing domestically. Because of this, even though the world stock market is approximately 50% international and 50% U.S., 20-30% international is a good balance to diversify your portfolio and lower risk without significantly increasing costs. Additionally, many U.S. companies are multi-nationals that buy and sell goods worldwide.
3 fund portfolio
For a simple long term portfolio, we’ll Invest in 3 areas: Domestic Stocks, International Stocks, and Domestic Bonds. Why these 3? Domestic stocks have historically performed very well over the past century in the long term. International stocks are great for diversification, but they typically have more fees and taxable events than domestic stock. Sometimes people will add in International Bonds and/or real assets like REITs and Commodities, but investing simply with these 3 makes it easy to manage the account at the cost of additional diversification.
Want to see what other portfolios you can build? Mebane Faber’s book on Global Asset Allocation has a great overview of different strategies and how they have worked out. However, these portfolios require more funds, which means more time spent selecting the funds and managing your account.
Every dollar you spend on fees is money you could have invested earning you more money and increasing your return on investment. Here’s a few ways you can minimize fees:
- Manage your own investments instead of paying an advisor (you must have the discipline to write and follow a plan to do this)
- Choose whole market index funds with low expense ratios instead of actively managed funds
- Choose a brokerage account with as few fees as possible. The common ones to avoid are annual account management fees and trading commissions
- If you buy mutual funds, buy no load mutual funds which do not contain a sales commission
- Never pay high interest credit cards, student loans etc. Pay these off first before investing
ETFs and Mutual Funds
ETFs and Mutual Funds combine many stocks into a single fund.
- Either is fine for the simple approach.
- Mutual funds trade at the end of the day. You can typically create automatic investments with them.
- ETFs can be traded any time during the day. They’re typically more tax efficient in individual accounts than mutual funds.
Exception: Vanguard Mutual Funds have increased tax efficiency due to a patent they own.
A REIT is a Real Estate Investment Trust. REITs own, operate, or finance income producing properties (e.g. rental houses, cell phone towers). They typically have higher dividends than stocks and some people use them as a real asset category or to overindex on the real estate sector. Avoiding them helps keep things simple due to the following reasons:
- They typically have higher dividends, but they are taxable at the higher ordinary income tax brackets which makes holding them in a taxable account unfavorable.
- By buying them you’re overindexing your portfolio on the real estate sector.
- Owning a personal and/or rental home can also keep you invested in the real estate market.
- By buying a total market index fund, you’re already invested in real estate companies.
However real assets like REITs can offer additional diversification from vanilla stocks and could help stabilize your portfolio in the event that the stock market crashed. You’ll have to decide yourself whether this asset makes sense for your personal situation, but if you decide to go with it, holding a REIT Index fund instead of individual REITs will help you diversify.
Some mutual funds are not portable. This means that you can only own it in one or a few brokers. If you plan to move brokerages at some point in time, keeping portable funds in your taxable brokerage account will make it so that you can transfer brokerages without incurring large taxable events. For example, if you buy Fidelity’s zero expense ratio funds like FZROX, in order to move to another brokerage you have to sell it which could cause you to incur capital gains tax. If you instead bought FSKAX which has a very low 0.015% expense ratio instead of 0% and is portable, you could transfer it to another broker without selling and incurring taxable events.
In a tax advantaged account like a 401k or IRA this is not relevant because you will not be taxed if you sell an asset for cash inside the account and don’t withdraw it, so you could sell and then transfer.
Be careful with transferring assets in a 401k/IRA
Suppose you leave an employer or want to transfer your money to a different broker (e.g. Vanguard -> Fidelity or vice versa). When transferring money between brokerages in a 401k/IRA, you want to make sure assets are transferred “in kind” which means no buying/selling takes place and the assets simply move from one brokerage to another. In the event that you do end up with a check, read the rules carefully to ensure you re-invest it properly and within the correct timeframe to avoid causing a distribution which would subject to to a large amount of taxes and fees.
Whenever you leave an employer with a 401k some employers allow you to keep the 401k if you want (but you can’t add new money) and others require you to move it. You can typically either transfer the 401k to a new employer or convert it to a Rollover IRA. A Rollover IRA makes it easier to select any broker and fund you want, since your company typically selects the 401k provider/funds. However, by federal law a 401k can provide additional protection from creditors, so if the 401k plan is good it can make sense to keep it in a 401k.
Determine what percentage of money you’ll put into each fund in the 3 fund portfolio. An aggressive strategy for long term returns could be 70% domestic stocks, 20% international stocks, and 10% domestic bonds. This is pretty aggressive and to be less aggressive, you can have 20-40% bonds, but long term returns will likely be less. Historically, stocks have outperformed bonds. A good question to ask yourself is how much of a drop in your portfolio can you stomach without changing your strategy. For examples look at the Impact of asset allocation on risk and return here. A 90%/10% stock/bond ratio is certainly not for everyone and you’ll have to decide for yourself what your risk tolerance is.
In 2021 since bond prices are expensive, why have any bonds? The stock market can have wide fluctuations and while it has always gone up over the long term, there can be periods of time when it goes down. Bonds provide a few benefits for this:
- Bonds are a stabilizer in your portfolio. When stocks go down you your balance may not go down as much if bonds stay up.
- In the event that stocks are down and you need cash, you can withdraw bonds without cashing out stocks.
- While bonds are not attractive investments right now, they have been better over the long term and we are looking for a long term strategy so that we can invest easily.
- With some municipal bonds the dividends may not be federally or state taxed, so you can receive tax free dividends.
In the event that stocks and bonds both go down or we had an inflationary period like the 1970s, real assets like REITs and Commodities (e.g. Gold), could help you whether the storm as those assets went up in that time period. However, if you can wait 5-10 years past any short term economic fluctuations, not having them simplifies account management.
Rebalancing is important to maintain your asset allocation. Suppose you want your asset allocation to be 90% stocks and 10% bonds and stocks have performed well, leaving you with 95% stocks and 5% bonds. In this case your portfolio is more risky than your initial desired asset allocation and you should rebalance.
How often should you rebalance? For a simple long term approach, rebalancing once per year offers you the benefits of rebalancing without too much management. When you write down your investment plan, write a date down to perform your rebalancing each year.
To rebalance, simply total up your account total, calculate how much of each asset you should have, and buy/sell accordingly. Be cautious of selling assets in a taxable account that have grown as you may owe capital gains tax. If you can contribute more to rebalance in taxable accounts instead, it may help you avoid those taxes.
What happens if you never rebalance? Since stocks typically perform better than bonds it’s likely you’ll end up with a higher account balance at the cost of additional volatility in your portfolio.
Sample Portfolio 1: Aggressive Easy Automatic Investor (portable, Fidelity)
In Sample Portfolio 1, the following percentages would be invested in all account types (taxable and tax advantaged). This approach is easy because most brokers allow automatic contributions and dividend reinvesting in taxable brokerage accounts. While simple, the downside is you’ll likely pay more in capital gains tax due to tax inefficiencies in the funds.
- 70% FSKAX (Total Market Index Fund)
- 20% FTIHX (Total International Index Fund)
- 10% FXNAX (U.S. Bond Index Fund)
Sample Portfolio 2: Aggressive Tax Efficient Investor (portable, Fidelity)
Sample portfolio 2 can be more work because there’s different funds in different account types. There’s also ETFs for tax advantages instead of mutual funds in the taxable brokerage account and municipal bonds to save on federal taxes. Investing in ETFs requires a little more work to calculate the dollar amount and select the right Limit Order instead of just selecting a dollar amount to invest like in Sample Portfolio 1.
- Taxable Brokerage account
- 70% ITOT (Total U.S. Stock Market ETF)
- 20% IXUS (Total International Stock ETF)
- 10% MUB (Municipal Bond ETF)
- 70% FSKAX (Total Market Index Fund)
- 20% FTIHX (Total International Index Fund)
- 10% FXNAX (U.S. Bond Index Fund)
While investing in municipal bonds can be more risky than than federal government bonds, we can diversify by having U.S. federal government bonds in the tax advantaged accounts and municipal bonds in the taxable brokerage account.
But my 401k/HSA/etc doesn’t support those funds!
If a provider doesn’t support the right funds, look for low cost total market index funds. For example, if you were an investor and wanted to do portfolio 2 but your 401k didn’t have FTIHX, you’d look for a similar international index fund like FSPSX. Passively managed indexed funds typically have low fees and turnover.
Suppose you had an HSA that only had Vanguard funds. You might end up with VIIIX, VTPSX, and VBMPX instead because that’s the closest thing you can find in the HSA account even though you might have another set of funds in your other accounts.
Researching a fund
If you’d like to research a fund in more depth, you can enter the ticker in your broker’s research website, e.g. Fidelity Research. You should be able to read the Prospectus which tells you about the fund and its risks. They also provide a high level overview of expense ratios, turnover, etc. If you drill down into composition tab you’ll be able to easily see the asset allocation, top holdings, countries, and sectors the fund invests in. Morningstar also has a search bar at the top of the website to easily search for funds to bring up similar information. In Morningstar, the composition tab is called “Portfolio.” .
Before investing in anything it’s important to do research! You should understand what you’re investing in and why. Researching different funds and reading the prospectuses will give you a better understanding of their differences.
1. The Plan!
Now that you’ve learned the background, it’s time to create and take action on a plan! Write out your investing plan in a document on your computer and reference it when making decisions. This will help you stay on track.
2. Create an account
- Create an account at a brokerage, e.g. Fidelity, Vanguard, etc. A brokerage account allows you to buy/sell stocks, bonds, ETFs, mutual funds, and more.
- Banks also typically have investment accounts, but usually charge annual fees.
- Smaller brokerages seem to have more frequent problems when the market is volatile. Orders can take longer to execute and trading may be restricted. Because of this larger brokerages can be more reliable.
In your account you’ll be buying stocks and bonds with a ticker symbol, e.g. AAPL for Apple, MSFT for Microsoft, FZROX for Fidelity’s ZERO Total Market Index Fund. Each stock, bond, ETF (Exchange traded fund), and Mutual Fund has a ticker symbol. The ticker symbol makes it easy to reference a stock/bond/fund and you’ll use the ticker symbol to purchase or sell assets.
For a 401k or HSA you’ll go through your employer to set up your account. To open a taxable brokerage account, 529, or IRA you’ll need to go directly through the brokerage.
3. Transfer money to your account
First, link your checking account to your brokerage account in the broker’s website. Next, transfer the amount of money you want to initially invest. You can also set up recurring transfers, but if you’re closely monitoring and managing your finances you can manually transfer any extra money to invest after each paycheck.
4. Buy assets
Once you have cash in your account, there will be a trading screen where you can buy assets.
You can then click trade to buy or sell assets.
When buying a mutual fund, you’ll simply enter the dollar amount you wish to buy. At the end of the day the correct number of shares will calculated for you and purchased. This is the most simple approach, but not always the most tax efficient in taxable accounts.
To purchase an ETF, there’s two types of orders: a market order and a limit order. A market order submits and order to the brokerage to purchase the asset immediately at current market prices. You’ll calculate the number of shares you want to buy and enter it along with the ticker. For example, to buy $1,000 in ITOT you’d divide $1,000 by the current share price and enter the number of shares. If ITOT was $88.5191/share, you could buy 11 shares for a total amount of $973.71. Some brokerages allow purchasing of “fractional shares” which means you could buy 11.29 shares instead of 11 and some don’t.
A limit order allows you to set a ceiling for the maximum price you’d like to pay. This is safer as you’ll never pay more than you want. For simple long term investing, setting a limit order few pennies higher than the current price gives you protection from massive swings in price while you’re placing the order and also makes it so that your order will likely execute quickly. This prevents you from having to monitor the website as much to see if your order went through or not.
5. The build up
Contribute as much as you can every month. Regular investments and compounding interest will help build your account up quicker. Compounding interest simply means that each year the interest you received from the last years will also earn interest.
By automating transfers into your account monthly or after every paycheck, you can quickly and regularly get money in your account to invest.
By automating purchasing of assets in a taxable account, when the money comes in via a transfer, it can save you the time of placing orders. Most brokerages allow automating purchasing of mutual funds and some allow automated ETF purchases but that’s less common. For this reason to start simple and stay automated, mutual funds save time. If you really want to auto purchase ETFs, some smaller brokerages like M1 Finance allow you to do so.
For a 401k or HSA it’s typically easy to set it up to deduct the money from your paycheck through your employer and set up the funds it’ll automatically purchase each paycheck.
Most accounts have the option to take dividends in cash or reinvest them in the asset they came from. To stay simple, reinvesting them in the same asset will make it so that you are invested in the market earlier and don’t have to monitor when dividends happen to reinvest. Funds pay dividends on different schedules and frequencies.
7. Don’t stray
Write out your investment plan as described in step 1 and don’t change it when the market goes up or down. Plan to stay invested for decades. Over the short term the stock market is volatile and can rise and fall dramatically, even 50% or more. However, over the long term, there is no point in the past century where it has not increased over a 20 year time frame.
8. The cash out
Once you’ve built up your portfolio to 3.5% of your annual expenses you are financially independent and the money will likely last forever as long as you withdraw 3.5% or less every year. People typically choose a withdraw rate ranging from 3-5%. 4% is a common number from the Trinity Study, but choosing 3.5% provides an additional margin of safety in the event that you start withdrawing and then the market crashes. More aggressive asset allocations (90%/10% or 80%/20% stocks/bonds) also provide a higher likelihood of success than more conservative allocations (60%/40% stocks/bonds). Of course this comes at the cost of seeing bigger dips in your account when the market goes down, even for a period of a few years.
Being financially independent means your investments can cover your standard of living for your lifetime without you having to work. This opens up the possibility for you to regain time you would spend working for learning, leisure, building your own businesses, etc. Don’t forget to include expected healthcare costs in your calculations!
As an example, if you had $1,000,000 in investments and your expenses were $35,000 or less per year you could start withdrawing $2,916/mo out with a high likelihood that the investments will last forever.
But what about Social Security?
Nothing’s guaranteed in life and if you’re young, considering that a bonus and margin of safety will allow you to feel more comfortable in retirement. If you’re closer to retirement age, including some amount of expected social security could make sense if you’re confident the program will be reliable. Social Security has a website where you can check your expected payouts to include in your calculations.
Ordinary income and capital gains taxes
Dividends you accrue throughout the year are taxed at ordinary income rates. When you sell an asset and the current price is more than you purchased it for (your cost basis), you will be subject to either short or long term capital gains tax. If you held the asset less than a year you’ll be taxed by the federal government at short term capital gains rate which follows the higher ordinary income tax brackets ranging from 10%-37%. If you held the asset for more than a year before selling you’ll be taxed by the federal government at the lower capital gains tax brackets ranging from 0%-20%.
Some states also have taxes on top of the federal rates. These range from 0-13.30%.
There’s also a Net Investment Income Tax of 3.8% that applies to higher earners.
Lower taxes in retirement
When you’re not working, you’d probably be in a lower tax bracket than you are now. Take this into consideration when figuring out which accounts to setup and where to invest.
Tax efficient fund choices
When choosing an ETF or a Mutual Fund, to lower taxes you’ll want to look for lower capital gains distributions and lower turnover to help reduce taxes. Turnover tells you the percentage of assets that have been replaced within the fund in a year. Higher turnover means the fund is more likely to see capital gains distributions and for you to be taxed on them.
Additional tax reduction methods
The simple approach is a great place to start. It’s better to start early and invest often than spend a lot of time optimizing everything. However, as you continue to invest, if you want to build and grow the maximum amount possible, taxes cost you money that could have been invested too! Here’s a few account types and strategies that can be helpful in reducing taxes and contributing more once you want to expand from a basic 401k and taxable brokerage account. Here’s a basic overview of the common strategies, and we’ll go more in depth on each in future posts.
A Traditional IRA allows you to contribute up to $6,000 (or $7,000 if you’re over 50). You’ll have to pay taxes on earnings and contributions when you withdraw the money, but you can deduct your contributions from your current income taxes if you’re within the income limits.
A Roth IRA allows you to contribute post tax money which will grow free and you can withdraw in retirement after age 59.5 and after a 5 year holding period without paying any taxes. There are some exceptions that allow you to withdraw early. You must be within the income limits to contribute to a Roth IRA.
A 529 is an educational savings plan that allows you to invest money that has already been taxed, let it grow, and withdraw money tax free for qualified educational expenses without paying capital gains taxes. It’s common to set up a 529 with your kids as the beneficiary. Some states also let you deduct contributions from your state income tax if you invest in the plan in the state you live in. However, some plans are better than others and some states 529 plans have fees and limited investment fund choices which you should look into for the state your are interested in investing. You can invest in a state plan that is not your own state if it makes more sense. With a 529 you create the account and set the beneficiary to be yourself or a family member. You can change the beneficiary twice per year.
An Health Savings Account (HSA) is triple tax advantaged. This means you put in pre-tax money, it grows tax free, and if you withdraw from it for qualified medical expenses, your withdraws are tax and penalty free. In 2021 you can contribute $7,200 per family or $3,600 for a single person (add $1,000 if you’re 55 or older). You must have a High Deductible Health Plan (HDHP) to qualify for an HSA. This means your health plan is likely cheaper each month, but your deductibles and out of pocket maxes can be pretty high, so make sure this plan makes sense for you first. You’ll be issued a debit card to make qualified expense purchases. Any money you don’t spend in a year is yours to keep and let keep growing.
A Flexible Spending Account (FSA) allows you to contribute up to $2,750 per year per employer without paying taxes for qualified medical expenses, but you must use the money within the year you contribute or it disappears.
Backdoor Roth IRA and Mega Backdoor Roth IRA are strategies that allow you to contribute additional money to a Roth account if you’re over the income limit or want to contribute more than the maximum Roth IRA limit. With a Backdoor Roth IRA you’ll have to ensure you don’t own any other IRAs and have to file an extra IRS 8606 form with your taxes each year. With the Mega Backdoor Roth it’s pretty straightforward and automatable and you’ll convert after-tax money in your 401k plan to Roth using what’s called an “in-plan conversion.” You’ll be issued a 1099-R form from your brokerage for the Mega Backdoor Roth to file with your taxes.
401k plans can be divided in pre-tax and after-tax portions. Pre-tax means you haven’t paid tax on the money and when you withdraw it, you’ll be taxed at ordinary income tax rates. Contributing as much as possible up to the pre-tax limit allows you to let your money grow and defer taxes until later. 401k after tax money contributions are not taxed at withdraw, but earnings are. Using a strategy like the Mega Backdoor Roth IRA also allows you to avoid taxes on the earnings of 401k after tax money.
Tax loss harvesting is a strategy where you sell assets at a loss in your taxable account then buy an asset that is similar, but not the substantially identical. This allows you to recognize up to $3,000 in losses in your taxes per year and save on taxes. By buying an asset that is similar, but not the same you avoid IRS wash sale rules and would expect to receive similar market performance of your original asset.
Protecting your Investments
Ensure you have good insurance on your home and vehicle. This will help protect you from large expenses if something goes wrong or a lawsuit happens. Additionally, once you’ve built up a large nest egg, Umbrella Insurance can provide additional liability insurance in case someone sues you and the liability coverage on your home/car isn’t enough. $1 million of additional liability from an umbrella policy is typically $300-$400/yr.
Shop around for everything! Insurance prices can be drastically different between carriers so always get at least 3 quotes. Any money you save is additional money you can invest. If you notice at renewal your rates go up, shop around again.
For protecting your income, some employers offer disability and/or life insurance that you can elect for free or a small fee per paycheck. You can also purchase these separately on the open market at typically higher prices.
Leaving money for the family
Once you start building a significant amount of investments, work with a lawyer to evaluate if a will or trust makes sense for you. Also plan out for your personal situation how much money your family will need and determine if your investments can cover it or if you need life insurance.
A house as an investment
A lot of people buy their own home with a mortgage having a fixed interest rate over 15 to 30 years. Technically you’d come out better in the long term if you have a low interest rate, e.g. 3% and invest extra money at a higher expected return, e.g. 7%. However, given the stock market can have long periods of decline, paying off the house early can give you the satisfaction and comfort to invest more. It’s also one less expense to worry about planning for in retirement, meaning if the house is paid off you’ll need less money invested in the market to pay for the mortgage. This can help you weather potentially large account value fluctuations from year to year.
Each year in addition to any W-2/1099 forms you receive for your job, you’ll also receive forms from your brokerage that you’ll have to file each year. This is another reason to simplify your accounts because you’ll have to log into less websites to print the forms.
Speculation & Alternatives
If you still want to speculate in individual stocks or buy alternative assets such as cryptocurrencies, crowdfunded real estate, crowdfunded loans, etc. maintaining 10% or less of your total portfolio in speculation/alternatives will allow you to explore those ideas without taking large amounts of risk. With any investment you should do lots of research into the risks, expected returns, and the probability of those returns. With the simple approach instead of spending time researching all of these different investment opportunities, we’d focus more time on increasing income and reducing expenses and invest more simply.
Here’s a few books on the basics that are pretty pretty easy to read. You’ll find some variations in strategy and funds but most of the principles are largely the same.