Investing for Beginners: 401k, IRA and Mutual Funds

You have been on your job for quite a while now, but investing has never really been a thought.

You just want to make sure you have enough money to pay your bills, the family is taking care of and a little extra to have some fun.

But what about your future?

Do you plan on working the rest of life?

I hope NOT!

I know from experience when you are working you just want to make sure your family is well taken care of and nothing else is really important. 

Or maybe you’re a millennial and you landed your first real job.

The first question you ask….

I’ve got my first job making money. Now what?

The majority of millennials are worried about experiencing life and seeing the world, but not you.

You want to be financially responsible with your money and prepare for your future by not depending on working a job until you’re 60+ years old.

You are most definitely my kind of individual.

As a millennial, I can understand being young and wanting to do things that you enjoy but I can also understand the importance and value of investing.

I mean I’m a young wife and mother of four so I really don’t have time for all that “experiencing life” stuff. I have experienced all I’m going to experience, well at least not for another 15 years.

But, does that really have to be the case?

Not at all!

I believe you can be young, experience life, have a family and invest in your future if that’s what you want to do.

I do!

And I’m going to tell you how you can also.

Where to Start

When it comes to investing there are so many places you can start, if you want you can jump straight off the cliff and go invest in real estate, but I wouldn’t recommend that just yet.

Retirement

How about….

Starting somewhere you will already be familiar with and that’s retirement.

Your job will offer you retirement benefits that you will pay into and hopefully, your employer will match that. That’s what we call social security.

Social security is a great benefit because it allows you to put money aside for your future.

Is Social Security enough?

You’re young, so I would say no. By the time you are retirement age social security will have changed drastically.

So, when thinking about retirement consider what many financial planners refer to as a three-legged stool. You have your social security, personal taxable savings, and your retirement plans.

The main retirement plans include:

  • IRA’s
  • 401K’s

IRA

An IRA is an individual retirement account. IRAs are a great way to save taxes and put money away for your future. An IRA serves as a shelter for our retirement.

After you open an IRA, you can fund it with any type of investment you want – stocks, mutual funds, bonds, or index funds.

There are two types of IRAs traditional and Roth.

Traditional IRA

The main advantage of traditional IRAs is they generally offer an immediate tax deduction, along with the tax-deferred growth of the money in the account.

How it works:

You contribute some of your annual earnings and the money you put into your account can be deducted from your taxable income for that year.

All the money earned in your IRA goes untaxed, so you have more money working for you. Only when you go to withdraw your money at retirement will it be taxed.

The maximum amount you can contribute to an IRA is $5,500 (if 60+ $6,500).

For example:

Let’s say you make $50,500 a year at your job and you decide to set aside $5,500 a year for retirement in your IRA. That $5,500 will go into your account, but at tax time, you’ll only be taxed for $45,000.

But before you get excited, you know the IRS was not about it to make it that easy.

There are some rules to qualify for that tax deduction.

Two factors that determine whether you’re eligible to deduct the full $5,500 from your taxable income are:

1) your adjusted gross income and

2) whether you have access to an employer-sponsored retirement account.

  • If your employer DOES NOT offer a retirement plan, you’re almost always allowed to deduct your full $5,500 contribution to a traditional IRA.  There’s a small exception to this rule–if your company doesn’t offer a retirement plan, but your spouse’s company does, you can make the full contribution ONLY IF you and your wife’s combined gross income is $186,000 or less AND you and your wife file your taxes jointly.
  • If your employer DOES offer a retirement plan, your traditional IRA contribution might not be fully deductible. Let’s say your employer offers a 401(k) plan, but you decide not to participate in it and instead opt to open up a personal IRA in order to keep more control over which investments you can choose. This rule means that you might not be able to deduct that full $5,500 IRA contribution from your taxes that year. You probably guessed that this rule is in place to encourage people to use their employer’s retirement plan.

You can deduct the full $5,500 if:

  • you’re single and your adjusted gross income is $62,000 or less, or
  • you’re married, you file a joint tax return, and together your gross adjusted income is $99,000 or less.
  • you’re married, but you and your wife file separately, and your personal adjusted gross income is less than $10,000.

Withdrawing from your traditional IRA. You can begin withdrawing your money from your traditional IRA without penalty when you’re 59 and 1/2 years old. If you withdraw early, you’ll have to pay the income taxes that would normally be due on your withdrawal PLUS an additional 10 percent as a penalty. The IRS makes some exceptions when it comes to this penalty. Exceptions include using the money to pay for educational expenses and health insurance premiums or to buy your first home.

However, the IRS doesn’t allow you to keep your money in your traditional IRA growing tax-free forever. Wouldn’t it be nice though?

At age 70 1/2 you have to start making minimum distributions from your account, IRS refers to them as required minimum distributions (RMDs). If you don’t, you have to pay a penalty. Bummer.

If you have children like myself and you are determined to raise money-smart kids.

A way to fast track their financial wealth is to start by opening them an IRA as soon as possible.

There’s no minimum age requirement and your child can earn compensation by doing household chores or even selling lemonade.

Roth IRAs

Roth IRAs are a lot like the traditional IRA, except for a major tax difference.

Money is taxed before it goes in.

While you can’t deduct contributions when you invest in a Roth IRA, you don’t have to pay income taxes on your money when you decide to withdraw it.

The contribution is the same as a traditional IRA. The maximum amount you can contribute is $5,500 (if 60+ $6,500).

Your ability to contribute the maximum $5,500 depends on your income.

Unlike with the traditional IRA, you cannot deduct your yearly contribution to your Roth IRA from your taxable income. And there are also rules on whether or not you can contribute the full $5,500 at all. You can contribute the full $5,500 if:

  • you’re single and your adjusted gross income is less than $186,000
  • you’re married filing jointly with your spouse, and your adjusted gross income is less than $186,000
  • If you make more than those limits, but less than $196,000 (for married couples filing jointly) or $133,000 (for singles or married couples filing separately) you can still contribute to a Roth IRA, but you can’t contribute the full $5,500.

Withdrawing from your Roth IRA. You can begin withdrawing from a Roth IRA without paying any taxes when you reach age 59 and 1/2.

But you can withdraw early from a Roth IRA if you want. You don’t have to pay a penalty for early withdrawal like you do with a traditional IRA. You’ll just have to pay taxes on any earnings your investment made while in the Roth IRA.

Withdrawals from a Roth IRA you’ve had less than five years.

  • If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and penalties. You may be able to avoid penalties (but not taxes) in the following situations:
  • You use the withdrawal (up to a $10,000-lifetime maximum) to pay for a first-time home purchase.
  • You use the withdrawal to pay for qualified education expenses.
  • You’re at least age 59½.
  • You become disabled or pass away.
  • You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.
  • The distribution is made in substantially equal periodic payments.

Withdrawals from a Roth IRA you’ve had more than five years.

  • If you’re under age 59½ and your Roth IRA has been open five years or more, your earnings will not be subject to taxes if you meet one of the following conditions:
  • You use the withdrawal (up to a $10,000-lifetime maximum) to pay for a first-time home purchase.
  • You use the withdrawal to pay for qualified education expenses.
  • You’re at least age 59½.
  • You become disabled or pass away.
  • You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.
  • The distribution is made in substantially equal periodic payments.
  • Unlike traditional IRAs, you can keep your money in your Roth IRA as long as you want. You’re not required to make minimum distributions at age 70 1/2.

401(k)s

A 401k is an employer-sponsored savings program that enables you to set aside money for retirement.

The biggest advantage of retirement accounts is the tax savings.

How 401(k)s work

In general, an employee must be at least 21 and have worked at least a year for the company in order to participate.

When you decide to contribute money to a 401(k) every pay your employer will deduct a predetermined amount from your paycheck to buy investments in your 401(k) account. The money won’t be taxed until you actually withdraw the money when you retire. This is called a pre-tax contribution.

Your Employer is responsible for hiring investment management firms to manage the money for all of its employees; selecting a diversified set of investments from which employees may choose; reviewing the quality of investments and making sure employees needs are met.

So when you opt into the 401(k), you’ll pick which investments you want to fund your retirement account with.  So do your due diligence and pick what’s best for you.

When it comes to deciding how much to set aside, some employers make it mandatory to contribute a certain percentage of your pay while others will allow you to contribute how little or how much you want.

Most will say you should contribute at least 10% of your paycheck for retirement.  But the more the better.

Let’s talk Employer Matching

In many plans, employers will contribute a certain amount of money for each dollar you contribute. This is what people like to call “free money”.

For example. Let’s say you make $50,000 a year and your employer says he will match you $1 for every dollar you contribute to your 401(k) on the first 5% of your salary you invest. You decide to save 10% of your salary in your 401(k). That’s $5,000 that YOU contribute out of your pocket to your 401(k).

Now here comes your employer’s contribution. He’ll match your contribution dollar for dollar up to 5% of your salary. That means your employer will contribute $2,500 to your account. That’s $2,500 of FREE money and a 50% return on your initial investment of $5,000.

Sounds good to me!

Contribution limits

The government has set limits on what we can contribute to our 401(k).

  • For employees ages 49 and below, the maximum amount they can contribute out of pocket is $18,000 a year. The maximum combined employee and employer contribution is $54,000 a year.
  • For employees who are older than 50, the government allows you to contribute a bit more so you can catch up on your savings as you prepare to stop working. The maximum employee contribution is $24,000 a year. The maximum combined employee and employer contribution is $60,000 a year.

Withdrawing

Generally, distributions of elective deferrals cannot be made until one of the following occurs:

  • You die, become disabled, or otherwise have a severance from employment.
  • The plan terminates and no successor defined contribution plan is established or maintained by the employer.
  • You reach age 59½ or incur a financial hardship.

If you withdraw before you’re 59 and 1/2, you will incur a 10% penalty in addition to any normal income taxes you’d have to pay. So let’s say you’re only 40 and you decide to withdraw $10,000 from your 401(k)–you’ll have to pay $1,000 in a penalty plus pay income taxes on that $10,000. Basically, if you withdraw early, you’re losing the tax savings you’d normally get with a 401(k).

However, you may qualify for a hardship distribution if you find yourself in immediate or heavy need. In this instance, the 10% penalty may not apply.

Borrowing

You can borrow from your 401(k), but I would avoid that….. so, I’m not going to go into that.

If you happen to work for the public sector you may have a 403(b) and they work basically the same as a 401(k).

Retirement accounts are not necessarily investments themselves; they’re what I like to call the “housing” for your investments.

For example, when you buy a stock in a regular personal account, the dividends it pays are taxable. But if you buy that same stock and put in into your retirement account, those same dividends are not taxed, until the money is taken out.

That leads me to the next section

Now that we have talked retirement options, which is the first thing you should handle before investing elsewhere there is one other thing after you have retirement out the way I would recommend you to invest in and that’s….

Mutual Funds

When it comes to investing millennials are at a significant advantage because they have lots of time on their side.

Many millennials really don’t know how to feel about investing because many feel as if they can’t afford it or that it’s too risky.

Mutual funds offer a compromise for millennials, who are wary of individual stocks but want higher investment returns.

Here are 4 reasons why I choose mutual funds for millennials:

  1. Diversification

Mutual funds enable you to invest in many companies at once, from the largest and most stable, to the newbies and fast-growing. This helps avoid the risk of investing in single stocks.

Also, investing in mutual funds requires minimal investment.

  1. Time

Millennials have time, which mutual funds are designed for.

For example, A 23-year-old who invests $5,000 a year in a mutual fund until age 53 would accumulate more than $424,000, assuming a 6 percent annual return. A 32-year-old following the same strategy with an identical return rate would have just shy of $184,000 at age 53 by comparison.

  1. Tax efficiency

Investing in mutual funds through a tax-advantaged retirement plan, as I mentioned above can yield millennials even more benefits.

  1. Choices

There are thousands of funds to choose from, so finding the right ones for you will take time and research. So, take these into consideration when opening an account:

  • expense ratio
  • share class
  • upfront fees
  • deferred sales charge
  • risk tolerance

investing is a major step, so make sure you consider your options.

I would personally recommend working with a financial planner if you find investing to be overwhelming or too much.

But now you have and know where to start.

  • Get your 401(k) together
  • contribute to an IRA
  • and start investing in mutual funds. Your 401(k) may even have mutual fund options for you. So ask?

Once you have mastered your mutual funds you can start looking into some other ways of investing, but if you start here you’re off to a bright financial future.

What investing are you doing or plan on doing?

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