Making Your Money Work for You
This article is not about credit card debt. It is about what you should do with free cash flow and savings after you have paid off any outstanding high interest rate debt. Yet since the statistics indicate that many people perpetually float high interest rate debt, I always begin with an appeal to my clients to start by paying that off. Once high interest rate debt is no longer an issue, we can get down to the details of where to put your money. The first step in this process is to consider the different investment accounts, and their benefits and limitations.
“The first step in financial freedom is getting rid of bad debt. Any debt that is charging you over 10% is bad debt. Your best investment is to pay that debt off with your individual free cash flow.”
If you have cleared your financial life from the burden of credit card debt, congratulations: by far the most reliable investment is the one that eliminates 18% interest rates. Warren Buffett himself cannot maintain anything like 18% returns on an investment.
If you have never had a problem with credit card debt, keep on the good path. Either way, if you have begun to accumulate cash, it is time to figure out what to do with it.
If you are spending less than you are making. In business terms, you are in a state of free cash flow. This is the first requirement to build up savings. It is actually the most important step, in that investments mean nothing without some unencumbered cash first.
I have written about why savings accounts are horrible places to keep cash long-term. The nuts and bolts of the argument is that, in the modern era of near-zero percent earnings on savings account funds, any cash that you hold long-term is all but guaranteed to depreciate. A dollar tomorrow does not buy as much as a dollar today. Holding cash is (to a much lesser extent) similar to credit card debt: you are paying interest (depreciation is effectively an interest rate charge on held cash), which buys you nothing, earns you nothing—is, really, good for nothing. (I should note here that holding cash during certain market conditions can be an effective investment strategy. Letting it build in your savings account without a second thought, however, is no strategy at all.)
If you could track a dollar through your bank account, the ideal would be that very few of those dollars would sit for more than a few weeks before being spent. This is not an appeal to consumerism or reckless spending: the point is not a justification to blow your cash, but to protect it by investing it responsibly. If you have too many dollars sitting idle, you need to start thinking about how to make that money work for you.
Most likely, that is why you are here.
The most flexible option for savings is to open a brokerage account. There are dozens and dozens of options. The landscape of brokerage accounts is large and competitive, and so most of the accounts offer free trades on stocks and ETFs, and low fees for options and futures.
There are several sites that give an overview on the various brokerages and their fee structure. Do not get too caught up in trying to find the perfect option: there are generally only slight differences, and changing from one brokerage to another is rarely ever difficult. Find a particular brokerage that seems to fit your needs and that you feel comfortable with, and open an account.
Many brokerages have no minimum requirement for account balances, so even if your excess cash is only a few hundred bucks (or you want to start off small until you get more comfortable) it is not an obstacle.
I will not get into the details of the process of buying and selling different investment options here—I cover that in another article and video. For now, the important thing to focus on is whether a brokerage account is right for your particular situation.
The biggest advantage to a brokerage account is the ease with which you can move funds in and out of the account. If you want to maintain a rainy day fund, a brokerage is a great place to do it: if you invest the money conservatively, the risk of loss will be low, while it should also be easy to maintain the purchasing power of your savings by getting a rate of return that at least covers inflation. For a touch more risk you can even make a few extra bucks—that is, your savings next year will buy you more than your savings would right now. This is the act of putting your money to work.
While the flexibility of brokerage accounts is its main selling point, taxes are its greatest downside: as in you generally must pay taxes on your earnings. There are two types of taxes on capital gains: long-term and short-term. (There is also what is called 60/40—where 60% of gains are taxed at the long-term rate, 40% at short-term—which is applicable to options and futures trading.)
Capital Gains: Long and Short Term
A long term investment, according to IRS logic, is any investment that a person owns for more than a year. Short-term is anything owned for less than a year. The tax rules are fairly straight-forward from there: long-term capital gains are taxed at one of three different levels: 0%, 15%, and 20%. Your income determines the tax level: for single-filers making between $40,001 and $441,500, the rate is 15%; for married joint-filers the 15% rate is for incomes between $80,001 and $496,600. Below these rates capital gains is 0%; above it the tax is 20%.
Short-term investments (those owned for less than a year) are taxed at your normal tax rate (since it is earnings on top of your regular earnings, the rate will equal your highest marginal tax rate). In all cases, the short-term capital gains rate is greater than the long-term rate: the government wants you to invest long-term.
Dividends on stocks are taxed at long-term rates as long as a few qualifications are met. And if you buy an ETF or mutual fund that reinvests dividends, you will not owe any taxes until you sell the ETF or mutual fund for a gain. If you hold onto a fund for a significant amount of time, the advantage is that you will earn interest on the full amount of the dividend, instead of only the portion that is left over after it has been taxed.
If you are in the 0% capital gains long-term rate (and you are not planning on buying or selling investments more than once a year) brokerage accounts have a great deal of flexibility without a serious underlying cost. If you are in the 15% or 20% bracket, you can consider the cost of a brokerage to include the tax burden that the government applies to your earnings. And do not forget to check your state to see if they tax capital gains as well.
By far the most popular retirement savings plans offered by employers are 401Ks. There can be significant advantages to 401K accounts: earnings are tax free while invested in the account, and there is no tax penalty applicable to short-term investments. And while retirement accounts generally have maximum annual amounts that can be contributed, 401Ks are relatively quite generous: individuals are allowed to contribute up to a maximum of $19,500 in 2020; adding employer contributions, a total of $56,000 can be contributed annually.
Which brings us to the next great advantage of 401Ks: many employers offer matching funds. With a 50% match, for example, the employer will deposit fifty-cents on every dollar of employee contributions. 100% would be dollar for dollar, and so forth. This represents free money, and perhaps the only circumstance where you may want to delay paying off a credit card in order to maintain those matching contributions: those 18% credit card interest rates will eventually eat you up, but it’ll take a few years before they cover the 50% or 100% (or whatever your particular employer offers) gains on matching 401K plans.
401K accounts suffer from a general lack of investment options (each employers plan is different, but no 401K plan provides the variety of investment options a brokerage does), and they suffer from limitations in flexibility: if you withdraw prior to age 59 ½ from a 401K, with a few exceptions, you will have to pay a 10% penalty to the IRS, and withdrawn funds will be added to your income for the purposes of tax—no matter how long you have held your investments, they will be taxed as short-term in the event of an early withdraw.
401K money has minimum distribution requirements once you turn 72 ½ (or when you retire – if your particular plan allows this). The IRS publishes the RMD (required minimum distribution) table online. Penalties for failing to withdraw from your 401K in accordance with these tables incurs significant penalties, so be sure to pay attention to it.
Roth vs Traditional
There are two kinds of 401K accounts: Traditional and Roth. Not all employers offer Roth 401Ks, but they are becoming more and more common. The difference between the two relates to when tax is paid: in a Traditional account, contributions are pretax—meaning that your taxable income is decreased by the amount that you contribute to your 401K. The 401K funds remain untaxed until you begin taking distributions, at which point they are counted as income and taxed normally.
Roth 401K contributions, on the other hand, are contributed after-tax. There is no tax benefit on the front end, but there is once you begin to take distributions: in retirement, the money is tax free. The general rule of thumb is that if you anticipate your taxes to be more in retirement than they are now, contribute to a Roth.
Note that using this tax measure for picking a Roth or Traditional 401K assumes that you add the tax savings from Traditional contributions into your 401K. If you do not contribute extra money in an amount equal to your tax savings, Roth savings will always outperform for retirement. Many people, for example, contribute the amount that their employer matches (i.e. if an employer matches up to 10% of contributions, many people simply contribute 10% regardless of whether it is a Traditional or a Roth plan). There is no reason to stop investing at your employers matching limit (and you should ALWAYS contribute at least as much as they match), but if you are going to contribute the same amount regardless of whether it is before or after taxes, put your money in a Roth. Your retirement self will thank you.
IRA accounts are often confused with 401Ks. While 401Ks are employer sponsored plans, IRA’s are self designated retirement plans. The contribution limits applicable to 401K plans are separate from IRA’s, so you can contribute the maximum allowed to both a 401K and an IRA (though not to two different kinds of IRA’s: if you have more than one IRA, the IRS contribution limits on IRAs is cumulative across the IRAs).
IRA’s also come in two flavors: Traditional and Roth. With few exceptions, Roth IRA’s are preferable to Traditional. There are two major reasons for this: since funds contributed to a Roth IRA have already been taxed, if you need to withdraw the principle from a Roth IRA due to an unexpected need, you can do so penalty and tax free at any time (this applies to a cash contribution: rollovers must be held in the account for 5-years before the principal can be withdrawn without penalty). Distribution of earnings on a Roth IRA prior to 59 ½ (or five years after making contributions, whichever is later) will be subject to 10% penalty and taxes.
The second reason that Roth IRA’s are superior is that there are no required minimum distributions in retirement. In other words, if you were able to cobble together $1,000,000 in a Roth IRA between contributions and earnings, and you were earning 5% in interest and dividends on the money in retirement, you could distribute $50,000 per year tax free. With no RMD, the Roth IRA earnings are never exposed to taxes.
The implications of this perpetual tax free status are highly dependent on the scope and terms of your planned distributions over the course of your retirement, but in pretty much all instances the Roth money will outperform Traditional, dollar for dollar. For example, if you utilize the IRS distribution tables you will be withdrawing around $65,000 from a traditional account the year after you turn 72 ½. Assuming you began with $1,000,000 in an IRA account, and factoring in inflation every year (so that your income increases by 2.5% every year to give consistent purchasing power), and assuming that you earn 5% on the residual savings every year, you will run out of money when you are 91 with a Traditional account.
Over the course of those years, you will have distributed $1,214,039 (after taxes) from your Traditional account. With a Roth IRA you would only have to withdraw $50,700 in year one (Roth distributions are tax free; assuming a 22% marginal tax rate, $65,000 in a taxable Traditional IRA distributions equals $50,700 in tax-free Roth). Adjusting for inflation in the same manner as with the Traditional funds, you would run out of Roth funds when you are 98. Over the course of those years you would have distributed $1,869,152: this is $655,113 more than the Traditional IRA.
On your original million bucks, this equates to around 2.5% per year additional earnings in retirement. It does not sound like much, but it is the difference between going broke at 91 as opposed to 98.
In truth, both accounts (with a little management) should last longer than those simplified calculations: if you are getting dividends from a dividend aristocrat (a company with a reliable history of increasing dividend payments over time), your returns will increase year over year along with inflation. The Roth advantage accelerates in this case: with the Roth you would still have $941,000 in principal if you lived to a hundred; adding that principal you your distributions would equal nearly $3-million. The Traditional account—due to the need to withdraw substantially more to cover taxes—would run out of money at 93 years age, with $1,358,903 worth of total distributions. This is a $1.6-million difference in returns (you, of course, would have to live to 100 to realize the full amount; but you would also leave quite a bit more in your estate for family and charity).
There are a couple of caveats to IRAs: strict income limits restrict who can invest in these funds; as well as annual contribution limitations. The total that you can contribute annually to all IRAs is $6,000 ($12,000—$6,000 for each spouse—if you file jointly). Note that there are a variety of income restrictions related to marital status, whether you or your spouse are covered by a plan at work, and if you are married whether you file jointly or not. Click here for a more detailed description on Traditional IRA limits. Roth IRAs have similar restrictions, but a bit more simplified. Click here for details on Roth IRA limits.
For the reasons listed in the previous section I would generally suggest investing in Roth IRAs. The mathematical truth of the matter is that—as long as you reinvest all your tax savings from a Traditional IRA—the differences between a Roth and a Traditional IRA shrink dramatically. Still, the Roth will be worth more over the long-term due to its perpetual tax-free status with no required minimum distributions. And I find that most people do not invest the taxes that are saved on a Traditional IRAs: either they are investing the full $6,000 allowed by rule anyway (i.e. they cannot invest the tax savings into an IRA), or they are not differentiating their taxes to the degree that they can discriminate between the different sources of their tax return.
Mathematically, the amount that you end up with in a Traditional IRA (minus taxes) will be the same as the amount that you end up with in a tax-free Roth IRA (assuming equal rates of return)—so long as you reinvest the tax gains from the Traditional contribution immediately. In reality, there is almost always a delay between contributions to a Traditional IRA and the tax returns from the deduction; this means that earnings on the tax portion will lag a bit, resulting in a slightly lower rate of total return.
The only truly compelling reason to contribute to a Traditional IRA is if you have reason to suspect that your earnings in retirement will be substantially lower than they are while you are investing (i.e. you are making much more in a particular year than you will make in retirement). For individuals who are close to retirement, it is possible to have a high degree of confidence that your tax rate will decline (due to a decline in income) in retirement: this is when a Traditional IRA comes into its own, although the longer that you will be using the funds in retirement, the more likely that the advantages of a Roth will overcome the tax benefits.
And there is this also: as I write this on the backside of Coronavirus, 2020, there are two compelling reasons to believe that current tax rates will inevitably increase for the majority of tax-payers: the tax rate is currently very low (from a historic perspective); and national deficits are incredibly high (cutting deficits will require both spending cuts and tax increases). There is an asymmetric risk of higher taxes in the years to come at most income levels. Roth accounts create additional protection for this risk.
If you have any questions feel free to contact me. Stay safe out there.