This is a continuation of a series of posts on personal finance. You can read the entire series here: http://blog.shinadachi.com/category/finance/
If your employer does not offer a 401-k or 403-b, there is still a way to get a similar tax advantage while saving for your retirement with an IRA (Individual Retirement Account).
IRAs are recommended over normal investment accounts for a simple reason: the significant tax advantage that it gives you.
IRAs come in two flavors: The traditional IRA and the Roth-IRA. They are taxed differently, as follows.
A traditional IRA account can be funded with your pre-tax money. This means that whatever you invest into an IRA account this year can be deducted from your income, resulting in a smaller income tax for you.
Once invested, your money will grow tax free, unlike a normal investment that incurs a tax on your capital gains.
When you take the money out in retirement, you will pay income taxes on whatever you take out.
A Roth-IRA account is funded with your post-tax income. This means that you will NOT be able to deduct your investment from your income. But because you have paid taxes before the initial investment, you can take it out in retirement completely tax free. And just like the traditional IRA above, the money also grows tax-free.
Which should you choose?
If you are trying to decide between a traditional IRA vs a Roth-IRA, consider how much your income is now, and how much you expect you will draw from your IRA in your retirement years.
This is not easy to figure out since your life and your future has a lot of unknowns, but the typical advice is that for young low-income earners, Roth-IRA may be the optimal choice as your income is likely lower today than in the future. You have a long time to amass a significant net-worth, which will likely lead to withdrawals in the future larger than your current income. I purposefully did not draw the line the separates young/old or low/high income, as each life situation is different and there is no clear answer here.
My case is a little special, because as an engineer and a freelance musician, I tend to make a lot of money in certain years and not in other years. So I actually invest in a traditional 401-k (similar rules to traditional IRA) in the years I work a normal day job, and convert a portion of it to a Roth-IRA when I focus on music. The conversion is considered a taxable event, but since I make significantly less money as a musician than as an engineer, my income for the years I work as a musician is taxed at a lower percentage.
How do you start an IRA account?
Most investment services allow you to open an IRA account with which to invest your money. Whatever you choose, a good philosophy to follow is to do the following with your assets.
1. Invest most of your assets in a diverse stock index fund. I like Warren Buffet’s advice, 90% stocks, 10% bonds, and rebalance occasionally to keep the ratio. This is good because even though the stock market is volatile, it has a higher average annual return in the long-run than other investment vehicles. One precaution here: volatility of the market makes some investors scared, or react to the market (like selling all of their stocks after a market crash). Don’t be like those investors, and stay invested and consistently stick to the 90/10 ratio for the best long-term results.
2. Invest with a firm that does not charge you a high fee. When I got my first job and started investing back in high school, I made the mistake of investing in mutual funds with fees as high as 1% annually. In hindsight this didn’t make much sense when many index funds have expense ratios below 0.1%.
Vanguard is considered the king of index funds with their variety of offerings and low fees. I am quite fond of their VTSAX fund, which is the total stock market fund that exposes you to the entire U.S. stock market. How cool that you can be a part owner of every single publicly traded U.S. company by simply investing in this one fund! There is also the VBTLX, the total bond market index fund. So implementing Buffet’s advice of 90% stocks and 10% bonds is easy with Vanguard. Invest 90% in VTSAX, 10% in VBTLX, and rebalance occasionally as the market fluctuates to stay close to a 90/10 holding ratio.
I also love the wealth of low-fee “robo-advisors” available today that implement strategies similar to the above, but does all the work of investing/rebalancing for you. This includes services like Schwab Intelligent Portfolio, Wealthfront, and Betterment. Robo-advisors tend to have much prettier and easy-to-use user-interfaces compared to Vanguard, so they are recommended for people who may not be interested in learning the nitty-gritty details of the different kinds of funds but simply want an easy way to consistently put away money for their future without having to think about it.