Monday, July 18, 2011

Winning the loser's game

Getting back to our roots here, we'll delve into some common personal finance topics and try to sort out the way the common man and woman can get a fair shake from the financial markets. I think it's fairly clear that, in general, people know they should be saving money. What's less clear is what people should do with it once they have it. Essentially, how do we get that whole compound interest thing going? First, investing is not as hard as it seems. Charlie Ellis once aptly called it a "loser's game," and with good reason. He compared it to amateur tennis, in that one wins largely by not making mistakes. Get the ball back to the other side and in bounds; do this enough against amateurs and you'll frequently win. Investing is similar in that it's not about making a big score, but simply avoiding mistakes. In this first of a series of posts, we'll explain how to get your money to make its own money.

One of the most basic facets of investing is making sure you avoid the tax man. Rather than beginning with a bunch of stock market jargon, we'll simply explain how it is that the common person can take advantage of everyday investment tax shelters (and you'll recognize all of them), fat cats and swiss bank accounts be damned.

The first and most important is the common 401(k) plan. Yes, that's right, that unsexy thingy you may have heard about while getting your paperwork on the first day of your new job. Well, ladies and gentlemen, a good 401(k) plan can be very sexy indeed. And here's why: it allows you to shelter up to $16500 from Uncle Sam's tentacles each and every year. You may have heard of another sexy feature: your company may be giving you free money by providing a match. If you're lucky, and, say, your company matches up to 6% (of your contribution), then on a pretax $35000 yearly salary they'll be giving you $2100 a year. With your contribution you'll be socking away $4200 per year and you're only missing 6% of your income. One of the best parts about it also helps with investor psychology; since the money is taken out our check before we see it, we usually don't miss it as we would otherwise.

There are two overall options with 401(k) plans. There's a regular (used in the calculation above) and a Roth option. With the regular plan, you get an immediate tax deduction of the amount you contribute (to the 401(k)), and then you don't pay taxes on the investment earnings until you pull it out. With the Roth option you pay taxes on the $5k in income now (so there's no deduction), and then you never pay taxes on your investment returns. So, no matter how high the balance when you retire, you won't pay the government a cent. Sexy indeed. The regular 401(k) is usually better if you're currently making a lot of money (and could use the tax breaks now), but for those who think they'll be making more money when they're 60 the Roth 401(k) would likely be the better bet. After you pay off your high interest debt, paying into your 401(k) up to the company match is the first step toward having your money make its own money. So, check with your human resources department, find out what the match is, and fill out the paperwork to make sure you're taking full advantage. The default option (likely a target retirement or life cycle fund), in terms of investment choices in your plan, is probably your best bet, but that'll be addressed here later in the week.

The second big tax shelter available to the humblest among us is the individual retirement account (IRA). Essentially, the government lets you put $5000 in an account each year (with the money invested in whatever you want, essentially, so it's more flexible than a 401(k)) and gives you tax breaks on that account. The tax benefits are almost the same with the 401(k). The regular IRA gives you a tax break now, but will tax you when you pull your money out in retirement. The Roth IRA makes you forgo the tax deduction now, but you will never pay taxes on the investment earnings. Think of it. You could be in the stock market for 40 years, and never owe the government a cent. IRA accounts (Roth and traditional) can be opened at virtually any financial institution you can think of. Since these types of accounts are for investing, I wouldn't recommend opening one at a bank (unless you like the amount of interest paid on your checking account). The place to do it is at a mutual fund company, and the best one is Vanguard. The reason? They let you invest "at cost." In other words, there isn't an owner (or shareholders) who collect the profits on the fees charged; the fees just cover the costs to run the funds. The investors are the owners. Sound too good to be true? The man who started Vanguard, Jack Bogle, has appropriately been dubbed Saint Jack by his loyal group of investor acolytes, the Bogleheads. Vanguard lets you invest, on the cheap, in anything worth your time.

While we'll delve into investment choices soon, to recap today's post, remember that investing is a loser's game. Just avoid the big mistakes. So...

1. Pay down your high interest debt
2. Invest in your 401(k) up to the company match.
3. Open an IRA and try to contribute to the $5000 max each year.
4. Try to top of your 401(k) to its $16500 yearly limit.

That's $21500 a year of tax protection. And you don't even have deal with anyone in Bermuda.

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