In out last few articles, we are been discussing how to accomplish your financial goals. This requires making investments.
Many people invest solely to make a profit. That is not a sufficient reason. Different investments are like different vehicles. If you are traveling from one town to the next, a car is likely to be your best form of transportation. However, if you are traveling from New York to Paris, a jet is your best bet.
Investment vehicles are much the same. Trying to save enough money for a down payment on a house in two years is very different than trying to set aside enough for a financially secure retirement in 30 years. In the first example, you cannot afford a lot of risk. In the second example, you can usually afford to be more aggressive because you have time to ride out most financial downturns. I suggest you choose investments based on the specific goals you are trying to accomplish, keeping in consideration your personal tolerance for risk as we demonstrated in last week’s column.
Defined benefit pensions, the ones paying a specific monthly amount based on your salary and years of service, are going by the wayside. They are being replaced by defined contribution plans, such as 401k plans. There are three benefits to investing in a 401k plan:
- The money you invest comes out of your pay before tax, so you can invest more than if you had to pay taxes on that money first.
- The interest your money earns grows tax-deferred.
- Many companies match employee contributions to some degree.
The following charts show the results of investing $3,000 a year from age 35 to 65 outside a 401k (1); inside a 401k (2); and finally, inside a 401k with the employer matching 50 percent of the individual’s contributions (3). As you can see, investing inside a 401k with employer matching is the preferred method of saving for retirement. Therefore, if this is available to you, it is highly recommended that you always invest as much as available to you can each year.
IRAs still make sense for some
An Individual Retirement Account (IRA) is also still a viable retirement vehicle for some people. Despite tougher rules enacted by Congress, depending on your income and whether or not you or a spouse are covered under a 401k, IRAs may still be a viable option to invest additional money in a tax deductible vehicle.
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For 2017, your total contribution to all traditional IRAs (including a Roth IRA) could not be more than:
- $5,500 ($6,500 if you are over 50 years old); or,
- Your taxable compensation for the year, if your compensation was less than the above dollar limit.
IRA contribution can be deductible depending on your personal qualifications. (Roth IRA contributions are not deductible.):
- Your deduction may be limited if you (or your spouse, if you are married) are covered by a retirement plan at work and your income exceeds certain levels.
- Your deduction is allowed in full if you (and your spouse, if you are married) are not covered by a retirement plan at work.
You can learn more about the current limits at the IRS website. Even if you do not qualify for a tax-deductible IRA, you can still have an IRA and benefit from tax deferral on the account’s earnings.
We have already stressed the importance of starting your investment program early. However, the chart below is one more example to help motivate you. It shows that a 21-year-old investing $2,000 a year in an IRA or 401k could stop investing at age 31 (investor A) and still accumulate more money by retirement than someone who made investments from age 31 to 65 (investor B).
Does this mean that if you are older than 21 then this example is not for you? Of course not; it is just definite proof of the power of starting your retirement investments today instead of waiting a few years.
The importance of estate planning
The final component of any financial plan is proper estate planning. Space does not allow in this column for an in-depth analysis of the various tools of estate planning, but below you will find some basic information about trusts. There are many to choose from, each designed with a very specific purpose. Please see a competent attorney who specializes in estate planning in order to develop a plan tailored to your needs.
Trusts can take care of a variety of problems, such as reducing or avoiding estate taxes, avoiding probate, managing money for children, etc. Here are examples of some of the trusts available and their purposes:
If you have followed my last eight columns, you now know the essential principles of personal financial management. Your financial goals are well within reach. Additionally, by completing the exercises in these columns, you now know approximately how much to set aside each month to turn every one of your financial goals into reality.
As pointed out previously, only a small percentage of Americans achieve true financial independence. By establishing a financial plan, and then implementing it, you will be poised to join them.
I wish you much success on your journey!