What about after you max out your IRA? Should you come back and top off your 401(k) to save every last tax-free penny the government will let you? No, and this is really a cruel twist of fate. Because of the HCE rules, only people who make less than $100,000 are actually eligible to contribute the maximum amount of pretax earnings to their 401(k) plans. If you’re making less than $100,000 before taxes, and you contribute $5,000 to your 401(k) every year to get the full company match along with another $5,000 to your IRA every year, why am I insisting that you not go back and take full advantage of your 401(k) plan’s tax-deferred status? Because as important as your retirement portfolio is, you still need a nonretirement portfolio. Your 401(k) may let you save and invest without having to pay taxes for years and years, but you can’t use that money until you turn 59½. It’s important to create a really robust retirement fund, but it’s also important to recognize when you’ve done everything you need to for retirement. Someone who’s contributing $5,000 a year to an IRA and getting a full company match on another $5,000 a year in a 401(k) is effectively saving $15,000 a year before taxes, and if we’re conservative and assume our investments compound only at a lowly 7 percent annually, in thirty years you’re looking at $1,533,859.37. Even with that paltry return, $1.5 million is enough for you to retire comfortably. If you’re making under $100,000 a year and investing $20,000 in both retirement accounts with pretax income, you’re short changing your discretionary, nonretirement investments, and you don’t want that. After all, you should be able to enjoy some of the rewards from investing before you turn 59½ and your 401(k) and IRA become accessible.
That’s all you need to know about being a good 401(k) investor, but being good at running a 401(k) doesn’t necessarily mean you’re any good at investing for retirement. You still need to start an individual retirement account.
Look, I’m sure you’ve seen hundreds if not thousands of advertisements for IRAs and Roth IRAs at this point in your life, and the most you want from an IRA is to not have to hear about it endlessly during the next commercial break. But these things are too good to pass up. An IRA is another form of tax-deferred account that lets you compound over and over again without needing to set anything aside for taxes until you start withdrawing money. In that sense, it’s just like a 401(k). But aside from the lack of any kind of matching funds, IRAs are superior to 401(k) plans in every other respect. With an IRA you can invest almost anywhere—choose from among thousands of stocks, thousands of funds—and you can do it without having to pay high administrative fees. The rules for taking money out of an IRA are similar to the rules for 401(k) disbursements. You can start taking the money out without penalty once you turn 59½, and you’re required to start taking your money out once you turn 70½. If you want to take money out of an IRA before you hit retirement age, you’ll get hit with a 10 percent penalty, just as with your 401(k) plan, unless you meet the hardship requirements, which are similar to 401(k) hardship requirements. You’re allowed to withdraw without paying a penalty if you become permanently disabled; if you need to pay nonreimbursed medical expenses in excess of 7.5 percent of your income; if you’ve been out of a job for twelve weeks and need to pay health insurance premiums; if you need to pay for education costs; and you can withdraw $10,000 from your IRA without penalty for the purchase of your first home. Other than that, any time you want to pull your money out before you turn 59½, you’ll have to pay income tax on your withdrawal and a 10 percent penalty. Just as with a 401(k), you really don’t want to pull money out of your IRA before you retire and give up your ability to compound ever-larger amounts of money thanks to your tax savings.
Another big difference between a 401(k) plan and an IRA is that the limits on IRA contributions are lower. In 2007, you can put $4,000 in an IRA, and in 2008 the limit goes up to $5,000. Anyone over 50 gets to contribute an extra $1,000, which is a kind of catch-up provision. You should invest in an IRA as you would anywhere, only slightly more conservatively. We’ll cover everything you need to know about your IRA investment options in the next two chapters.
Now what about the Roth IRA? This is an altogether different kind of retirement account. Contributions to a Roth IRA are made with after-tax income, so, unlike a regular 401(k) or an IRA, your contributions are not tax-deferred. The upside here is that you pay no taxes on your investment gains in a Roth IRA, so any earnings from the stock market with this type of account are totally untaxed as long as you follow the rules. Plus, the rules for taking money out of the account are much less stringent, largely because you’ve already paid taxes on your contributions. You’re allowed to withdraw the full amount you’ve contributed to a Roth IRA at any time without paying any kind of penalty. After you turn 59½, as long as your Roth IRA has been open for five or more years, you can start withdrawing your investment earnings tax-free. Just as with a regular IRA or a 401(k), none of your transactions in the account can be taxed. For example, you won’t pay dividend or capital gains taxes on the earnings from your Roth IRA investments. In addition, you can withdraw up to $10,000 of your investment earnings tax-and penalty-free to buy your first home. But you can have a Roth IRA only if you make less than $110,000 a year if you’re single or $160,000 a year if you’re married and file your taxes jointly.
In addition to Roth IRAs, you can now also get a Roth 401(k), although only if your employer gives you the option. A Roth 401(k) is what you’d expect: your contributions are made with after-tax income, but you won’t pay any taxes on your gains as long as you don’t withdraw the money early and have had the account set up for at least five years. You can even get an employer match for Roth 401(k) contributions, but the match will go into a traditional 401(k) plan, not the Roth 401(k), and the match will be determined by your pretax income, not the after-tax income you actually end up contributing to a Roth 401(k). There’s one more rule: the contribution limits on 401(k) plans and IRAs include all of your accounts. So in 2008, if you have both a 401(k) plan and a Roth 401(k), you can contribute only $16,000 between the two. The same goes for IRAs: if you have an IRA and a Roth IRA in 2008, you’re allowed to contribute only $5,000 between the two accounts.
So when do you want a regular IRA and when do you want a Roth IRA? This question isn’t nearly as important with 401(k) plans because it’s unlikely you’ll be offered a Roth 401(k) option, and that is not nearly as enticing as a Roth IRA, because you can’t easily withdraw your contributions. The rule of thumb when choosing between an IRA and a Roth IRA is that you want to contribute to a Roth when you’re young and in a low tax bracket, as long as you expect to be in a higher tax bracket after you retire. You pay your low tax rate on your Roth contributions, and then don’t pay any tax on disbursements as long as you wait until the year you turn 59½ to take them. Of course, once you’re making $110,000 if you’re single or $160,000 if you’re married and file your taxes jointly, the government will take the Roth option away from you.
What about deciding between making an IRA contribution and a 401(k) contribution? As long as you still haven’t used up your company match, you want to contribute to your 401(k) before putting a dime into an IRA. As soon as you’ve taken full advantage of the employer match, it’s time to stop funding your 401(k) for the year and max out your IRA, because without the employer match, a 401(k) plan is a pretty crummy way to invest, even with the incredible tax savings. And an IRA gives you the freedom to manage your money well. In a 401(k), the high fees and poor fund offerings doom you to substandard returns. Once you’ve got the full match in your 401(k) and you’ve filled your IRA to the max for the year, you’ve got your retirement taken care of. Just keep up that routine for the next thirty or forty years.
I know these retirement accounts are pretty dull, but you can’t start to make yourself wealthy in the present until you’ve done everything you can to make sure you’re even wealthier in the future. I know it sounds backward, I know it’s boring, I know you just want to invest in some great stocks that are going much higher, or if yo
u don’t have the time for stocks, one of the few mutual funds that consistently beats the S&P 500. But you need to understand that no matter what else you do, you need to pay for your retirement, and the cheapest, smartest time to start paying is as soon as possible. Now that you know that 401(k) plans and IRAs are worthwhile and how best to take advantage of them, it’s time to get more detailed and look at what you’ll actually be buying with these accounts and with your discretionary account, where you’re allowed to have fun and aim to get rich tomorrow rather than by the time you turn 60.
4
INVESTING FOR A LIFETIME—AND WHAT YOU’RE INVESTING IN
We’ve gotten to the stage where you know how to live, spend, and save in order to set yourself up to start building the long-term wealth and security that you’re really after. But if that’s all you know, you won’t get too far. Who cares about your fund or your IRA or that you know all the tricks to 401(k) investing if you’re no good at investing, period? That’s really what it all comes down to, and it’s why I’ve spent so much time teaching people how to become better investors in my previous two books, my columns, and, of course, on my TV show. Knowing how to invest goes well beyond retirement. Being able to save and invest for retirement is enough only if you’re happy to spend most of your life living from paycheck to paycheck and suddenly strike it rich when you reach retirement age and are allowed to start withdrawing from your 401(k) and your IRA.
I told you before that building a retirement fund is your top priority, but keep in mind that you also must build your nonretirement fund, what I call your discretionary portfolio. That is only slightly less important than your retirement money. For anyone who wants to build wealth to use in that big chunk of your life that happens before you turn 59½, you need to invest as much as you can in your discretionary portfolio without looting what should go to retirement funds. You don’t just need to know how to do this when you’re 25, 35, 45, or 55. You need to be growing your nonretirement capital for your entire working life—this book isn’t called Stay Mad for Life for nothing. You should start sooner if your family and relatives loved to shower you with money as you grew up.
To create the best possible retirement fund and the best possible discretionary fund you need to know what you’re investing in and what you should be investing in. It’s my job to teach you both of these. I talk about how most people in this country don’t know the difference between a stock and a bond. I’m usually exaggerating to make a point, and if you’re familiar with some of my more flamboyant work, I’m sure you’re used to it by now. Most people understand the difference between why people buy stocks (for capital appreciation) and why they buy bonds (for capital preservation), although I doubt many people would use those terms. That’s not enough. In fact, it’s a recipe for trouble. The more you know, the less money you’re liable to lose. Knowledge is power only because knowledge leads to profit, and that increases your spending power. You have to know what a stock actually is and what a bond actually is, and here too I’ll concede that many people know this. But can most people explain what makes a High-quality bond different from a junk bond in a little more detail than just what the names suggest? And while we’re on bonds, what’s the difference between a Treasury note, a Treasury bill, and a Treasury bond? You need to know that too.
I will teach you what you need to know in order to decide whether or not to invest in something, be it a security or a fund. I’ll tell you who they’re for, I’ll tell you what you need to do to successfully invest in them, and I’ll tell you something about how to evaluate them. I won’t go into stocks in much depth here, because stocks are a big subject for at least an entire book, and I’ve already written two of them. But that’s the thing—I am and have been such an ardent proponent of stocks that I’ve neglected going over almost everything else, all the nonstock investments, in the same kind of detail. Not everyone has the time, energy, and patience to make money with stocks, or at least to do it well. Not everyone should own stocks. In fact, and don’t accuse me of hypocrisy for saying this, most people should not invest in individual stocks, because investing in stocks takes too much homework for people with full-time jobs, unless they have a tremendous inclination to do this homework. I have to admit, though—proudly—that if you can watch my show, you probably have time to practice stock-picking and do a good job at it.
In the past, I may have done more harm than good by encouraging people to invest in individual stocks. I don’t feel guilty about it, because I have always hammered home the point that if you’re going to invest in stocks, which can make you an incredible amount of money, you have to be willing to work really hard at it. I know that when I give that disclaimer, the immediate response of most people, as with any other disclaimer, is to ignore it. Who cares that I’m saying stocks take hard work and devotion when I’m also telling you my life story and you know that in less than a handful of years I made myself a millionaire using stocks? Warnings don’t work when there’s a compelling story. That is, I believe, why so many of these get-rich-quick books sell so well and work so poorly.
I’m not the first self-made millionaire to write a book telling you how to get rich. The difference between me and most of the other guys, the ones who’ve already made it, is that most of them sell their story, not their advice. I made my story a separate book, Confessions of a Street Addict, which I think sent a mixed message about being a great money manager. When I say these guys sell their stories, I mean that their books go something like this: “I made a fortune doing this thing—let me tell you all about it. And if I did it, so can you.” If it’s a book about real estate, more often than not it probably doesn’t contain much good advice about investing in real estate. Instead, the book sells you a false promise, the promise that if the author got rich investing in real estate, you can too, as long as you follow in his or her footsteps.
I will not make that promise, and I certainly won’t sell it to you. I did get rich investing in stocks, and some of you can do the same, but that’s not a plan. It’s not advice. And if I came out and said, “Hey, stocks worked for me; they’ll be great for you too,” that would be terrible advice. Stocks are great if you have a lot of time and you’re really interested in investing. Most people don’t have a lot of free time, and they rightly don’t want to spend ten hours a week researching and learning about stocks. That’s the majority. They can still get rich, they can still build long-term prosperity, but they don’t need to know about stock trading to do it. They need to know how to invest well in a way that’s much less time-consuming, and they must know how to change their approach to investing as they age. Statistically speaking, when I say “they,” I probably mean you right now. I call changing your approach to investing as you get older “investing for a lifetime.” Now I’ll teach you not just investing for a lifetime, but also what to invest in for a lifetime.
Before I go through everything you might consider investing in, and at what time of life you should do it, I just want to remind you that as I explain each of these potential investments, I’ll also be explaining what’s right for your discretionary fund and what’s right for your retirement fund. The rules are a little different for each, and you’ll be a very unhappy retiree if you forget that. You can and should take more risks with your discretionary portfolio. That means investing more aggressively in riskier assets and caring just a little bit less about capital preservation most of the time and a little more about capital appreciation. Also, unlike your retirement fund, your discretionary fund doesn’t get all those nice gifts from the government. The money in your retirement account, as you know, comes from your pretax income, and you don’t get taxed on your gains for as long as you keep them inside the 401(k) or IRA (unless it’s a Roth, and then you don’t pay income tax when you withdraw money once you retire). Unfortunately, that’s not the way it works inside a regular, old-fashioned nonretirement account that you have with a bank or a broker. You’re investing your discretionary capital with after-tax in
come, and as you saw in the previous chapter, doing that, along with the tax on your capital gains, takes a big bite out of your ability to make massive investing gains. Investing your discretionary capital isn’t like having one arm tied behind your back; it’s just that retirement investing is like having an extra arm, thanks to the tax savings.
This is part of the reason you should take more risk with your nonretirement portfolio. You need it to make up for what the tax man takes away. Of course, the main reason is that you’re using your discretionary money to pay for things like college tuition, a home, or maybe a new car. (Incidentally, buying a new car is considered the classic example of a bad investment, because as soon as it leaves the lot it loses half of its value. If you don’t consider your car an investment—I consider mine a necessity because I live in the suburbs and need to drive to get anywhere—the fact that it’s a poor investment shouldn’t matter.) These things, while important, aren’t as essential as paying for retirement. If you take a lot of risk in your discretionary portfolio and you lose the money you’d earmarked for the Lexus, it’s not the end of the world if you have to drive a Kia, especially since Kias are pretty decent cars. But if you invest a lot of money in your IRA in a really risky stock or in stock options, which are very risky (and I’ll explain what you need to know about them later in this chapter), and you lose that money, not being able to pay for a couple years of your retirement is a serious problem.
Jim Cramer's Stay Mad for Life Page 11
