Financial Planning with Jack Lemon's Dad

Many people live paycheck to paycheck. Sometimes that cannot be avoided- the jobs don't pay very well, it costs money to live, etc. However, sometimes if we make the tough choices we can set aside something from each paycheck. One of the easiest ways to do this is when you get a raise, put half of that raise directly into savings. It's money you didn't have before so it is extra income that should be easy to pretend is not there.

Everyone should have a bit of an emergency fund. $500 - $1000 is good because often vehicle emergencies cost that much or more. So if you have it set aside for an emergency, life is less stressful.

Once you become a good saver, setting aside a percentage each paycheck, then you will want to start investing for the future, for retirement.

When you are young retirement seems so far away that it may seem inconsequential. However, if you can start investing while you are young, the money will be able to grow exponentially throughout your career.

There are many different ways to invest your money. You could just open up a brokerage account online and start buying and selling stocks, bonds, mutual funds etc. the main trouble with that is you have to pay taxes on every dollar you gain when you sell the stock, bond, mutual fund, etc.

A better option is to invest in a retirement account. The beauty of a retirement account is that it grows tax free, and you don't have to pay taxes every time you sell a stock, bond or mutual fund, etc. There are four main types of retirement accounts to discuss here. The four accounts are actually like a two by two grid.

On the first axis, you can have a 401k and/or an IRA, One the second axis you can choose to have the fund be traditional and/or Roth. The and/or's are there because you can have all four types in some cases.

Some people are lucky enough to have an employer that provides a 401k retirement program for their employees. Often the employer will match your deposits by a percentage, like 50% or 80% etc. that is free money. make sure to invest as much as they will match up to. For instance if they match 50% up to $4000, then when you put in $4000, they add $2000 so you instantly made a 50% profit for your future. The limit this year for 401k investments is 22,500.

Anybody that earns money can invest in an IRA (Individual Retirement (savings) Account). You can only put in up to as much as you have earned. So if you only earn $4000, you can only put in $4000. On the other hand the maximum you can invest this year is limited to $6500, no matter how much you earn.

On the second axis is traditional versus Roth. A traditional retirement account means you invest the money before paying income taxes on your earnings. So if you earn $50,000, and you put $6000 in your 401k and $4000 in your IRA then that $10,000 goes directly into your retirement accounts, and it's like you only made $40,000 for the year, and you only pay income taxes on that $40,000. That $10,000 in your retirement accounts grows tax free no matter what buying and selling of stocks, bonds, mutual funds etc. you do during your investment career. However, you do pay taxes on that money when you start withdrawing it at retirement.

The thinking here is that during your working career you will be making more money and will be in a higher tax bracket than when you start withdrawing the money. For instance if you make $100,000 and are paying 15% income taxes, if you drop $20,000 into retirement accounts then you only pay income taxes on $80,000 now. Then when you retire, you withdraw $50,000 per year from your account and pay lower taxes on it than you would have when you were making $100,000.

On the other hand is the Roth style account. A Roth account, named after the late Delaware Sen. William Roth, is set up where you pay the income taxes on it now, up front. The retirement account grows tax free, and when you retire and start withdrawing money, you don't pay any income taxes on it at all, since you paid it up front. All the earnings are tax free as well.This can work out great if you are in a low tax bracket now, paying only 10-12% income tax, and you expect your money to grow very well over your career so that you will be withdrawing $100,000 per year later.

I believe the best option is some in each type of account because there are advantages and disadvantages for each strategy. Finding the perfect strategy is a case by case decision, and depends on your earnings, how much you can invest versus how much you want to pay in taxes now versus later.

Even if you don't put much into the Roth options, you should at least have a little in Roth because there is a stipulation where the account has tro be 5 years old before you can withdraw funds tax free.

The final note is regarding how much to put into stocks versus bonds versus mutual funds etc.The american stock market grows on average 10% per year. which means it will double your investments every seven years. Some years it will lose money overall, some years it will gain 30%. Though over the lifetime of your career it holds true to roughly 10%. Bonds have a lower return on investment but are more predictable, they return 3-6% each year. Mutual funds are all over the map. Every mutual fund manager is trying to beat the market. On average only 5% of mutual funds actually beat the market, most earn less than the market averages. The winning strategy here is to find a good market index fund that tracks the major stock market like the S&P 500.

There is a formula where you take 100 or 120 and subtract your age, the remainder is the percentage that should be in the stock market versus the bond market.(bonds likewise have index funds that track the major bond funds).

Another strategy is to find really good companies that perform well every year and are still growing and put money in those stocks, and hold them for a long time. That is Warren Buffett's strategy....

Happy investing!