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Facebook says I live in the Bay Area. Twitter boasts that I like puns and bad jokes (@The_PUNisher_SF), and then Reddit upvotes and says I LOVE puns and bad jokes. And this blog tells you about my experiences using social media sites and learning to fit them all together into my life.

Wednesday, February 5, 2020

Investing in Money Literacy

Our society doesn't talk much about money. The only way to know someone's wealth is by looking at their spending habits - their house, their car, their lifestyle - basically all the money they don't have. To see the big picture, you would need to see their debt tolerance, their savings habits, and their overall net worth.

So why is this important? Simply put, most people are not properly saving for retirement. 95% of Americans are not financially independent at age 65 (according to The Bogleheads' Guide to Investing). Life expectancy is going up and the future of social security is uncertain. This means your current income doesn't just need to support your lifestyle now, but also in retirement!

The earlier you start saving for retirement, the sooner you start building good habits, living within your means, and letting your money grow through compounding interest. Personal finance can be complicated to understand, but even the simplest information can set you up on a path to wealth.

Here's some basic information that can start you on that path:


Budgeting
"You have to tell money what to do or it leaves" -Dave Ramsey

A general guideline for how to spend your paycheck is known as the 50/30/20 rule. 50% of your takehome pay should go to needs (house, food, car), 30% can go to wants (hobbies, dining, vacation), and 20% should go to savings. It also helps to be mindful of small repeating habits that can add up over time. This is known as the "latte factor" (buying a daily $5 coffee can cost $1,800 a year!).

Recommended First Step: Create a monthly budget for your household, and check in regularly to watch your spending and adjust your goals. You can use free budgeting tools like Mint or YNAB, but a spreadsheet works great too. Write down personal long-term goals (like the age you'd like to become a millionaire, or how much money you want when you retire) and check in on your progress quarterly or at least once a year.


Debt
"[Money] is a good servant but a bad master" -Alexander Dumas

Borrowing money can be useful, but it's risky and can end up costing more than the original purchase. If you want to buy something because "you've earned it", wait until you've actually earned it first!

Recommended First Step: Aim to be debt-free. If you need structured guidance, follow Dave Ramsey's baby steps. Once you're out of debt, stay there by making sure you have money before you spend it. Always pay your credit card balance within the 21-day grace period to avoid fees.


Emergency Funds

Many people recommend having 3-6 months worth of expenses set aside in case you lose your source of income. If you can't work or need to pay for an expensive repair, this money will buffer you from going into debt while you focus on fixing the problem. This money should be easily accessible and not tied up in risky investments (like the stock market).

Recommended First Step: Open a high-yield savings account for your emergency savings. But remember, even a generous account earning 2% won't actually earn money, it will just stay on pace with inflation (2019 inflation was 1.76%).



Retirement Accounts
"The best time to plant a tree was before. The second best time is now." (loose interpretation of Chinese Proverb)

Retirement accounts can be complicated and overwhelming, but choosing to start an account is the most important decision you'll make.

When you start contributing 15% of your paycheck for retirement, your money will earn interest, and your interest will earn interest too. This is called compound interest, which Albert Einstein supposedly called "the eighth wonder of the world".

Here's how a one-time investment of $1,000 would grow over 40 years (assuming a 7% annual return):

After 40 years, your $1,000 investment would be almost $15,000! (excluding unknown factors like inflation, taxes, unpredictable markets, etc). But the bottom line is, time is your best ingredient for growing money.

There are many types of retirement accounts, and it can be confusing to choose one. But again, making the decision to open any account will set you on the right path, and you can always change your account as you learn more and get more comfortable with the terminology.

There are 2 main types of retirement accounts:
  • 401k - This is a company-sponsored plan where employees contribute and the company offers a match (which you should always take!). When you leave your job, you can roll it over to an IRA so it remains tax-free and gives you more control for how to allocate it. The name "401(k)" comes from the IRS code section 401(k) which allows pre-tax contributions.
  • IRA - This is a personal account that you can open through a brokerage firm (like Vanguard), and isn't tied to your place of employment. IRAs generally give you more options for how to allocate your money.
There are several differences between these types of accounts like who is eligible, how much you can contribute, and how you can withdraw.

When funding your retirement accounts, you can choose 2 different types of contributions:
  • Traditional - This money is taken out of your paycheck before it is taxed, and will be taxed later in life when you withdraw the money (plus any earnings). Since you'll likely be in a lower tax bracket in retirement, this could save you a lot of money in taxes. Other names include: pre-tax, tax-advantaged, tax-sheltered, tax-deferred, tax-favored...you get the idea.
  • Roth - This money gets taxed before it is contributed, and doesn't receive any tax-sheltering benefit. However, you won't owe any taxes when you take the money out, and all earnings are tax-free as well. The benefits are you're effectively "locking in" your current tax rate, which is good if you're in a lower tax bracket or if you worry the tax policy is going to change. 
Whether you contribute Traditional or Roth, your employer matches are Traditional (since the tax break is what appeals to companies in the first place). Again, there are benefits and drawbacks to both of these options, so there usually isn't one right (or wrong!) answer. Some people recommend using both types of contributions so you have diversity.

Recommended First Step: If you're able, open a 401k through your employer and an IRA through any brokerage firm (I recommend Vanguard) and contribute as much as you're able. The 2020 annual limits are $19.5k and $6k respectfully. If this is intimidating, start small and contribute minimum amounts just to build good habits. Remember, anything is better than nothing.

Note: Anyone who earns income can open an IRA. Which means a teenager with a part-time job could get a 5-10 year head start on their compounding interest by putting a small amount aside (and in this case, a Roth IRA would be better since they're in such a low tax bracket).


Retirement Goal
"It's your job to put the gold into your golden years." -The Bogleheads' Guide to Investing (loosely interpreted)

So how much money do you need in order to retire? The simplest formula is known as the 4% rule. This says you can withdraw 4% of your total savings each year, and it should last about 30 years in an average market. Here are some examples following this rule:
  • If you have $315,000 at the start of retirement, you can withdraw $12,600 a year (the US poverty line)
  • If you have $1 million at the start of retirement, you can withdraw $40,000 a year
  • If you have $2.5 million at the start of retirement, you can withdraw $100,000 a year
This likely won't be your only source of income, since social security should add another $10,000-20,000 per year, but it's safer not to count on that money during this planning stage. According to the Social Security Administration, social security will likely be reduced to 75% of its value within the next 15 years, and will need other adjustments to correct its funds (like raising the retirement age). You can still expect to get *some* social security in retirement, but it's safer to consider it a bonus.

Recommended First Step: Determine your retirement goal (Nerdwallet has a good calculator here) and put it in writing, then check in on your progress each year to make sure you're still on track.


Additional Investments

After you've funded your retirement accounts, you may have additional money you want to invest. This is when you should consider buying appreciating assets (like real estate) or investing in the stock market.

Individual company stocks are risky, and should only be purchased with money you are willing to lose. Index funds and ETFs are a safer option, since these are collections of diversified stocks, which have a lower risk of losing all your money. As long as the overall stock market is trending upward (known as a "bull market"), your fund will rise as well. A good index fund can earn anywhere from 7% to 15% in a given year. Please note, you should never invest money in the stock market unless you understand the risk.

Recommended First Step: Open a brokerage account with Vanguard and buy shares of a Total Stock Market fund (I recommend VTSAX or VTI - one is an index fund and the other is an ETF, but both track the same funds and both have very low fees). Track your progress, but don't be afraid of a market down-turn. Remember that in historical 15-year periods, stock markets have always made money. Several stockbrokers have recently stopped charging transaction fees, so it's easier to experiment with buying and selling stocks. I recommend Robinhood since it's user-friendly and simple.


Summary

I hope this information has motivated you to set goals for your money. Even a small amount of savings can make a big difference. Remember that the goal isn't to deprive yourself of what brings you joy - after all, life has no guarantees and it's important to live in the present. Instead, the goal is to create healthy behaviors that drive you toward success, and give you perspective on where your money can be most useful. If you still decide to make a big purchase, at least it is an informed decision.

By setting up the right behaviors, you can control your retirement. While there's no way to predict the future, you can at least remove financial obstacles and gift yourself independence. And I have no doubt your future self will thank you for it!


Additional Resources

These guidelines are from my own experience and research, meant to inspire you to gain control of your finances. I encourage you to research, form your own opinions, and consult a financial expert before making any significant changes. Financial data changes often, so any numbers provided here should be checked for accuracy.

I'm still learning on this journey, so please comment if you have a different viewpoint or different information you would like to share.

If you're inspired to continue learning, here are some resources that I've found valuable:
  • Personal Finance wiki on Reddit - Has great step-by-step instructions for how to allocate your income
  • The Dave Ramsey Show podcast - This is a great resource if you're struggling to get out of debt and need a behavioral change
  • Vanguard - This is a good place to open an IRA or brokerage account. The company is known for its low fees and good philosophies and leadership by founder Jack Bogle (the namesake of the "Bogleheads" movement).
  • Mint - This is a free tool to create a budget and link your accounts to track progress (another case where you're likely the product, also has a lot of connection issues)
  • Ally (online bank) - Offers high-yield savings accounts with strong rates, good place to put your emergency fund
  • Investing for Beginners site on Investopedia
  • IRS.gov Free File - I think everyone should do their own taxes at least once in their life, to understand how it works. It is a freeing and free experience!
  • Other website resources such as: Motley FoolNerdWalletBankrateYahoo Finance

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