Getting More Bang For Your Buck
April 17, 2002
For most of us in our 20s and early 30s, thoughts of retirement couldn't be farther away, and setting money aside for our golden years probably doesn't factor into our current financial plans. Thinking in the direction of future finance can be hard. With all the choices we're already making (or are continuing to put off), investment and saving can seem like one more headache. But now is exactly the time when we should be thinking about and planning for retirement, children’s college tuition and home ownership.
Obviously, the world of money markets can be daunting, especially to those of us who slept through our general-ed economics classes in college. So, as a service to slack twentysomethings everywhere, here's a brief look at some basics of personal investment and planning, especially in the area of IRAs.
In order to understand financial planning, you need to understand the three basic investment categories (stocks, bonds, and cash investments) and how they work. They each make money in ways fairly easy to understand.
Stocks are ownership shares that investors buy in a corporation. If you buy stock in a company, really, you are buying a piece of that company, so that when the value of the company goes up, so does the value of your stock.
Bonds are loans investors make to either corporations or governments. In other words, it’s a bit like taking out a loan from the bank to buy a car paying it back with interest, except backwards. You’re the “bank” and the government is “buying the car,” you get your money back with interest.
Cash investments include bank savings accounts, Certificates of Deposit, and U.S. Treasury Bills. These are fairly standard: you give them your money for keeping and you a fairly low return percentage (between 2 and 3 percent yearly). Another investment option that is broader in scope is called a mutual fund. Mutual funds can be stocks, bonds, cash or some combination of the three. Here, you, the investor, pay a mutual fund company to invest broadly in many stocks, etc. As they do well, you do well. It seems to be the best of all worlds in many ways. Of course, you can always put your money to work in other investment categories outside the big three: stamps, comic books, gold and silver coins, hairpieces, Elvis memorabilia ...
A right proper way to get more bang for your investment buck is to look into tax-deferred savings plans. These are government instituted plans that include Individual Retirement Accounts (IRAs) and salary-reduction plans like: 401k(s), Keoghs or Simples. I’ll leave the salary reduction stuff alone and focus on the IRAs, since just about anyone can take advantage of IRAs. Now, the important thing to know about IRAs is this: they have tax-deferred status and they hold just about whatever you want to put in them. In other words, if you wanted to buy 100 shares of Harley-Davidson at $52 a share and put it in an IRA, then you wouldn’t have to pay taxes on your stock until you take it out at retirement. Plus, you’d get to deduct any gains you made on your income tax returns every year. This is pretty huge, because normally in any other situation, the government would be taxing the heck out of your savings. Let’s look at this another way: Basically, an IRA is just a government-sanctioned place to put your investments where they won’t be taxed until withdrawal. This allows for your investments to grow larger at a faster rate, since they aren’t being hampered by yearly taxation.
A few years ago, Congress approved a new type of IRA, the Roth IRA. The Roth differs from the standard IRA mainly because it is tax-free; whatever you put in a Roth is not subject to taxation upon withdrawal. This is very huge, and it’s definitely something to take advantage of. There are only two possible down sides to the Roth: first the lack of any annual deductions that you can take on your income tax. Simplified, this means the government won’t give you any money back for investing in an IRA at the end of the fiscal year. The second down side is the $3000 in investments per year maximum, meaning that you can only buy $3000 worth of stocks, bonds, mutual funds, etc. to put into your IRA yearly. But, if you’re in your 20s or early 30s you may not be willing to devote much more than that to savings per year anyway, plus it looks like congress has a plan to increase that maximum number to $4000 by 2005 and $5000 by 2008.
How do you take advantage of a Roth IRA? The first step can be to find an investment firm or personal CPA you trust to help with your investments and to monitor growth. Usually for a modest fee a firm will chart your investments and report your earnings monthly. The second step is to decide which type of investments are right for you. A good rule of thumb is to make sure you are funding your IRA with plenty of diverse investments. This keeps the risk of losing money down and the chances of making money up. Diversity means having stocks, bonds and mutual funds in an IRA. Diversity also means making sure you have stocks from many different industries in your portfolio. For example, a wise investment would be one that includes technology, health care, consumer, financial and industrial stocks. This is why mutual funds are such a good choice for IRA investments, they help diversify a portfolio that, in turn, provides a buffer for economic downturns (see post-Dotcom era Wall Street) and strengthens your return percentages. Also, mutual funds provide diversity at a cheaper price, which helps you stay under the yearly maximum.
Whatever investment path you take, it’s always a good idea to ask plenty of questions, find out all you can, and take your time making decisions. The more you know about investments the better your chances are of having a greater measure of successful returns. Of course, don’t be afraid to make mistakes either; sometimes that’s the best way to learn.
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