One of my favorite hobbies is playing poker. The similarities between the skills needed in the game and those needed in investing are nearly identical, but that’s for a whole other post. In the poker world when trying to improve your game, you try to identify “leaks” or, small things you’re repeatedly doing wrong which add up to cost you a lot of money over time. Well the same thing happens in our everyday lives. We all have bad habits that are costing us money and significantly hurting our net worth over time. So from time to time I’ll continue with these series of posts that will identify and help us all plug these so-called leaks. And no, this isn’t going to be one of those generic posts that tell you if you stop buying coffee on your way to work every morning you could save $3000 in a year! While that may be a true statement, it’s also bullshit. If you think starting to use your Mr. Coffee every morning is going to change your long-term financial situation, I hate to break it to you, but you’re wasting your time.
With that said, the leak I’d like to focus on is:
Not using tax advantaged accounts/passing up on “free” money:
This is something that comes up a lot on personal finance and investing websites. A lot of people even know about all the stuff I’m going to mention, but still fail to take action! This isn’t hard stuff & it makes a huge difference over time.
401(k): If you’re out there and you have a job. Your employer most likely offers a 401(k), and probably some sort of matching contribution (usually from 3-6% of your salary in my experience). If you’re not contributing AT LEAST the amount to secure your full company match you might as well start taking $20 bills out of your wallet and start lighting them on fire. When you were a kid if your parents told you that if you put $20 into your bank account they would give you $20 you would have been ecstatic! The same principle applies. This is especially important for people who don’t make a ton of money. Say you make $35,000/yr and your employer matches 100% of your contributions up to 3% of your salary. That’s a $1050/yr handout that you’re looking at and saying “no thanks” to by not contributing. Not to mention how that money can grow by being invested and you don’t have to pay tax on any of it until you’re retired & actually pull the money out of the account. So it’s really a no-brainer. You don’t have to live on bread and water in order to pour money into your 401(k), but if you’re not contributing at least enough to get your full match you’re just flushing money down the toilet.
Roth IRA: The Roth IRA is probably the most powerful retirement vehicle available for those of us who are still in the early stages of our careers and for anyone whose income qualifies them (see link for details). The reason being is that contributions to a Roth IRA happen after-tax, however any growth on the money you contribute is tax-free. Meaning that when you retire & go to use the money you don’t pay any tax at all! So a 30 year old who can contribute the max will contribute $5000 that has already been taxed out of his/her paycheck today, invest it, and watch that investment grow for 30+ years and not have to pay tax on any of the capital gains after the fact. It’s one of those “too good to be true” scenarios that is actually true. Which is why it’s frustrating to see so many people in my generation, many of them who even KNOW about Roth IRA’s not take advantage of the opportunity. I know it can be harder in this scenario because so many of us are saving for our first houses, or weddings, or paying off student loans. But even contributing $1-2000 a year can grow to a very significant sum come retirement time. With social security most likely not in our future and pensions going way of the dinosaurs, it’s imperative to take action now and not have to worry later in life.
Traditional/Rollover IRA: The traditional IRA is another retirement vehicle which can be very important to you financial freedom. Much like the Roth, the contribution limit per year is $5000 for most people. However unlike the Roth, there is no income limit and the money contributed is pre-tax just like a 401(k). So if you work for a company that doesn’t provide a 401(k) (or related plan such as a 403b) it’s imperative you contribute to an IRA to save for retirement. A traditional IRA is also extremely useful for people who are above the income limits for a Roth IRA as you can stock away extra money for retirement and lower your tax bill at tax time due to your contributions being pre-tax and therefore lowering your taxable income each year.
A rollover IRA falls into the same category as the traditional IRA because in this day in age, as so many of us change jobs relatively frequently it’s important to take our 401(k)’s with us. It can be tempting to just cash out your 401(k) when you lose/change your job but that comes with a steep price. First of all you’ll have to pay tax on that amount. Secondly you’ll have to pay an early withdrawal penalty of up to 10%! Therefore by rolling over your 401(k) into an IRA you can keep your nest egg intact & keep investing the money on a tax advantaged basis.
HSA (Health Savings Account): I’ll admit this is more of personal preference/comfort. But if you’re younger without any dependants & in good health you may want to consider a Health Savings Account. A HSA is comes along with having a high deductible health plan. This essentially means instead of having a $50 or $100 deductible with your typical insurance, you’d pay $2000-$3000 for your deductible. That may sound nuts to you, but hear me out…first of all you pay next to nothing out of each paycheck toward your health plan & most routine checkups/preventative care are still covered 100%. So if you’re young and in good health the chances you’ll need to make an emergency room visit or pay for a lot of medications are very slim. So having one of these plans comes with a HSA, which operates kind of like a 401(k). You contribute money pre-tax into the HSA (some employers will even match just like a 401(k)) and can invest that money to help it grow faster. This money sits in your HSA and never “expires”, the only catch is that the money must be used for legit medical/health care. So instead of paying a lot up front into a health plan that you might not use, you contribute less to the actual plan and put the rest into an HSA which you keep and can grow into (hopefully) much later on when you’ll need to draw on that money for a medical expense. It’s definitely not something I’d recommend for everyone but it’s definitely something you should look into. I’ve had one for a few years now and I really like what it has to offer. You can take it from job to job and if you’re unemployed and without insurance you still have that HSA money to draw on in case anything happens.
I’m sure there are some details/types of accounts I’m leaving out, but the idea here is to get you to think about and use these different accounts available to you in order to best improve your personal financial situation. It should also go without saying, I’m not your financial adviser, so do your own research & talk to someone you trust before investing your own money into anything.