Investing Basics for 20-Something’s

Congratulations! You’ve got a job, paid down your student loans and credit cards, and have a little money leftover each month. You know you should invest this money for retirement, but you aren’t sure exactly where to start. This guide should help you out. 

Does your company offer a 401(K) Plan and match?

If so, let’s start here. If not, skip to the next section. Most employers offer a 401(K) plan, and most employers offer matching contributions (something like $0.50 per dollar you contribute, up to 6% of your salary). 401(K) plans are employer sponsored retirement plans which allow your savings to grow tax deferred (that is, you pay income tax on your withdrawals in retirement; however, you do not have to pay tax on dividends or capital gains). Employer matches are basically free money, so I would highly recommend contributing up to the employer match into your 401(K) plan. You can begin taking money out of your 401(K) without penalty at age 59 and a half. 

As the investment options for 401(K) plans differ from employer to employer, I cannot give much advice as to how exactly to invest your money. I will say, look for funds with low fees (Vanguard) and high equity allocations. Equities are riskier, but will almost certainly perform better over the long run. Plus, you are young, and have plenty of time to tolerate swings in your retirement portfolio. The maximum contribution to a 401(K) in 2015 is $18,000, but once you hit your employer match I would recommend moving on to a Roth IRA. This is because you can’t access money in your 401(K) if you want to buy a house or a car, for example, without paying a 10% penalty. 

Open a Roth IRA

If you are contributing enough to receive the full match on your 401(K) plan, the next step should be to open a Roth IRA. I recommend using a service like Betterment or WealthFront. These services provide you with a low cost, well-diversified portfolio and often offer additional services such as rebalancing and tax-loss harvesting which serve to boost returns.

With a Roth IRA, you pay regular income tax now and then never have to pay a dime of tax again. A Roth also has some additional benefits. You can take out the contributions you make to a Roth at any time with no penalty (you can’t take out any earnings your investments have made without a 10% penalty, however, but I will come back to this later). So if you want to purchase a house, you are free to take out the money you have contributed to your Roth. Just like a 401(K), you can begin taking distributions from your Roth IRA at age 59 and a half. 

The contribution limit for a Roth IRA is $5,500 for 2015. You can tap into up to $10,000 the earnings of your Roth IRA without penalty if your account has been open for five years and it is for a qualified purchase, such as a home. 

The Next Step

If you still have money left over after reaching your employer match on your 401(K), and hitting the contribution limit of $5,500 on your Roth IRA, then congratulations, you are doing much better financially than most millennials. 

At this point you need to consider your goals. Do you:

1) Have a specific purchase in mind, such as a home?

If you have a large purchase on the horizon, such as a home, I would recommend opening a taxable account, again with a service such as Betterment or WealthFront. While taxable accounts don’t offer the same tax benefits as IRAs and 401(K)s, they do give you the flexibility to take out money as you please. 

2) Want to save as much as possible for retirement. 

If your goal is simply to maximize retirement savings, you should continue to contribute to your 401(K), up to the $18,000 contribution limit due to the tax benefits that a 401(K) provides. Once you hit this limit, your only choice is to open a taxable account. 

I hope this column gives 20 something’s a good idea of which accounts to use in investing. If you are reading this column, then you are getting a good start on your way to a long and happy retirement!

The Optimum Combination of Cash Back Rewards Credit Cards

For those of you who checked out my previous post on using cash back rewards credit cards as an investment strategy, I mentioned that there is an optimum combination of cards which can allow the average consumer to achieve the highest rate of cash back rewards.  Samuel L. Jackson thinks his card is the best because it offers 1.5% cash back on every purchase, every single day.  Well, I believe one could easily get an average of 3.5% cash back on discretionary spending.  And as shown in this chart, a 1.0% bump in cash back rewards could result in nearly $50,000 in additional retirement savings over a 40 year career.

It is important to note that cash back rewards credit cards are generally reserved only for the most creditworthy individuals.  One probably needs a 750+ credit score to qualify for these cards.  While I do recommend owning all of these cards, I don’t advise applying for all of these cards at once, as this will negatively impact your credit score.  A proper balance of applying for credit responsibly and adding these cards to the arsenal will payout well for the savvy consumer.

The first step in identifying the proper combination of cash back rewards credit cards is to establish your main spending categories.  I assume if you are financially savvy enough to be reading this blog, you probably (hopefully) keep a budget so this should be easy enough.  My main spending categories and average monthly spend are below:

• Groceries: $400
• Gas : $200
• Restaurants $200
• Department Stores: $100
• Miscellaneous: $400

Now comes the fun part:

Groceries:

I highly recommend the American Express Blue Cash Preferred Credit Card for the groceries category.  This baby offers 6% cash back on groceries.  I also recommend this card for gas (see below).  There is a $75 annual fee associated with this card.  There is also a free version of the card which offers 3% cash back on groceries, but if you spend more than $50/week on groceries it makes sense to go with the Preferred version.

Gas:

In general, I would recommend using the American Express Blue Cash Preferred Credit Card mentioned above for gas, unless gas becomes a 5% rotating category discussed below.  3% cash back on gas is the highest year-round cash back rewards rate I’ve seen.

Rotating 5% Categories:

Here’s where it gets a bit tricky.  Restaurants, department stores, and gas are often in 5% rotating cash back categories.  By timing purchases and being aware of each card’s respective 5% category calendar, one can really boost the cash back they earn.  Here are the cards I recommend:

Discover It Card (No Annual Fee)

U.S. Bank Cash Plus Card (No Annual Fee)

Chase Freedom (No Annual Fee)

Miscellaneous:

The clear winner for miscellaneous purchases is the Citi Double Cash Card (No Annual Fee).  I haven’t seen any other cards out there that offer 2.0% cash back on ALL purchases.  Granted, you get 1.0% when you buy, and 1.0% when you pay, but I would assume my readers are intelligent enough not to carry a balance on a credit card.  By not carrying a balance, you will get the full 2.0% cash back each month.

Conclusion:

I hope the below table summarizes how beneficial it can be to own this combination of cards.  I’ve assumed both restaurants and departments are a rotating 5% category year-round on at least one of the three cards mentioned above.  I’ve also assumed only a 3.0% cash back rate on gas, but in reality, we would get 5% cash back in at least one quarter of the year with the above cards:

As you can see, an arsenal of cash back credit cards can yield real savings if used properly.  $561.00 in cash back on spending of $15,600.00 is a rate of 3.60%!  Tell that to Samuel L.

Using Cash Back Rewards as an Investment Strategy

All you hear this days is how bad credit cards are for you.  “They’ll hurt your credit score, the interest rate is absurdly high, credit card companies charge outrageous late fees, credit cards cause identify theft.”  The list goes on and on and many millenials don’t even own credit cards; however, most individuals don’t realize how incredibly beneficial credit cards are for the responsible consumer.  Not only are they as convenient and ubiquitous as debit cards, credit cards offer additional benefits such as fraud protection and rewards programs.  Today I am going to discuss the latter.  You may get annoyed of Samuel L. Jackson telling you that you can get unlimited 1.5% cash back on your Capital One® Quicksilver® Cash Rewards Credit Card, but in fact, if managed properly these cash rewards credit cards can really add up.  There is a certain strategy for obtaining the highest possible cash back percentage, but that discussion will be saved for another day.  Here is how you can view a credit card as an investment strategy:

According to a study performed by Experian in 2011, the average American household spends $12,800 on discretionary spending per year.  I believe it is reasonable to assume that those financially responsible enough to be reading this blog would have closer to $20,000 in annual discretionary spending.  I also believe it is acceptable to assume all discretionary expenses could be put on a credit card.  Required expenses, (i.e. rent) generally cannot be put on a credit card.  By simply using the Capital One card mentioned above, one could save $192 and $300 at the spending rates above, respectively.  By using the proper combination of cards, it is feasible to fetch a cash back rewards rate of 2.0% or even 2.5%.

Now I argue that since you would have spent this money anyways had you only had a debit card to use for the purchase, this money can be treated as excess income and should be invested (cash back rewards are not taxable, they are treated as a reduction in the purchase price).  If this cash back is invested over an entire career, say 40 years, it becomes clear that using a cash back rewards credit card can pay huge dividends.

We’ve graphed the results at the spending rates and cash back rewards rates discussed above.  We’ve assumed that a 23 year old would be able to get one or more of these cards after demonstrating their ability to manage credit responsibly during their first year of employment.  We’ve assumed this 23 year old will retire in 40 years.  Inflation is assumed to be 2.5% and investment returns a conservative 6.0%.

 

As you can see, at a $20,000 annual discretionary spending rate and 2.5 % cash back rewards rate, one could add close to $125,000 towards their retirement.  That’s a lot of dough for doing almost nothing!