How General Investments WorkPosted: September 27, 2008
Ok, for those of you who don’t know what a boring person I am stop reading right now…I only write this so I can retain the one or two friends I still have and not drag them into my little world of pleasure for which they have no interest in sharing or hearing about. I have it on good authority that there are only 6 ½ people on the planet that find this interesting.
I love money; I love what it can do. I love the fact that if you are careful and watch it closely you can actually pay yourself more than anyone else you owe money to and when you reach that point it has the ability to do things on it’s own that you will never be able to do by going to work and earning money. The coolest thing that I think I have learned as an adult is that jobs don’t make money, money makes money…now I just need to reach the point where the cycle runs itself. It is fascinating to watch this happen step-by-step.
I learned new things about finances…and I am so excited! I finally had a great guy from USAA explain some stuff to me about exactly how a Roth IRA vs. an IRA vs. my work 403B vs. the just everyday Mutual fund works. It is so nice to finally have someone lay that out straight. It is especially nice considering I have all of these accounts (except a normal IRA) and all with different companies. He also went into a pretty good amount of detail about what is meant when they say you should re-balance your portfolio to keep it diversified and on track. I get it now. I am not sure if I understand everything enough to put everything into practice but I think I understand all of the principle behind the concept.
First for the retirement funds:
We had been having a very large debate in my house as to the pros and cons of maxing out the Roth IRA verses going with other investment vehicles…my main issue being this-I intend for this to be the lowest earning period in my life. I could not figure out the benefit of tax protecting money now that I would have to pay in the future (in our sixties) when I think our tax bracket will be peaking. I plan to be worth several millions at that point. I thought that it would be best to pay the taxes now on both the principle and the interest and be done with it so that what I build up would not have to be taxed at the rate I might be at in 30 years.
I was mixing up the benefits of the various different types of accounts, I was thinking of my Roth IRA as if it had to follow the rules of a traditional IRA or even worse my 403B plan. So here are the rules as I understand them in layman’s terms.
Roth IRA: You pay taxes on the money you make and then invest the money into this account (for us we can put in up to 4K a year each because of how much we make and we are married.) Because you have already paid Uncle Sam he leaves your shit alone – all of it, forever – the rest of the interest that you earn is never taxed not even when you take it out. This means if you don’t touch it for the full time you shouldn’t (until somewhere in your late 50’s) then when you pull it out you owe no more taxes at all, your done…yippy. The other upside is that you already gave big brother his cut so he doesn’t smack you down so hard if you do need some of the money before you are in your late 50’s…the down side to that is you lose all of the shelter for the tax break on the earned interest if you pull the money out early. You can only make contributions to this type of account while you are poor-ish…because everything about it rocks. I think your combined income has to be below 160K, so we still have a few more years (sigh) of being able to contribute to this. I can see no reason to contribute to anything else if you have not maxed out this type of account.
IRA: I didn’t listen quite as closely here, because I don’t have any…but it is similar if a bit crappier than the Roth IRA. From what I remember, everything that you invest is removed directly from your taxable income (lowers the amount of money you have to say you made this year) and both the principle investment and the earned interest grow tax free until you have to take the money out…presumably because in your retirement years when you have the ability to pull this money out without penalty you will not be working and will therefore be paying a lot less in taxes so it shouldn’t hurt as much to pay the taxes on this then as it does when you were working and in a higher bracket. This seems not to work for me because I think we will be earning more in our 60’s than any other time in our life, but I get the point for most people.
Lots of penalties for pulling money out early, you have to pay all of the taxes plus a fee just for touching it. Moral is – save in another way for a rainy day.
403B: (This is for hospitals and teachers I think…I have no clue how close it is to a 401K but I think they are fairly close. I have always worked for a college or Hospital when I invested in one of these.) Very similar to an IRA, see all of the rules above. This has been a great way for me to drop me earned income at will (if you need to lose a few hundred dollars to get down to a lower tax bracket, you can up your contribution and it comes out pre-tax.) Plus almost all employers that offer these do some sort of contribution match…free money is cool. I typically max to what the employer match is and then go in a different route for everything else, these are usually to difficult to move and roll over, you have to sign a crap load of forms and jump through hoops…it annoys me.
Mutual Funds: These are your run of the mill take them and buy them as you please investments. You will have already paid taxes on the principle investment because you buy them with post tax money, and every year you have to pay taxes on the amount of money that you earn in interest…even if you don’t sell anything and actually pocket that money. This was kind of news to me this year, for some reason I thought that you didn’t have to pay taxes until you cashed out your money. Not true, so when you get to a point where you have a lot of money making money and you are not cashing it out and living off of it you have to take that into account for planning to pay taxes. This year this almost bumped us up into another tax bracket, luckily we had moving expenses for deductions to counteract the earnings but I will watch this closer from now on. The ball had been rolling so slowly for so many years as we built up the pile that I missed it when things got moving, then one day it reached a critical mass in which the investment sort of became self sustaining. Now we could put money in or not and it would keep making a good amount of money…pretty cool but definitely has tax consequences.
Balancing the portfolio:
As far as the balancing of the funds, I think I understand the concept now…I just think we have too many different accounts for me to do it properly. I have going to have to re-evaluate who is getting my money and condense the accounts before I can do this correctly. But in essence I think it is a way of riding out some of the changes in the market and staying on top of the desire to buy low and sell high. There are some ratios that he advised for our age and ability to handle risk. This is what I can remember off of the top of my head:
85/15: Mutual funds to Bonds
70/30: Large Cap/Small Cap.
No more than 5% specialty (like precious metals)
No more than 20% International
6 months liquid cash for rainy days (For my family we like 12 different 12 month CD’s that come to maturity one each month and auto renew for another year if you don’t need them. That way you never have to wait more than a month to get into emergency money with a decent interest rate.)
First of all this tells me I need to learn more about the funds that I am investing in, I know some of the categories that they fall into but not all. Second it tells me that I am too heavy in some areas. The reason he gave for this division is that if we keep things balanced like this across the portfolio something should always be going up and we should always be getting a good deal on something else. It forces you to stick with the plan of buy low and sell high without chasing the next big thing.
What I mean by this is if you have $100 dollars a month going into investments and your portfolio gets out of whack then this means that part of the stuff you have invested in has done well and part hasn’t.
Should look like:
A=30% of total investment allotment
Actually looks like this after 6 months:
-I need to sell 10% of B and 5% of C and buy what that will get me of A…to get everything back to equilibrium (the first example.)
This means I sold high for B and C and bought low for A, thus actually making more money than if I just left my money alone. When I explained this the first time to someone he looked at me like I was nuts and asked why the hell I would want to short change the investments that were doing well to buy the crap investment. It is because B and C cost too much right now, that is why they are making me money, I can only buy a very little amount of them for the same money that I can buy several of the under performing A investment. In the future when A is doing well it will out pace the others and the situation will be reversed.
This is why you mix the portfolio with things that do well in different times in the market. When one of your guys is doing well you steal from him to buy more of the cheap guy…In this game numbers are your power base. In the short term I don’t care what a fund is worth I care about building up the number of funds that I own. The worth can change every day, you can’t take away my number of shares.
I kind of instinctively knew this, I knew enough to get excited every time that the market fell and wonder what the hell was wrong with the people on TV who were telling people to sell when all I wanted to do was buy cheap shit…hell the first thing I did after 9/11 was start investing for the first time. But now I think I have a better idea of how to be proactive, I won’t just get happy when these dips occur, I’ll actually be able to look into re-balancing my account while I can buy low.
Ok, I am done boring you, but hey if you made it this far and you actually have any interest in this stuff call me I would love to have someone to talk to.