The No Debt Plan: Step Six: Investing for Retirement

by Kevin on November 17, 2008

This is the ninth post in my series/guide called the No Debt Plan. It’s designed to help you set up a budget, get out of debt, and build wealth.

So you want to be worth millions some day… doesn’t everyone? Living a frugal lifestyle and paying off your debt is a great step in the right direction. But you can’t just sit your extra cash in an ING Direct savings account and hope for the best, as you’ll likely lose out over time to inflation.

It’s time to start investing your money. There are literally millions of different ways you could invest your money. You could start a hobby based business (like blogging!), invest in an apartment building that you rent out for profit, or buy some land in hopes that is appreciates over time to be worth something.

In this section of the No Debt Plan, when I say investing I mean investing your money for retirement in the stock market and traditional methods of doing that.

Take Your Emotions Out of the Retirement Equation

The stock market can be quite the scary place. Just recently here in 2008 we’ve seen one of those stock market “corrections” that will end up in the history books some day. The S&P 500 is down around 30% over the last 12 months. Panic is always right around the corner, waiting on bad news like unemployment numbers are up or GDP is down or manufacturing orders are way down.

Staring at CNBC all day long listening to pundits and talking heads is one of the worst things you can do for your long term investing. I have to admit I am guilty of checking the stock market at work. I figure if I am going to live through history I might as well take notice of it. But in reality I should just ignore most of what is being said and keep plugging away at my plan.

Emotions will entice you to do all kinds of crazy things. When the news is bad you will be inclined to sell everything in your portfolio and stick it in cash. Result? You might save in the short term as the market falls, but then you miss the market rebound next month. When the news is good you will be inclined to take on all sorts of risk which, in the long run, usually doesn’t work out well for inexperienced investors.

Set up your system to remove emotions from the equation. Revise your plan once a year, reallocate your investments then, too. Go back to living your life and stop worrying about the markets.

Automatic Investing — Payments Help You Reach Your Retirement Goals

Have you heard of The Automatic Millionaire? The book is probably the best $13 you could spend this month, or you could pick it up from the library. I’ll admit I haven’t read the full book, but I understand the basic premise. Essentially a great step towards becoming a millionaire is to make saving and investing automatic. I wholeheartedly agree.

Why are automatic payments so important? Pointing back to my first point in this article, you want to remove emotions from investing. If you setup your system to automatically take $400 from your checking account each month and put it into a retirement account, there is very little emotion involved. Markets up? Money still is saved for retirement. Markets down? The money lands in the retirement account just the same. Your emotions don’t influence your buying decision.

General Order of Investing Account: 401k, IRA/Roth IRA, Individual Accounts

I recommend a specific order of accounts that should take priority for your investing for retirement. Every individual’s situation is different, but in general this order works out best.

Before I get to the order, let me point this out: these are retirement accounts, not retirement investments. Some people get confused thinking that the different accounts limit the types of investments you can make in the account. This is somewhat true (your employer’s 401k won’t allow you to invest in every possible investment in the world), but generally you are open to invest in whatever you please.

Think of it this way: a retirement account is an account in the way that a checking account and a savings account are accounts. It’s a place your money goes. You have to then make investments within the account, or the money will just sit there like it would in any other account.

Now, for my preferred order of investing:

401k/Roth 401k

Many employers offer a 401k plan to employees. Employers usually offer a matching contribution for every dollar that you put into the account. For example, if your employer does a 100% match of every dollar you put into the account (up to 3% of your salary), then if you put in 3% of every paycheck into your 401k… the employer will match that contribution. If that turns out to be $100 per paycheck, then your employer will give you $100 per paycheck into your 401k account. That’s free money to the tune of a 100% return.

Other employers may only do a 50% match, or give you a fixed amount per year as a match. Any way you cut it, as long as you get a match you are getting free money. Thus, 401k plans top my list as long as your employer gives you any kind of match.

A traditional 401k plan also gives you a tax break because your contribution if a pre-tax contribution. What does this mean? A quick example: your paycheck is $1,000 before taxes, you are in the 25% tax bracket, and you contribute $100 to your 401k each paycheck. Normally you would pay $250 in taxes ($1,000 x 25%). Thanks to the 401k contribution lowering your taxable income to $900, you only pay taxes of $225. (You pay taxes when you withdraw the money in retirement.)

A Roth 401k let’s you pay your taxes now and never pay taxes on the money ever again. There’s a debate running on if this turns out to be a good thing in the long run, but we won’t get into that now.

You are limited to contributing $15,500 of your own money to a 401k account in 2008 (unless you are over 50 — if you are, you can contribute an additional $5,000 in 2008). In 2009, the contribution limits are bumped up to $16,500 (plus $5,500 if you are older than 50).

Traditional or Roth IRA

My next preferred investment account is an individual retirement account (IRA). Similar to the 401k plans, there are two different types of IRAs. Traditional is pre-tax, Roth is post-tax.

The main difference between a 401k plan and IRAs is that your 401k investment options is limited to what your employer chooses. With an IRA, your investment options are virtually limitless. Within an IRA account you can invest in individual stocks, mutual funds, and CDs. With a 401k plan you are limited to just the mutual funds that your employer offers.

IRA contributions are limited to $5,000 in 2008 ($6,000 if 50+). In 2009, the contributions stay the same.

Individual Taxable Investment Accounts

If you are lucky enough to have money left over after maxing out your 401k and IRA, you could open up a taxable investment account. Much like an IRA account, your investment options are virtually limitless with this option. If you are lucky enough to have money to invest after the $20,500 it would take to get to this point, congrats.

Start Early

The best thing you can do for retirement is to start now. Let time and compound interest work on your side, growing your portfolio as time marches on. Another quick example:

You start investing $1,000 at age 25 in Vanguard’s Target Retirement Fund 2050 (VFIFX) which has an expense ratio of 0.21% per year. On average your investment earns 7% per year until retirement at age 65. You only invest for 10 years. At age 65 your initial $10,000 investment is worth roughly $118,939.

Your friend waits until age 35 and invests in the same fund, with the same expense ratio, and the same returns. He also decides to invest $1,000 every year until retirement. Even though he contributes from age 35 to age 64 — $30,000 versus $10,000 — his portfolio is only worth $112,653.

Now imagine a second friend that starts investing at the same age you do (25), but continues to contribute until retirement. Her portfolio is worth $231,592.

Time works for you if you start early. Plain and simple. The later in life you wait to start investing, the less positive impact time will have for your portfolio. Get started now!

Don’t Ignore Your Investments: Asset Allocation is Important

Unfortunately, investing is not normally a “set it and forget it” deal. To start out, you need to discover your ideal asset allocation. What percentage of your portfolio do you want in stocks, what percentage in bonds, what percentage in cash? I’ve written about the 120 minus your age stock allocation formula in the past.

Asset allocation has been highlighted recently by the financial crisis. Imagine being 57 years old and your portfolio is 100% stocks. With the market down 30%+ over the last year, your retirement is severely affected. I gave an example of how much money you wouldn’t have lost with risk management and the imaginary portfolio.

At least once per year you should look at your investments and make sure they still reflect what you decided your asset allocation should be. If not, you need to make adjustments to get everything back in line. I’ve got several articles about asset allocation on the blog, just do a search for “asset allocation” up in the search bar at the top.

The bottom line: get educated on investing, get started as soon as possible, and make sure your allocation is in line with what you want (and what is proper for your age).

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December 1, 2008 at 12:06 am


PGW November 17, 2008 at 3:11 pm

I wonder why you illustrate with the example of Vanguard’s Target Retirement Fund 2050 (VFIFX)…and illustrate with 7% return? This fund has been around less than three years! I know the point you re trying to make is to invest at an early age…but to me it seems like your secondary point is one of promoting the fund. If this is way off base, I apologize…but a better example would have cited a fund that has some historical data behind it.

Kevin November 17, 2008 at 3:37 pm

@PGW: Thanks for asking the question. Have you looked at the fund?

Yes, it has been around less than 3 years. However, it is a fund of funds that have been around longer. Plus the funds are tracking indexes rather than being actively managed. So I’m not guaranteeing the funds will earn 7%, I’m counting more on the fact that the markets as a whole will earn at least 7%. I could have picked Vanguard’s S&P 500 index, or Fidelity’s, or T Rowe Price’s. I didn’t say just the return of the index because I need something to take expense ratios out of, so I picked the fund I know.

I am invested in the Vanguard fund mentioned, but they don’t pay affiliate commissions or anything like that. I’m not trying to convince you to start using Vanguard. Again, I’m using the fund as a proxy for my estimated market returns (and I know it’s expense ratio).

Hope that clears up any confusion.

Scott November 18, 2008 at 11:55 am


Great blog full of worthwhile information.

For automatic investing, have you looked into ING Direct’s ShareBuilder brokerage? What are your thoughts?

Start-Up November 18, 2008 at 12:09 pm

quick note as to the order of investing vehicles. I agree 401k’s should go first if you get a company match. I do not have a company match, and some companies are beginning to drop the match with the poor economic outlook. If you company doesnt match, and you don’t like the funds in the 401k, then invest in an IRA first and be able to select your funds.

Kevin November 18, 2008 at 2:43 pm

@Scott: This is the one product of ING Direct that I can’t support. It’s a great idea to get people to continually do it, but $4 per trade is a hefty cost unless you are investing a ton of money up front. For example, if you’re only investing $50 per month, that $4 cost is an 8% cost. That’s a lot.

I prefer an IRA with Vanguard mutual funds (or ETFs). With the mutual fund your expense ratio is slightly higher than with ETFs, but there are no transaction costs.

If you’re just getting started investing, I would recommend sending the money to a savings account and save up the money to invest it regularly either in an ETF or a mutual fund.

@Start-up: You are right, I was going to mention that but was trying to keep the length of the article down.

Russell November 20, 2008 at 8:40 am

Kevin, that was all pretty good, except there are limitations on the traditional IRA if you’re participating in a 401(k). This year I’m stuck in that situation, even though I was only employed 6 months before becoming self-employed. Because I was enrolled in the 401(k) in 2008 my IRA would not be deductible. (Although I have read conflicting opinion on this rule.)

The Roth IRA does not have this restriction, so I’ve chosen that this year, and for those still employed and participating in a 401(k) the Roth IRA would be the next choice for surplus investment funds.

Noey February 18, 2013 at 3:44 pm

Hi Kevin, great post. Have you read the Automatic Millionaire yet? Great read. I borrowed it from the library.

Kevin February 18, 2013 at 5:46 pm

I have not, but I understand the overall theme.

Jim December 29, 2013 at 3:44 pm

I have been looking into budgeting and the best ways to budget, this was very helpful, good blog, full of amazing info.

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