Ultimate Financial Lifestyle Guide - Part 1
Posted Oct 31, 2007 | 3 Comments
tags: checking,
fidelity,
investing,
money,
schwab,
vanguard
Who doesn’t want freedom, control, and peace of mind in their financial lifestyle? Is there any reason not to lower all your expenses and maximize earnings? In this series of articles, I’ll detail the ultimate products and strategies that can enhance your financial lifestyle in every aspect. In Part 1, I will discuss the importance of saving money, the best online checking accounts, the best brokerage accounts, and Roth IRAs.
Saving is Everything
No matter how much or how little you make, the only thing that matters in the long run is how much you save. And the earlier, the much better. Aim for saving 20% or more of your income. If this isn’t possible, do yourself a favor and at least try to salvage 10%. Start early and aggressively and you won’t have to save nearly as much later. The power of compound growth is illustrated profoundly in the graph below. It shows three different investment scenarios, all with $4000 annual contributions compounding over time at 8% annual return:
As you can see, a $40,000 total investment, made in $4000 increments over ten years, beats a $120,000 investment started ten years later. In fact, the $40,000 investment will continue to beat the one started ten years later into perpetuity, despite additional $4000 contributions each year! Looking at the first curve above, you can see that combining these two scenarios – early and continued investment – is a recipe for becoming a millionaire by age 65. Of course you can reach that point much sooner if you are able to invest a lot early in life, giving your exponential growth curve something like a steroid injection, except legal.
Roth IRA
The Roth IRA is the biggest tax break for individuals ever created. Max it out every year, as early as you can. I start this guide with the importance of saving and IRAs because probably the single best thing you can do for your finances is to pay yourself first. Secure money for your contribution ahead of each New Year’s like someone is holding your child for a ransom. Then you can pay yourself on January 1st and know that you’ve already met the most important financial goal for the year.
The key feature of a Roth IRA is that you avoid capital gains taxes on your investments; you pay tax on the invested money right at the start and then never again. A Traditional IRA lets you deduct your contributions from your taxes, but in retirement, your withdrawals are taxed as regular income – not good, especially since your initial investment will have grown exponentially. If you are able to contribute the maximum amount to your Roth IRA each year, which is harder to do since you are using taxed money, it is almost always a better option compared to a Traditional IRA, regardless of your current and future tax bracket, as illustrated in this article.
If you don’t already have a Roth IRA, I’d recommend opening one with Fidelity or Vanguard, as they both offer an exhaustive array of mutual funds, have great customer service, and most importantly, they have low expenses. As for what you should invest in, remember, this is your IRA, not Wall Street. Investing in it should be boring, not like a never-ending episode of “Mad Money”. To start, you could do much worse than to use one of the target-retirement funds that give you an appropriate asset allocation that automatically adjusts over time. While your money is (hopefully) growing in this fund, you can devote some time to learn more about asset allocation strategies and the benefits of index funds. Read Index Funds: The 12-Step Program for Active Investors
Schwab Investor Checking / Fidelity mySmart Cash Account
See my checking deals article for a review of high-interest checking accounts. Most people have a single checking account where they keep thousands of dollars earning 0% interest. If you are one of them, look into one of these accounts, you will be very glad you did.
Since my checking deals article was published, Schwab lowered the APY on the Investor Checking account from 4.25% to 4.00%, but I think it remains the best overall product out there. The APY is still very competitive, and it has the most complete feature-set of any internet-based checking account in existence:
- No minimum balance
- Unlimited ATM rebates (use any ATM you want)
- Free Checkfree BillPay
- Fast, free ACH
- Free, unlimited paper checks
- Unlimited pre-paid deposit envelopes (no postage necessary)
- Free Direct Connect access in Quicken
A quasi-checking account is offered by Fidelity called the mySmart Cash Account that matches the Schwab account on the above features. It has the potential for higher earning if you keep your cash in a linked money market fund earning ~5%. Read more about setting it up correctly on FatWallet. My only reservation about this account stems from the fact that it is actually a brokerage account in a checking account’s clothing. This has a couple of implications. First, you can’t see your balance when you use ATMs. Also, Quicken sees it as an investment account, which can cause a number of problems when you try to replicate the functionality you get with regular checking accounts. Schwab, meanwhile, shows both ledger and available balances at ATMs and appears as a regular checking account in Quicken.
It’s a good idea to have at least 3 months of living expenses stashed away as a liquid asset, available on demand. With an account like Investor Checking or mySmart, you have one-stop shop in a full-featured checking account that also earns high-interest for keeping a cushion of cash as an “emergency fund”. You can just subordinate the account you may already have at a local branch bank, using it for making deposits at local ATMs or branches. You can then ACH the money to your high-interest account to start earning interest the next day.
Vanguard / Fidelity Brokerage Account
If you go beyond funding your IRA each year and keeping a cash pool of 3 to 6 months of living expenses on hand, you should consider starting to invest in mutual funds or ETFs in a regular taxable brokerage account. Choosing between Fidelity and Vanguard can be looked at as a clash of the titans of active vs. passively managed funds, respectively, although each broker offers both types of funds. I have become a believer in passive index funds, because of their extremely low expenses and tax advantages over high turnover mutual funds. Vanguard’s mutual funds have an average expense ratio of 0.21 percent, one-sixth of the average fund’s 1.27 percent. In the words of Vanguard’s founder, Jack Bogle:
“Asset allocation is critically important; but cost is critically important, too – All other factors pale in into insignificance.”
A nice article was recently on Morningstar that gives some common sense advice on investing with ETFs, a type of index fund. If you want a great, honest, and concise overview of finance management and investing, I can highly recommend a book I’m reading now, The Bogleheads’ Guide to Investing
Ignore advice of financial advisers and brokers who will suggest high-load, high-expense funds that siphon a share of your investment to support their own livelihood. Research has shown time and again that an index such as the S&P 500 will beat most actively managed portfolios by a wide margin over a long period of time. For more on constructing your portfolio, just ask some friendly Bogleheads for assistance.
If you decide to go with Investor Checking instead of the mySmart account, you can still put a big chunk of cash, your “emergency fund” money, into a money market fund with Fidelity or Vanguard and get that extra percentage point of earnings. Again, these earn ~5% APY and can be readily sold off whenever you need cash. The only qualifier is a $2500 minimum investment and $2000 minimum balance to avoid fees. To me, this is the ideal scenario, as your Quicken experience isn’t crippled with the MySmart account, and you still get the ~5% APY for a large amount of your liquid assets.
More to Come…
Part 2 of my Ultimate Financial Lifestyle Guide will look at the most successful money saving strategies, online shopping deals, and today’s top rewards credit cards.
#1 Craig Feb 2, 01:59 PM