The Basics Series Part 5 of 5
There are two ways to make money.
Work for your money – Getting paid by your employer or owning your own business
Get your money to work for you – Allocate your savings toward investments that generate passive income
Understanding how to optimize these two areas is fundamental to increasing your net worth and reaching financial independence.
This article focuses on everything teachers need to know about getting their money to work for them.
It is intended to give teachers an overview of investing so that they can understand some basic terminology and make more educated decisions.
Let’s jump in.
What is Investing?
The simple definition of investing is allocating funds to an asset or endeavor with the expectation of making a profit. Basically, it’s giving your money to something for the hope of getting more money back in the future. This article focuses specifically on investing in financial assets.
Why Should I Invest?
Investing allows your money to grow with no extra work.
Investing will help you to reach your financial goals quicker.
Who Should Invest?
The amount that you invest and the diversification of your investments might change throughout your life, but investing is beneficial to all.
Also, you don’t need to be a math genius or an economics major to invest.
When Should I Invest?
Due to the power of compound interest, the more time your money has to grow, the greater your return will be. Therefore, the earlier you start investing the better. For example, if a 20 year old invests 10k in an account earning an average 10% yearly return, and doesn’t invest anything else for the rest of his/her life, that person would have almost $1.2 million dollars after 50 years.
Where Should I Invest?
There are different options when it comes to where you hold your investments and the types of investments you make. The subsequent sections will walk you through those options.
Investment accounts are where you keep your investments.
Think of it like the household where your particular investments are held.
Just like different households have different rules, different investment accounts have different rules as well.
Each investment account is structured differently and provide different pro’s and con’s depending on your financial goals.
There are three main types of investment accounts available to educators. The first two are opened on your own, and the third is through your employer.
1. Individual Taxable Brokerage Account
2. Individual Retirement Account (IRA)
3. Employer Sponsored Retirement Account (403b, 457, Pension)
1. Individual Taxable Brokerage Account
A brokerage account is a basic investing account opened by yourself through a brokerage firm. It allows you to deposit funds for buying and selling investments with very little restrictions.
Pros: No contribution limits and No withdrawal restrictions
Cons: No tax benefit – Money is taxed on deposit and capital gains are taxed on withdrawal.
2. Individual Retirement Accounts (IRA’s)
An IRA is a retirement savings account opened by yourself. Unlike a brokerage account, IRA’s allow you to save for retirement in a tax advantaged way. There are two main types- Roth IRA and Traditional IRA. When choosing which type of IRA is best for you, you need to ask yourself the question “Will your tax rate be higher or lower at your time of retirement?”. If you think it will be higher, than choose a Roth IRA, if you think it will be lower than choose a Traditional.
Money is contributed post-tax, and all withdrawals are tax-free.
Pros: Tax-free withdrawals, Can withdraw contributions at any time.
Cons: Contribution limits, Income restrictions, Contributions are taxed on the way in, penalty for withdrawing capital gains prior to age 59.5.
Money is contributed pre-tax, but taxed on withdrawal
Pros: Contributions are made pre-tax
Cons: Contribution Limits, Withdrawal penalties before age 59..5, Withdrawals are taxed on the way out.
3. Employer Sponsored Retirement Account (Pension, 403b, 457)
An employer sponsored retirement account is a retirement savings account sponsored by your employer. There are two types of employer sponsored retirement accounts-a defined benefit plan(pension) and a defined contribution plan (403b and 457b). Not all types of employer sponsored retirement plans are available to employees. Check with your particular employer to see which plans are available to you.
Defined Benefit Plan (Pension)
A pension is a retirement plan where the employer invests on your behalf, and guarantees a benefit to the employee at retirement based on factors such as length of employment and salary history. The employer is responsible for investment risk, and is legally responsible to make payments to the employee regardless of investment performance. Typically, the employer and employee fund the plan with regular payments into a tax-deferred account.
Pros: Guaranteed income if you work long enough to receive some or full benefits.
Cons: Payout rules, have to work for long amount of years to receive full benefits
A tax-deferred retirement plan offered by employers where employees contribute a fixed amount or percentage of their paycheck to an investment account intended for retirement. Unlike a pension, the employee assumes the investment risk and participation in the plan is self-directed and at the discretion of the employee. There are two types of defined contribution plans available to educators – 403b’s an 457b’s.
Tax-deferred account offered to public educational institutions, non-profit organizations, and church related organizations. Similar to a 401k offered to private sector employees. Investment contributions are automatically deducted pre-tax (traditional) or after tax (roth) from your paycheck, and grow tax-deferred in your investment account. Your 403b must be opened with a participating vendor through your employer, and investment options are usually limited to mutual funds and annuities. For more information about 403b’s including what to watch out for click here.
Pros: Pre-tax contributions(unless doing roth), tax-differed growth, automated deductions from paycheck, fairly high contribution limits.
Cons: Contribution limits (although fairly high), Withdrawal penalties before age 59.5, Withdrawals are taxed on the way out (unless doing roth), Limited vendor and investment options
Tax-deferred account, also known as a deferred compensation plan, offered by state and local public employers and some nonprofit employers. Investment contributions are automatically deducted pre-tax (traditional) or after tax (roth) from your paycheck, and grow tax-deferred in your investment account. Similar to a 403b. Biggest difference between a 457b and 403b is that you can withdraw funds from a 457b if you leave your job before age 59.5 with no penalty. For more information about 457b’s including what to watch out for click here.
Pros: No penalty for early withdrawal if you leave job, Pre-tax contributions(unless doing roth), tax-differed growth, automated deductions from paycheck, fairly high contribution limits
Cons: Contribution limits (although fairly high), Withdrawal penalties before age 59.5 only if you stay with job, Withdrawals are taxed on the way out(unless doing roth), Limited investment options
These are the actual financial assets you are investing in within your investment accounts.
Each investment vehicle has a certain amount of risk associated with it.
The four main investment vehicles are
1. Individual Stocks
2. Mutual Funds
3. Index Funds/ETF’s
1. Individual Stocks
Piece of an individual company. Can be purchased through a licensed broker.
2. Mutual Funds
Grouping of assets (usually a grouping of stocks). It is overseen and actively managed by a fund manager, and utilizes pooled money from investors to invest in its assets (stocks, bonds, etc.). Investors can purchase shares of the mutual fund, and their performance is dictated by the individual growth and decline of the assets within the fund.
Loan to a company. Basically a form of debt. Bonds don’t give you any ownership of a company. You give a loan to a company or government organization and they pay you back on a specific date and provide periodic interest payments along the way.
4. ETF’s/Index Funds
Type of mutual fund that closely matches a financial market index. Allows for easy diversification since you are purchasing many stocks or bonds within an index. Returns are reflective of a particular index and have no active management.
Which Investments are best for me?
The investments you make will depend on three things:
1. Short Term vs. Long Term
2. Risk tolerance
3. Financial goals
1. Short Term vs. Long Term
Short term (1-5 years)
Money that you will need to access in the next 1-5 years.
Maybe it’s money you’re saving for a house, for a car, for a computer, or an emergency fund.
The investment account should allow for quick access to your money, and the investment vehicle should have little to no risk.
Recommended Short Term Accounts
- High interest savings accounts
- Certificates of Deposit
Recommended Short Term Investment Vehicles/Assets
Long term investments (10+ years)
Money that you won’t need to access for 10+ years.
Retirement savings is the most common long term investment.
This money can take on higher risk, and can benefit from the power of compound interest
Recommended Long Term Accounts
- Any retirement account (403b, 457b, IRA, etc.)
Recommended Long Term Investment Vehicles/Assets
- Mutual Funds/ETF’s
- Real Estate
2. Risk Tolerance
This is the amount of volatility you are able to withstand from your investments. Risk and return are usually connected-meaning a high return is usually accompanied with taking on higher risk.
Generally, high risk is better for long term investing. Low risk is better for short term investing.
Consider a 25 year old millennial looking to save for retirement. This person would most likely invest in something that generates more money/higher interest over the long term. They can also take on more risk as their money is not needed anytime soon.
This compared to a 55 year old saving for retirement in the next few years who would mostly likely choose investments that generate less return but have little risk. This person would be more interested in minimizing risk since they will need access to their money sooner.
3. Financial Goals
Ask yourself those important life questions.
What age are you looking to retire? When do you want to buy your first house? What do you want your net worth to be at age 30? 40? 50? How much risk are you willing to take on?
Knowing your financial goals will play an important role in which investment accounts you use and the investment vehicles you invest in.
The Bottom Line
Investing is a necessary part of building net worth, saving for retirement, and providing lifestyle options.
Educators have a variety of different investment tools available at their disposal.
Start investing sooner rather than later.
Congratulations! You finished The Basics series!
I hope that you learned some new things and are excited to continue your financial journey!
Next, check out the blog and explore other articles that interest you.