Investing in your 20s is one of the greatest steps you can take toward being a bona fide, successful adult. It pays to get a jumpstart on saving for financial goals like retirement, especially because of compound returns.
Compound returns are returns that you earn on the money you invested and all previous profits, which means your money grows at an increasing rate). Keep in mind, investing comes with risk, including the risk of loss and past performance is no guarantee of the future. If you’re successful, your 70-year-old self might just look back on 20-something you and be grateful you took the time to learn to invest.
Financial planning in your 20s can seem overwhelming at first; there are a lot of people with differing opinions and it’s hard to know where to start. This is especially true of investing, but remember that you don’t need to be bringing in the big bucks to be a savvy investor.
Thanks to advancements in investment technology and options available to investors of all income brackets, investing has never been more accessible. Below, we’ll discuss a few different strategies to invest money in your 20s.
Thinking About Financial Goals
Here’s a great first step: separate money into different “buckets” depending on your goal for that money. For example, the money you save for a house down payment is earmarked for a different goal than the retirement money you won’t touch for 40 or more years and should therefore be invested differently.
When thinking about goals, ask yourself these two questions: First, what is your goal for this money? Second, when will you want to use the money?
If you have savings that currently is not working toward a specific financial goal, take some time to think about what goal you’d like to apply it to. A great first saving goal is to have three to six months of living expenses in an emergency fund. After that, it might be good to turn your attention toward retirement savings and investing.
Housing Your Money
Once you have outlined some money goals, you could consider setting up your accounts. Often, the type of account you open depends on when you need the money. It can help to think about financial needs in terms of immediate needs, mid-term needs, and long-term needs.
Food, bills, rent, and everything else you must pay for on a month-to-month basis is an immediate need. Often people keep this money—along with a cushion so you don’t overdraft your account—in a checking account, or a cash management account like SoFi Money.
Mid-term money is any money you might need in the next couple of years, such as an emergency fund (so long as you have fast access to this money), travel fund, wedding fund, or down payment savings.
It might make sense to keep this money in a high-yield savings account. While you can use the savings account offered by a bank with whom you do your checking, there are other options that can offer you a better interest rate on your money.
For example, many people are migrating to online banking experiences over traditional big name banks. Because these financial service companies do not offer brick and mortar locations, they are often able to offer a slightly higher interest rate within their products than a commercial bank. Your credit union might also have a high-yield savings account option.
High-interest savings accounts, along with other “cash equivalents” like certificate of deposits (CDs) and money market funds are considered to be lower-risk investments.
Mid- to Long-term Money:
For money you’ll use in five to 20 years, you may want to take slightly more risk than a high-yield savings account. Therefore, you’ll have to decide if you want to keep the money in a high-yield bank account or in CDs, or open an account where you can invest that money (called a brokerage account) in stocks, bonds, mutual funds, or other asset classes. You can also do a combination of the two.
For a child’s college, look into a 529 plan which can offer tax benefits over a brokerage account (though you may be limited on what you can invest in, depending on your state).
You’ve probably already heard of the better known retirement accounts like an IRA, Roth IRA, or a 401k account. Retirement accounts like these can offer important tax benefits.
Choosing the right retirement account can be tricky because there are a variety of different ones. The next section in this article is dedicated solely to retirement accounts.
A 20-Something’s Guide to Retirement Accounts:
Many retirement accounts are tax-advantaged, meaning that you won’t pay immediate capital gains taxes on the money earned through investing. This is the primary benefit of using any retirement account.
For a traditional IRA and a 401k, you pay taxes when you withdraw your money in retirement, but not when you put the money in. When you contribute to a Roth IRA, you pay taxes on the money when you put it in the retirement account, but do not have to pay taxes on the money upon withdrawal.
Most companies that offer a retirement account use a 401k. (If you work in a government job you likely have a 403b.) When you make a contribution to a 401k, many companies will “match” that contribution.
For example, an employer might contribute 3% of your salary to your 401k account when you contribute 6%. This is a great deal; since the employer is essentially donating money directly to your retirement. Take advantage of your company match—and 401k account—if you have such an opportunity.
401k accounts are also useful because they are fairly straightforward to use; you can increase your contribution amount and the money can be taken directly from your paycheck.
Traditional IRAs are tax-deferred accounts which means that, like a 401k account (and most other retirement account types except a Roth IRA), you won’t pay income taxes on the money that you contribute to the account. Instead, you’ll pay them when you pull the money out to use in retirement.
You can contribute up to $6,000 per year (as of 2019) to a Traditional IRA so long as you aren’t already covered by a retirement account at work. Additionally, if you are 50 years or older, you can contribute an additional $1,000 to your traditional IRA each year.
This is a good option for someone that doesn’t have a workplace 401k and doesn’t qualify for a Roth IRA because they earn too much. However, there are income limits to how much income you can defer if you are covered by a work-based retirement plan.
A SEP IRA is much like a Traditional IRA, but for self-employed persons. It has much higher contribution amounts than a Traditional IRA, so consider a SEP IRA if you own your own business.
Unlike tax-deferred accounts, you fund a Roth IRA with money that you’ve already paid taxes on. Because you are paying taxes “now” as opposed to “later,” a Roth IRA can be great for investors who are currently in low income-tax brackets and expect to earn (and spend) more in the future.
Like a Traditional IRA, a Roth IRA has a $6,000 (as of 2019) contribution limit. And, if you are over 50 years old, you can contribute an addition $1,000 each year. Unlike a Traditional IRA, there are limits to how much money you can earn to use a Roth IRA. Currently, eligibility starts phasing out at $120,000 for single tax filers and $189,000 for joint tax filers.
To open a Traditional or Roth IRA, you can do so through any brokerage bank, mutual fund house, or other financial institution. Retirement accounts are also offered by some online investment advisors who can open an account for you in a matter of minutes.
Understanding the Asset Classes
Once you’ve determined which account you’ll be using you’ll you need to determine your investing strategy and goals. One important thing to understand about investing in your 20s is the tradeoff between risk and reward. You cannot have one without the other.
Higher risk generally should come with a possibility of higher reward, and that risk usually comes in the form of volatility. Because higher-risk assets can go through periods of significant downside, they are generally only recommended for money that you won’t need for decades or more.
Two primary asset classes are stocks and bonds, explained here:
A stock is a tiny piece of ownership in a publicly-traded company. When you invest in a stock, you could earn money through capital appreciation (the value of the stock growing over time) or through dividends, which are periodic cash payments made by the company to shareholders.
Stocks can be volatile as prices fluctuate according to supply and demand forces as they trade on an open exchange. This volatility may still result in higher long-term returns over time—stocks have shown a growth rate of approximately 10% annually over time (according to the S&P 500 returns between 1926 to 2017).
Stocks are also called equity investments, because you own equity in a company. Other types of equity investments include limited partnerships, gold, direct investments in real estate, and equity real estate investment trusts (REITs), which are bundled real estate investments that trade like a stock.
A bond is a contract where you loan a company or the government money for a fixed period of time. The money you earn on that investment is the interest they pay you for borrowing your money.
Although not risk-free, bonds are generally considered less risky than stocks because they are a contract that comes with a stated rate of return. Bonds backed by the U.S. government, called treasury bonds, are the safest within the category of bonds because it is unlikely that the U.S. government will go bankrupt.
Bonds are considered debt investments because you are literally investing in the debt of some entity. In addition to treasuries and corporate bonds, there are also municipal bonds, which are issued by state and local governments, and mortgage- and asset-backed bonds, which are bundles of mortgages or other financial assets which pass through the interest paid on mortgages or assets.
How to Get Started Investing
While you can certainly invest directly in stocks, bonds, or any of the other asset classes mentioned above, you can also utilize funds—either mutual funds or exchange-traded funds (ETFs)—to gain exposure to your asset class(es) of choice.
An investment fund is essentially a basket of investments; a basket of stocks, bonds, or of any other investment type or combination thereof. Funds are useful because they provide immediate diversification—safety against the risk of having too much invested in one stock, sector, or any other single asset.
Funds come in two primary varieties; they are either actively or passively managed. A fund that is passively managed is attempting to track a specific index. ETFs tend to be passively managed, but there is more active funds out there. Mutual funds can be either passively or actively managed.
Active management means that there is someone actively buying and selling stocks to try and outperform the market. (Unfortunately, they rarely do.) If you would like to use passively managed mutual funds, look for the ones labeled index funds.
An index is used to track the performance of a certain market, and therefore represents the market average. Index mutual funds and ETFs typically have very low fees, which means you get to keep more of your own money.
Stocks vs Bonds: Which Are the Smarter Investment?
People often invest in a combination of stocks and bonds, which is easy to do using funds. One strategy for investing in your 20s is to invest a higher allocation of your long-term investments in stocks and less in bonds, slowly moving into more bond funds the closer you get to retirement. This “big picture” decision is called asset allocation.
While some folks may want to take a do-it-yourself approach to investing in funds (like SoFi Active Investing), there are other options for investors who want a completely hands-off approach (like SoFi Automated Investing). Retirement target date funds package together several funds, shifting into a higher bond exposure as you approach the selected retirement date.
Some retirement target date funds use managed funds, which can increase the cost for you and potentially underperform compared to their peers or the index they seek to track.
No matter what route you go, it’s a good idea is just get started. Good luck and happy investing in your 20s!
Original source: Sofi Learn