What is investing?
Investing is the act of putting money into an account or other investment to make a profit over time. It is usually associated with a specific financial goal, like saving for your retirement.
How do you know when you're ready to invest? Let's review a couple of financial items to consider taking care of first, like paying off debt and building savings, to better prepare for the highs and lows that may come with the investment market.
Preparing your finances
Pay off your high-interest debt
Let’s say you could potentially earn 10% in the stock market. That sounds nice until you realize you’re paying over 20% in interest on what you owe the credit card companies. Instead, you could take the money you want to invest and put it toward paying off that high-interest credit card debt first.
Build your emergency fund
Emergency funds help you weather unexpected expenses, everything from the cost of a sizable car repair to replacing a furnace, all without withdrawing money from your investment accounts. A good rule of thumb is to set aside three to six months’ worth of expenses in your emergency fund. Why is this important? You never know when you may be hit with a surprise expense. If you don’t have an emergency fund, you may have to sell off your investments at a point when the market is down and take a big loss. Or you could have to pay a penalty for cashing out of certain investments like your 401(k). Or you may get hit with both (ugh).
Crush credit card debt with a personal loan
When should you start?
The simple answer is that it’s typically a good idea to start investing as soon as you are able. There are two reasons. First, it helps you build the habit. Investing consistently helps improve your chances of reaching your investment goals. Second, starting early lets you take full advantage of compounding interest. That’s when the interest you earn starts earning interest and your wealth starts to snowball. Here is a post that further explains how compounding interest works.
Investing for retirement
It can be too easy to put off retirement saving because the end goal may feel so far off. But that’s exactly why you should start as soon as possible. All the years ahead give your money the opportunity to snowball thanks to compounding interest.
An employer-sponsored retirement plan – like a 401(k) – can be a smart way to save, especially if your company offers a match. This gives you a triple bonus:
- Because a 401(k) is a tax-deferred account, the money you invest comes out of your paycheck before taxes are taken out. This means you’re investing the full value of your money before the IRS jumps in for its cut.
- Your money and the interest earned grow tax-free until you retire. So rather than giving up part of that interest in taxes throughout your employment, you can keep it right in your 401(k) and potentially earn interest on your full interest.
- With your plan, your employer may offer a match. This means the company kicks in an amount equal to what you put in your 401(k) (up to a certain percentage – typically 4% to 6% of your yearly salary). It’s smart to contribute at least enough so you can earn the match. Think of it as free money. Or think of it like getting paid to invest.
If your employer doesn’t offer a plan like a 401(k), you still have options. You can invest in a traditional IRA (Individual Retirement Account) through a bank or credit union, or an investment company. An IRA may give you a double bonus. First, the money you put in your IRA can come out of your pay before taxes, so once again, you’re investing money that otherwise would have gone to the IRS. And second, your money and the interest earned grow tax-free until you retire.
Another option is to invest in a Roth IRA. A Roth account allows you to pay the taxes on what you invest upfront. Here are the pros and cons:
Pros:
- There are no taxes on your earnings so you get tax-free withdrawals in retirement (after age 59½)
- There are fewer restrictions on where your Roth IRA can be invested
- You can withdraw your contributions (not earnings) at any time without penalty
- There is no required minimum distribution at age 72 like other retirement plan accounts
Cons:
- Paying taxes upfront means you may have less to invest
- You don’t get a tax deduction in the years you make your contributions (unlike a tax-deferred retirement investment)
- Income limits may disqualify you from contributing to a Roth IRA
- You have to wait 5 years from the date of your initial investment to withdraw your earnings
Investing for other goals
There are other reasons to invest besides retirement. You may want to save for a down payment on a house, college tuition, a big trip, and more.
When investing for these goals, use these three factors to guide your approach:
- How much money you will need – Determine the amount you will need for your goal.
- When you want to reach your goal – If the goal is 18 years away (like funding college education), you may be fine with the ups and downs of the stock market – knowing that, historically, the market has outperformed more conservative investments. If you want to reach a goal in five years or less, you may want to forgo the risk of the stock market and put your money in a safer investment, like a CD or money market account. You may miss out on some earning power but you won’t have the risk of a dip in the market when you need your money.
- The investment return you can potentially expect – This is tied to the time you have to reach your goal. If you have a longer timeline, you could invest in stocks where it has not been unusual to see an 8% - 10% return in a given year. If you have a short timeline and can’t risk the volatility of the stock market, you may decide on a more conservative investment like a CD where you could earn 4% - 5% (as of the date of this post).
Once you have worked through these three factors, you can work backward from the goal date to determine how much you need to save each month. Here is a useful calculator you can use. By the way, these three factors can be used to determine an investment approach for your retirement as well.
Are you ready to invest?
To answer this question, let’s review what we’ve covered:
- Have you paid down high-interest debt?
- Have you set aside an emergency fund of three to six months’ of expenses?
- Have you worked through the three factors to determine how you will invest?
Once you’ve answered “yes” to all of these, you can begin to find the best investment to fit your specific situation.
For more on getting started with investing, check out the investing section in our Education Hub. You’ll find valuable insight and guides to begin your investing journey.
