Now that your budget has money to save, where should you put it? There are two basic concepts that should guide all of your investment decisions: minimize taxes and minimize expenses. There are hundreds of different investing techniques and asset classes, and thousands of different types of investments, but study after study has shown that these are the two most critical aspects for the vast majority of investors. With these two fundamentals, other advanced techniques may improve portfolio returns. However without them almost nothing else can overcome the drag of taxes and expenses.
The Thrift Savings Plan (TSP)
If you can invest money before you have to pay taxes on it, then you can put more money in your investments. The less you have to pay in fees, the more money you have compounding for you. And the longer you can avoid paying taxes on an investment’s profits, the more you have and the longer that money can compound. You’ll attempt to exploit each of these concepts to the limits of the law for as long as you can.
One military benefit applies both “minimize” concepts simultaneously. The federal Thrift Savings Plan (for both federal civil-service employees and the military) is a tax-deferred account combining the world’s largest index funds with the world’s lowest expenses. Your payroll contributions come from before-tax money (up to the legal limit) and you don’t have to pay taxes on TSP funds until you withdraw them. Better still, the fund’s expenses have been dropping as their assets have been growing. After starting the 21st century with expenses of three basis points (0.03%), the TSP expense ratio was as low as 1.9 bp in 2007. Even Vanguard’s expense ratios are higher than the TSP.
The TSP is your ultimate savings autopilot. After you sign up, you set your contribution level on MyPay, the Defense Finance and Accounting Service (DFAS) website. You can send over 90% of your pre-tax pay to the TSP, and you may be able to contribute special pay & bonuses as well. You can change it every month. When you meet the annual limits then the TSP will automatically stop deducting contributions from your pay for the rest of that year, and it’ll automatically resume contributions next year.
(March 2012 update: This post was written in 2010, before the Roth TSP feature was available. Today, most servicemembers should maximize the Roth TSP option before using the conventional TSP.)
Individual Retirement Arrangement (IRA)
The TSP is probably the preferred retirement savings system for the vast majority of veterans because of its pretax contributions, its tax deferral, and its low expenses. But once its contributions limits are reached, what next? When you can save more money then you can put it in an Individual Retirement Arrangement (IRA).
There are two types of IRAs: conventional and Roth (named for the sponsor of the enabling legislation). Each type of IRA has its own advantages and disadvantages, and you may be able to contribute to either or both (while remaining within the overall contribution limit). IRAs are similar to the TSP because both will grow tax-deferred and have very specific withdrawal rules. The difference is that you have to select your own IRA account custodian (a financial company like Fidelity Investments or Vanguard) and choose from a much wider range of assets and funds. The main advantage of an IRA is that it’s another tax-deferred method of investing for retirement. IRAs have lower contribution limits and higher expenses than the TSP so they’re usually a second choice to that program, but you have more control over how the account is handled and more choices over its investments.
When you’re in your teens and 20s and 30s, focus on contributing to the accounts. Let the accounts compound and grow for at least 20 years. Don’t worry about future withdrawals. You’re always able to tap the funds in an emergency (although with hefty penalties) and there are other ways to tap some the money for education, a first-time home purchase, or early retirement. There will be plenty of time to design a withdrawal plan when you’re ready to retire, and there may be plenty of changes to the withdrawal rules before then. The prospects of emergencies or legal changes are far less significant than the benefits of decades of tax-deferred compounding. Later in this post you’ll also learn how to set aside other funds to handle emergencies or short-term goals.
Both the TSP and IRAs have several methods of withdrawing the funds. They’re designed to take monthly contributions from an early age, compound them for decades, and disburse them for many years after retirement. In most cases, early withdrawals incur a heavy penalty (and taxes) if they’re taken before you’re eligible. However there are penalty-free methods of borrowing or withdrawing some of the money before the minimum age of eligibility. Your TSP/IRA goal is to build the accounts without being tempted to touch them before you’re retired. You can get your money back if you really need to (usually at a penalty) but the system is designed to keep you from acting impulsively. The withdrawal systems are far beyond the scope of this post but the “Recommended reading” section has several references that will turn you into a TSP/IRA expert. For now, remember that your retirement planning will include other assets that you’ll spend first in retirement while you’re letting your tax-deferred accounts compound as long as possible.
Taxable investment accounts
What are these other assets? Is it possible to save more than your TSP and IRA limits? Sure, and the more assets you save early in your career then the sooner you’ll be able to retire.
The TSP and IRAs are the only tax-deferred savings plans available to the vast majority of veterans. Federal civil-service employees can also use the TSP, and state employees may have other tax-deferred plans. Civilian employees have a wide variety of tax-deferred savings plans with tax-code acronyms like 401(k) and 403(b). At any time, however, anyone can save more money in taxable accounts. They’re referred to as taxable accounts because you pay annual taxes on the dividends & capital gains and whenever you sell at a profit. Although profits are taxable, the goal is still to maximize savings while minimizing taxes and expenses.
Taxable accounts are as simple as opening a checking/savings account with a bank or a credit union, and as complicated as a financial brokerage account. The simpler your plan, the easier it is to execute. The vast majority of veterans will open an account with a mutual-fund company (again like Fidelity Investments or Vanguard or Schwab) to buy low-cost index funds. In another post we’ll talk about what types of assets and funds to consider, but for now your focus should be on saving as much as possible for as long as possible.
After setting up TSP and IRA contributions, a veteran’s next priority should be funds for emergencies and short-term goals. An “emergency” is a car repair, fixing a home’s broken water pipe, or a short-notice round-trip plane ticket to help a loved one. Emergencies are not material items like a new truck, an outfit for a business/social event, or concert tickets– those are short-term goals. A short-term goal is a savings program for anything that meets your values and could happen in the next few years. It includes a house down payment, college tuition, a wedding, or even a fantasy vacation. Your budget includes short-term savings goals for entertainment as well as lifestyle upgrades.
The emergency and short-term funds should earn more interest than a checking account, but there should be zero risk of loss. The two most popular types of accounts for this fund are money-market funds or certificates of deposit (CDs). The best rates for these two accounts are usually found at credit unions like Navy Federal Credit Union or Pentagon Federal Credit Union. If you’re a veteran then you’re eligible to join these credit unions. You can join PenFed even if you’ve never been in the military!
The size of the fund is up to you and your goals– anywhere from one month’s to eight month’s pay for an emergency fund. The fund may need to be bigger if you’re transferring to a new duty station or leaving the military, but as long as you expect a biweekly paycheck then you can minimize the size of your emergency fund.
If you’ve studied investment returns then you know that you pay a price for financial security. Your money-market funds and CDs are almost always insured against loss but you receive a much lower rate of return than you would in high-yield bonds, tech stocks, or other investments that have a risk of loss. It can really hurt to park your money in a 3% CD when everything else in the world seems to be paying 6%, and it’s tempting to chase a higher yield.
Don’t do it. Don’t chase a higher yield with your safe money. You’re saving it for emergencies and for important short-term goals. This is not the account to be used for maximizing returns by risking short-term losses– that’s for the TSP, IRAs, and long-term taxable accounts. A short-term account may earn a lower return, but its payoff comes when you need the money. It’s much easier to sleep at night if you know that you have the money available to cover an emergency without having to use a credit card or even get a payday loan. And although a CD may only pay 3% for years, the real savings come from the discounts given to those who can pay cash. You want to be the buyer who can swoop in on a bargain with money in hand, not the desperate seller who needs the money to pay for an emergency. Your cash makes sellers and contractors very happy to give discounts, and that’s the ultimate payoff for short-term savings.
Once you’ve planned your savings for emergencies and short-term goals, the final taxable account in every veteran’s portfolio is for long-term investments. These funds won’t be needed for far-off goals of at least five years (house down payment) and possibly even longer (kid’s college tuition, retirement). Although they’re not tax-deferred like the TSP or an IRA, these investments can be placed in similar assets like equity index funds. Taxes and expenses can still be minimized by using funds that don’t trade frequently (low turnover) and that don’t distribute a lot of dividends or capital gains. Most of them grow their share price or issue only qualified dividends which are taxed at lower rates.
Next post we’ll discuss investment assets like real estate, equities, bonds, and commodities. Depending on your preferences and your paycheck you may want to invest in some or all of them.
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