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Investing 101

A disclaimer to start: These tips do not apply to everyone. Each person's financial situation is unique, and parts of what I am about to write may or may not apply to the reader. However, the purpose of this post is to give a simplified view of how I approached my finances and hopefully provide some advice along the way. For this post, I would assume we are comfortable earners in stable jobs, and we are looking for ways to save up and invest for the future.

To start with, we will go over some basic deductions that may appear on your pay statements, along with an introduction to retirement accounts and their advantages. The aim of this exercise is to understand terms in the US financial system. I will have a separate post about actionable items.

Understanding the pay statement

Assuming you are a full-time salaried employee, you would have access to your pay statement through your company portal or a provider such as ADP.

Your statement would have a section termed 'Earnings' that shows the pre-tax earnings (a.k.a, Gross pay). This section shows what the company paid you. Let us assume this is $5000

Somewhere on your statement would be a line item that says "Your federal taxable income," followed by a number, say $4000. Notice that this number is lower than the Gross pay. The part of your statement that makes the difference is under a section called 'Deductions.'

There would usually be several entries under deductions. Some of these are 'pre-tax' deductions (e.g., 401k contributions, and life insurance). They contribute to reducing your taxable income, which means that you don't give taxes on every dollar your company pays you.

So the keywords are as follows :

What you see in your bank account is your net pay. One might imagine that taking steps to minimize deductions and maximize net pay is the best way to go. But, things are a bit more nuanced than that. Assuming you can afford it, the financially astute thing to do is to put the right amounts of contributions in suitable buckets to maximize returns over the long term. Even if it means a slightly lower net pay in the short term.

You will see further in this article how pre-tax deductions are a way to plan and save for your future. The tax system is built in a way to encourage saving for retirement and medical expenses. Opting for those deductions benefits you in the long run and helps save money on taxes in the present.

We will look at some of the standard pre-tax deductions and how they can be beneficial to us.

Pre-Tax Deductions

What are they? You will notice that there are deductions related to medical benefits. You may see entries that say 'Medical,' 'Vision,' Dental,' etc., which account for your payments towards your medical, vision, and dental insurance, respectively. These reflect your choices during the medical enrollment window towards the end of the previous year (or during a significant life event).

In addition, if you opted for added benefits during the enrollment window, such as life or disability insurance, among others, they also show up here.

P.S: Most companies highly discount the medical insurance payments for their employee. For instance, if the insurance company charges 500$ a month for their services, your employer may pay nearly 400$ and only require the employee to pay the remaining $100 through their paycheck. However, most companies are not as generous towards the employee's dependents. For instance, when my spouse was temporarily added as a dependant on my insurance plan, her payments amounted to nearly eight times the sum I needed to pay as an employee.

HSA and FSA (Health Savings Account and Flexible Savings Account)

In case you have opted for HSA or FSA contributions, you would also see these deductions pre-tax. In case you are not aware of what these accounts are, read on.

What are they? Most employers provide at least one HSA plan among their offerings during the benefits enrollment window every year. An HSA account is effectively a savings account that is only used for medical expenses. "What is the big deal?" one may ask. "Can't I just use my regular saving account for this purpose?" Well, yes, you can, but the HSA comes with three key advantages:

Thus, the HSA is a great tax-free way to put aside money for any medical expenses. Even if you are a healthy individual today, you are bound to be hit by medical costs later in life. So, you might as well save for it tax-free and with additional help from your employer.

💡 HSA accounts stay with you even if you switch employers or change your medical plan the following year. You can still use the HSA account to pay for your medical expenses.

The medical plans that come with HSA are usually High-Deductible plans. This means you might have higher out-of-pocket expenses if you get hit with medical expenses that year. As a result, you might only want to opt for the HSA plan if you are a generally healthy individual with no significant medical costs coming the following year (think surgeries, childbirth).

An FSA account is similar to the HSA in that it is a tax-free savings account for medical expenses. But it allows for greater flexibility in spending. E.g., you can pay for child care, and you do not need to opt for a High-Deductible medical plan to have an FSA. The downsides are that the contributions made to an FSA HAVE to be used that year. You can only carry a limited amount (~$550) to the following year.

Retirement

Before we jump into the rest of the deductions, it is worth understanding a bit about how finances may work out for us after retirement. Most people intend to keep up nearly 80% of their current spending habits after retirement. Increasingly people view retirement not as the end of their enjoyable life but as a chance to be carefree. People want to spend on vacations, and gifts and indulge in experiences they were never able to as younger adults. Moreover, life expectancies are only on the rise. Let's assume you fall into this ever-expanding segment of people who want to continue spending post-retirement and live a long life. Then you would need to save up a large chunk of money to draw from your reserves during old age.

There are a few sources of post-retirement income that people use. They are Social Security (assuming you qualify for it), Retirement accounts (401K, IRAs), taxable investment accounts, and downsizing of the home.

Social Security

What is it? It is essential to know how Social Security works before considering it a significant source of post-retirement income. Social Security collects taxes from the currently employed generation and workers and adds them to a pool. This pool of money is then distributed among the eligible population depending on the applicant's pre-retirement income.

This pool is currently funded by about 6% of workers' income on the first ~140k earned. These numbers are subject to change by the government. (You can see these reductions in your paycheck against a line item termed 'Social Security Tax' or similar.)

Let's come back to our retirement plans. You might start to realize that the income you may receive from the Social Security program is subject to immense risk. The shrinking worker pool would diminish the funds in Social Security by the time we are of retirement age. Moreover, due to people's higher life expectancy and the more significant number of people retiring (compared to the people employed), the funds available to each eligible person may shrink further. We have not even talked about the chance of the Social Security program undergoing massive change by government policies. (Many people consider the Social Security program as a form of socialism which is a loaded word in America)

💡 The key takeaway is that the Social Security program is not a reliable source of post-retirement income. We need to hedge our bets elsewhere if we want to count on a standard of living once we stop earning from our day jobs. I'd go so far as to say, planning to rely only on Social Security during retirement is not planning at all. Social Security is a safety net. Not a source of income.

Retirement Accounts

There are three main types of retirement accounts: 401k, Traditional IRA, and Roths.

All of them are retirement savings accounts, meaning what you put in gets saved for your retirement. (As opposed to Social Security, where you are merely contributing to a pool) All of them have penalties for withdrawing early. Meaning you pay a percentage of the funds as a penalty to the IRS if you remove cash out of these accounts before you are about 60. (There are some exceptions, but I will consider them out of the scope of this post)

401K

What is it? 401K is a savings plan provided by your employer. Such an account is usually an account with an institution such as Fidelity. There are a few massive advantages of the 401K over regular savings accounts:

Traditional IRA

What is it? If your employer does not offer 401Ks, then you have the option of contributing to a traditional IRA instead. (If you are not sure, check your employee portal or benefits page. Most large employers provide 401Ks)

The Traditional IRA is identical to the 401K except that your employer does not create an account for you. It is still a retirement account, meaning you can only withdraw from it after retirement to avoid penalties. You would need to look around at different financial institutions to open an IRA account (e.g., Fidelity, Merril Lynch). Look for an account with low fees.

The Traditional IRA has the same tax benefits as the 401k and is subject to identical contribution limits.

ROTH Accounts

What are they Roth accounts are alternative retirement accounts (introduced in a bill by a Senator called Roth, hence the name) with a different taxation mechanism. There is a Roth 401k and a Roth IRA, the Roth versions of the accounts we saw before.

The critical difference between Roth accounts and their traditional counterparts is when we pay taxes on the contribution amount. For traditional accounts, the taxes are deferred until withdrawal. i.e., you pay taxes when you withdraw your money rather than pay taxes now. (Due to this reason, the traditional retirement accounts are often referred to as tax-deferred accounts). On the other hand, you pay taxes when contributing to your Roth account, and then it grows tax-free! Moreover, you pay no taxes at all during withdrawal.

What is the difference between whether you pay taxes now or later? Well, there are two questions to consider: What are your earnings now relative to what you'd expect later in life? How much time does the money have to grow in the account?

Most people in the sweet spot of their careers, who fall into high tax brackets now, would probably want to defer their taxes (opt for a traditional account). This decision makes them fall into a lower tax bracket during withdrawal and therefore pay fewer taxes on the amount.

On the other hand, people in their early careers may fall into a low tax bracket, and their money has a lot of time to grow tax-free. Consequently, they would find it beneficial to put money into a Roth account instead of the traditional retirement accounts.

For all retirement accounts, including Roths, there are penalties for withdrawing money early, i.e., before about 60 years of age.

Note: Roth IRAs have an upper-income threshold beyond which you cannot contribute to a ROTH account. e.g., if you earn more than 140k (as an individual), you may not contribute directly to a Roth IRA account. If you are interested in Roth IRAs, you may want to check the qualifications needed for the current tax year.

On the other hand, Roth 401ks have the same contribution limits as 401ks. Not all employers offer them, though.

Executive summary

This turned out to be a longer post than I set out to write. But, we have covered a few concepts here.