Start With The Fundamentals
When it comes to investing, the three components that help someone be successful are:
- The amount you invest
- The time that the money is invested
- The rate of return that the investment gets
The two components that someone can control are the amount they invest and how long they invest. If someone only invests $10 and gets a 300% return, they only make $30—a great return but not a great outcome.
If someone only invests $1,000 for ten years and averages a 10% return, they will have $2,593.74. At the same time, an average of 10% for 40 years will give some $45,259.26.
The rate of return that someone gets is out of their control, but they can use strategies to influence their return, like knowing that investing in stocks outperforms bonds 99% of the time over 30 years. Below is a Callan chart showing how different asset classes have performed over 20 years and can help someone decide where to invest based on their financial risk tolerance.
Understanding The Tax Benefits
Another thing that investors need to think about is taxes. I discussed how understanding tax brackets could help someone figure out if they should contribute to a Roth or Traditional account in a previous post. But overall, contributions to a traditional account get you a tax break now, but in the future, you pay taxes. With a contribution to a Roth account, you don’t get a tax break now, but you don’t pay taxes on the growth in the future. It depends on when someone benefits the most from paying the taxes.
Let’s say we have two single people making $100k, and one contributes $10k to their traditional 401k, while the other contributes $10k to their Roth 401k. They both invest in the same exact investments for 40 years and average a 10% return. This $10k contribution would be worth $452,592.56. But the person who did the Roth had to pay an extra $2950 in taxes when they contributed the money, assuming they are in the 24% federal tax bracket and a 5.5% state tax bracket.
What Are My Choices?
The person who did the traditional has an extra $2,950 today, and they have three choices:
- spend it
- save it
- invest it
All three options can be valid, based on the person’s situation. They might want that money to go on a vacation with their family because they know they are on track for their other financial goals like retirement. They could save it and replenish the emergency fund that they had to use to fix their car. Investing could be another option.
Investing $2,950 for 40 years at a 10% return could get the person an extra $133,514.80. This scenario also assumes that the person doing the Roth can’t afford the $18,368.78 to match the $12,950 that the traditional person can do.
The decision to invest depends on someone’s capabilities and investment choices. If someone wants to start a business in a couple of years but still wants to invest, the traditional path would be the best. The person would get access to the cash faster and hopefully get a higher return from the business. A business can grow more quickly than stocks, but more risk must be accepted, and more work must be done.
Thinking In Terms of Value
As you can see from the Callan chart, nothing stays at the top consistently. What matters most with growth and getting the most value is your annualized rate of return and limiting your volatility, which can be achieved by creating a diversified portfolio.
Think of rates of return as the new valuation of an asset. If a company was worth $1 billion in 2020 and then was worth $1.1 billion in 2021, then everyone’s investment in this company would have risen by 10%. There could also be a decline in a company’s stock, but that is a new reflection of the company’s valuation at that moment in time.
So if you can see that something is going to be more valuable in five years versus forty years, then you can take the calculated risk to put your money in an asset that will give you the most expected benefit. Don’t forget this asset could be yourself as well.
If you can turn that $2,950 into $133,514 in five years versus 40 years or more, that will also be more valuable. Understanding the expected value of your decisions can help you make the right move but requires planning to increase the likelihood of success.
There are trade-offs and opportunity costs for choosing one tax-advantageous account over another (don’t forget about Medicare taxes and required minimum distributions). Still, it is easier to know which direction to take if you know your goals (or the value you want). Then you can use strategic planning to turn your good situation into the best situation by creating or obtaining a plan that you can execute.
Final Takeaway
Overall, understanding the marginally benefits for each decision can help you make the best moves possible. This type of thinking requires having the wisdom to create the plan and then the discipline to follow through. And the fastest way to make your goals happen with the right strategies is not to ask how I can make this happen, but who can show me the route faster since one hour with a professional saves the amateur 8 hours.
If you don’t know what direction you should take, it doesn’t matter which direction you choose. So spend some time thinking about what you want to happen in 2022 and beyond, then make it happen.
P.S.
I’m doing a webinar on Tuesday, Jan. 18th, 2022 at 4pm CST on how to pick the right tax strategies for your investment accounts. Click here to sign-up.
