OK, so let’s go over both these routes on how money goes from being earned to being invested.
[highlight the employer -> 401k route]
We’ll start with the employer to 401k route since that’s the most common. 79% of Americans have access to a 401k – which is still crazy to me. This is the ideal place to learn how to invest!
Every 401k provider is a little different, but they do have a few things in common. You’ll want to specify:
- How much of each paycheck will go into the account before taxes.
- If your base pay is $100,000, and you specify 10%, that means you’ll contribute $10,000 goes into your account every year.
- If your company offers a 401k match, you realllly should set this to at least what they match.
- Next, you’ll want to set what investments this money goes towards.
- Evaluating all the funds you have available and select which one is a bigger topic, so for this example, we’ll just assume we put it all into an S&P 500 index fund.
With that setup, paycheck in that amount of money is transferred straight from your employer to your 401k provider and immediately invested. It never hits your bank account and it’s never invested in cash during that time.
It’s pretty simple actually. If you’re like 32% of Americans, you’re already using a 401k already, even if you might not have known how it worked behind the scenes.
Investing on your own has a few additional steps. These steps will be the same regardless of what type of investment account you’re using.
This graphic assumes a few things:
- $5,000/month in earnings
- 10% contribution to your 401(k)
- Employer match equal to “100% of your contribution up to 5%”
- 20% taken out for taxes and health insurance.
- $2,500 in monthly expenses
- $1,000 in additional investments.
For example, let’s say we earned $5000 a month. You put 10% of your income into your 401(k), which means $500 is being invested. When people say investing in your 401(k) is “free money” they mean that $250 from your employer match which wouldn’t be included if you didn’t invest in your 401(k).
For the other $4500, you’ll have some amount taken out for taxes, social security, medicare, health insurance. The remainder gets deposited into your bank account.
From there, you pay out all your expenses. In this case, we also transfer $1,000 directly to our investment account. In this case, we’ll say we’re transferring it to Vanguard.
Just like with our 401k, we decide what we want to invest in at Vanguard and the money is automatically invested in that.
Unlike our 401k however, we could either transfer it to Vanguard as cash, then transfer it into a fund like the S&P 500 index, or we could let Vanguard know to just transfer money from our bank account directly into the S&P 500 index.
Behind the scenes, Vanguard is talking to your bank and doing all the work for you to move the money. It’s essentially the same thing that happens when you pay off your credit card – money is being moved from your bank account to another account you own. After the money gets to Vanguard, it’s only then that Vanguard will buy the investment for you.
This is an extremely common case where you’ll have multiple investment accounts each with different investments in them.
For this case the total amount the person earned was $5,000 + $250 in the employer match for a total of $5,250. If we take out taxes, their “take home pay” was $4,250.
They saved $1,750 of $4,250, or about 41%. We use the term “savings rate” for this number. People calculate it in a bunch of different ways – some not taking into account taxes & fees, some using it. I prefer this method.
If this person continued this path, investing in the stock market while it grew at a pace of 7% (5% after inflation) they would be financially independent in about 21 years. At which time they could withdraw about 4% of their portfolio every year for at least 30 years.
Side note: this assumes the stock market returns a consistent amount and that you have $0 saved up today. If you have a bunch saved up already or are paying off debt the “years until FI” could be wildly different.
One of the most common ways to set up an investment with an online investment company is to use an automatic transaction. This behaves almost exactly like a 401(k) contribution.
[Show my Vanguard account with an automatic deposit]
For Vanguard, you can set up an automatic transaction.
[walk through the process of creating an automatic deposit]
There are a few hard parts of this that you’re not seeing right now.
First off is linking your bank account and your investment account. This isn’t difficult, but it usually takes a few days. You’ll give Vanguard your bank account number and routing number, then they’ll make a few small deposits in that account. You’ll go back to the vanguard website and enter in the amounts of these deposits. After that, the accounts will be linked and you’ll be able to transfer TO or FROM them.
It’s the same process as connecting any two accounts.
Second is deciding what funds to select. Which funds you use will depend on your goals, diversification, tax consequences, fees, where you are in life, and a lot more. We’ll build-up to this one, as we learn about all of these topics, and just stick with the S&P 500 index fund until then in our examples since it’s the largest Vanguard mutual in the world and a solid investment. In the next course we’ll dig into how to evaluate and select funds too.
And that’s really all there is to set up an investment. You don’t need to worry about the stock price of what you’re investing in. If we invest $1,000 in a mutual fund and the price is $287.64, that means our automatic investment will buy $1,000/$287.64, or 3.476 shares. This assures that you’re investing the full $1,000. That’s the same way your 401(k) works — allocating every cent you invest.
So this has been a look at how investment accounts differ from savings and checking accounts and what it looks like for your money to move into before tax and after-tax accounts.
Ok, takeaway time.
#1 – The process of investing involves moving money to an investment account, either a 401(k) or another one that you’ve opened, and then moving it from cash to a specific investment there. Your 401(k) does this for you in one step.
#2 – Your 401(k) is the absolute best place to start investing. There are tax-advantages to this approach plus an employer match – which is often referred to as “free money”.
#3 – You can calculate your “savings rate” by taking the total amount you’re investing (including your employer match) and dividing that into your total take-home pay. Using that number and the chart above, you could see when you’d be financially independent if you started today!
In the next lesson, we’ll look at how to beat the stock market! Something every investor wants to do. (spoiler: you can’t).