Quite often, financially intelligent young professionals get out of school, start in the professional world, and actually stick quite strongly to the “spend less than you earn” mantra. They fund their Roth IRAs and their 401(k)s, but they still find themselves spending much less than they’re bringing in. And they wonder what’s next.
“Fred” writes in with a question along these lines:
I’m in my mid 20′s and just got my first job, currently make ~$50k. In 3 years I will graduate from medical residency and be making 3-4x that. I’ve had a very fortunate upbringing- no student loans, no credit card debt, and about $100k invested in securities. My question is regarding IRA and 401k contributions. Once I’ve contributed up to my 401k’s match, and max out my Roth IRA what should I do next? The current wisdom is to max out my 401k contribution. I feel quite certain that my taxes (once I make ~$200k annually) will eventually be much higher because of our spiraling debt/ Obama tax plan. Would it still be wise to max out my 401k?
There are several pieces of the puzzle worth discussing here.
First, never, ever count your chickens before they hatch. The most common mistake that I see people making is their assumption that they will be earning more in the future. That may be the plan, but plans can change – they are often derailed by life, health, changing interests, opportunities both missed and otherwise, and so on. Do not make spending decisions now based on what you hope will happen in the future.
When I found myself in a very long-term stable job in 2004, I made the mistake of essentially betting that I would have that income in perpetuity – nothing would keep me from earning that money until retirement. Flash forward to 2009 and what do I see? An opportunity came along and I jumped on board. I’m earning less than I might have otherwise, but every morning I feel absolutely that I made the right choice.
So many things can happen over the next few years. You might become disenchanted with your current work. You might fall in love and have a child. You might fall into ill health. In each of these events, you likely will not be earning three times your current salary in a few years.
Instead, a much more prudent path is to build a firm foundation for whatever may come. As I noted above, many people are at least peripherally aware of this, investing money into retirement. But retirement investing is just the start.
Build a very healthy emergency fund. It’s always useful to have at least six months’ worth of living expenses available in a very liquid place, like a high-interest savings account. Don’t be afraid of the size of the goal – just start an automatic plan to scoop some portion of your paycheck right into that savings account. Hold onto it – use it for big emergencies, then replenish it afterwards.
Invest in yourself. Never be afraid to invest money in making yourself better. Lose weight – if you have difficulty doing it on your own and can afford it, hire a trainer to motivate you. Get your teeth straightened and cleaned. Work on your self-confidence and take opportunities to speak in public. Invest in clothes that are well-made and durable – ones that will last through whatever may come.
Invest in a taxable account. If you’ve got an emergency fund, no debts, and a well-padded emergency fund, start investing in a taxable account. How exactly you do this depends on your risk – my recommendation is to invest in index funds using a buy-and-hold strategy. Hold onto that money for now and wait for opportunities to come to you. That money may eventually become a home. It may become the basis for a business. It may become the backbone of a very early retirement. Whatever it is, having it in a taxable account means you can utilize it for whatever you need, whenever you need it.
What about investing more for retirement? If you’re already maxing out an IRA and picking up all of your employer’s matching in your 401(k), your bases are pretty well covered for retirement. Investing beyond that can be helpful over the long run, but if you’re doing it at the expense of an emergency fund, your own personal health, or other personal goals, you should spend some time asking yourself what your true goals are.
My argument is simply this: money invested in a taxable account is likely a good option in this situation. While you do have to pay capital gains tax on the dividends (as well as on the gains if you sell the investments), that money can be used for any purpose without penalty: retirement, a home, startup money for a business, a wedding, education for a new career, or anything else that might come your way. Your future is not set in stone – don’t set all of your savings and investments in stone, either.