Monday, August 06, 2007

More Financial Advice for my friend

The previous questioner follows up. I'll answer one question at a time:
Is there a difference between IRA and Roth IRA?
Yes. The short answer is that you want a Roth IRA, as do most young people. You can read "the long answer" below to understand why, but don't worry about all the contingencies and learning all the details and just sign up for a Roth IRA today.

The long answer is that an IRA and a Roth IRA reduce your taxes in different ways. With a regular IRA, you reduce that year's taxable income by the amount of your contribution, lowering that year's taxes. When you withdraw money from an IRA (starting when you're 59 1/2), you then pay taxes on it like any other investment. One downside is that you would have to pay a penalty if you withdrew the money before you were 59 1/2 unless you were using it buy a house or one of a limited number of other exceptions. This became a pain and made it so that it didn't really help young people as much as people with higher incomes. Hence, the Roth IRA was started.

With a Roth IRA, you don't get a tax deduction now, but when you withdraw it later, you don't pay any taxes. You have to have it in there until you are 59 1/2 to withdraw the funds tax-free, though you can get it sooner if you are buying your first house or for one of the other exceptions. You can also withdraw it at any time and just pay the taxes like you normally would. But if you can keep it in there to grow tax-free, that will make a huge difference over time.

So you either get the deduction now, or you get it later, depending on which of the two you choose. Beginning workers (and even those in college or before if you have ANY type of income) should have a Roth IRA. When you make more money later, you can then open up a traditional IRA alongside your roth.
I currently have a checking account and money market savings account with Bank of America and a brokerage account with TDAmeritrade. I think a 401k account or IRA is the next step. My company matches 50% of my contribution on 401k. I know they are good because they are tax deferred (I think), but is that the only benefit of it?
Congratulations! Your employer offers 401k matching, which is like getting free money. You should sign up for that as soon as possible. A 401k is just like a traditional IRA. So basically it reduces your taxable income. But with the company matching half of your contribution, that's like getting a 1/3 discount on everything. Contribute to the max of their matching!

Also, I'm not one to complain about your specific accounts, but compare money market accounts with BofA with those of your brokerage account with TDAmeritrade. You may find you can get a higher rate with the brokerage account. But look first. Also, to return to the Roth IRA discussion above, ask TDAmeritrade about opening up an IRA with them. Or if you're looking to switch brokers, this would be a good catalyst, because for simplicity's sake you might want to have your regular brokerage account in the same place as the IRA.
As for the ETF's, are there any that you are currently in that have consistent performance with low expenses or any that you are thinking about getting into? I've been checking them out recently and don't really know what to look for. Obviously, it is good to have high return with low expenses, but what's acceptable. Do you buy into ETF's that favor foreign securities, large cap, medium cap, or any other combination?
I personally am trying to be in the vast minority of people who try to beat the market average. Time will tell if I can do it, but the odds are against me. Even so called experts mostly fail. Something like 70% of mutual funds don't beat the market average (mostly because they have higher expenses that an index tracking fund or ETF). The market average refers to the S&P 500, which is loosely speaking the 500 largest US companies (called the S&P because the company Standard & Poor's maintains the list). The best solution is to just go with the average and get a market index fund. A good ETF is ticker symbol SPY, which tracks the S&P 500 and sports a ridiculously low expense ratio of .1%. This means that for every $1000 you invest, you only pay $1 per year. The problem with an ETF like this is that you pay a transaction fee every time you go in and out (for you $10 with TDAmeritrade). So you might benefit from getting in to an index mutual fund, which will have lower transactions costs. The biggest is symbol VFINX, run by Vanguard with a .18% expense ratio. See what TDAmeritrade offers and which funds from other companies it will let you buy.

I would put the bulk of your investing in one form of S&P 500 tracking or another. You could also include another ETF or mutual fund for international stocks if you want. We're too young for bonds.
I know 401k's are good because they are tax deferred, but is that the only benefit of it?
Maybe I haven't demonstrated how much of a difference tax deferred can make.... (don't look at the numbers, just look at how much of a difference it makes over time).


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