No one ever said getting rich was easy, but that doesn't mean it's entirely out of your control.
In fact, with a disciplined saving and investing approach over the course of your career, you have a pretty good chance of retiring with all the income and net worth you need for retirement.
That is, unless you're making these two mistakes.
The sneaky fees costing you thousands
Mutual funds and exchange-traded funds are the primary investment vehicles for many investors; on the surface, they're great tools to invest passively while you focus on your job and family.
Unfortunately, there is a catch. These funds aren't free, and sometimes they're really expensive.
On the first or second page of the prospectus document that comes with an investment in a fund, the company is required to disclose how much it's charging you to manage the fund. Generally, that fee comes to about 1% of your assets invested in the fund, but it can vary widely, from as low as 0.1% to 3% or higher.
The trick is to read beyond that first page of fee disclosures. Oftentimes you'll find fee after fee after fee listed throughout the prospectus. In the fine print, you'll see that the fees are to cover all sorts of costs incurred by the fund.
Add all those fees up, and you could be looking at paying 3%-5% of your money in fees, right off the top, every single year. Over a 35- or 40-year career, that can add up to millions.
The problem becomes worse if you're using an expensive financial advisor to assist you with choosing your fund options. The typical fee charged by a financial advisor is 1% of your investment assets. That fee is just another big bite out of your annual returns.
The S&P 500 has returned 8.66% annually from January 1980 to January 2015. If you made the mistake of paying out 1% to a financial advisor, 1% for mutual fund management fees, and 1% for all the other hidden fees, your actual returns would have been just 5.66% per year. Include an adjustment for inflation and those returns fall to 2.23% annually in real terms.
You're simply never going to get rich with a return of 2.23% per year. Instead, make sure you find a true low-cost fund to invest your hard-earned dollars in.
The taxman cometh
Of the two certainties in life -- death and taxes -- only one is preventing you from getting rich.
Specifically, there are two major tax mistakes that far too many investors make: selling their winning positions too quickly, which triggers short-term capital gains tax rates, and failing to take advantage of tax-sheltered investment accounts.
Let's start with capital gains taxes. I think we all recognize that the U.S. tax system is pretty doggone complicated, and the taxes we pay on our investment gains are no different. There are short-term capital gains rates and there are long-term capital gains rates, and the difference between them can be huge.
If you bought a stock on Jan. 1 for $10, you'd be very happy to see that stock rise to $20 by Dec. 31. If you were to sell it on Dec. 31, though, you'd trigger the short-term capital gains rate, which is equal to your ordinary tax rate. For the 2014 calendar year, that could be as high as 39.6%.
Wait one more day, though, and sell on Jan. 1 of the following year, and that moves you past the arbitrary one-year divide and into the long-term capital gains tax rate. That rate depends on your own individual financial situation, but for most taxpayers it will be either 0%, 15%, or 20%.
| Purchase Price Jan. 1 (year 1) | Sale Price | Sale Date | Pre-Tax Profit | Tax Rate | Taxes Paid | Net Profit | |
|---|---|---|---|---|---|---|---|
| Scenario 1 | $10.00 | $20.00 | Dec. 31 | $10.00 | 39.6% | $3.96 | $6.04 |
| Scenario 2 | $10.00 | $20.00 | Jan. 1 (year 2) | $10.00 | 15.0% | $1.50 | $8.50 |
Both scenarios exclude brokerage fees for simplicity.
By holding on to your investments for a year or longer, you can save yourself thousands and thousands of dollars over the long term by literally cutting your tax bill in half. All it takes is 12 short months of disciplined holding.
Those savings can be reinvested where they will grow even faster, with more and more compound interest for your pocketbook.
In this scenario, the patient investor increased his profits by 40.7% just by being smart about managing his capital gains taxes.
Why pay capital gains taxes at all?
With those terribly high short-term capital gains taxes out of the way, we can now shift our focus to an even more lucrative topic: tax-sheltered accounts such as 401(k)s and IRAs.
These accounts are specially designed and approved by the government to encourage Americans to save and invest for retirement. The income goes into the account and is subtracted from that year's taxable income. For the next 20, 30, or 50 years, that money can grow tax free. That's right -- no short-term or long-term capital gains taxes. When it's finally time to retire, you withdrawal that money incrementally and pay taxes only on the withdrawals at a tax rate based on your retirement income.
For most people, retirement income will be lower than the income earned while working, so even after all those years of tax-free wealth building, the tax rate you pay will also be lower than it is now.
For those just starting out in their careers and currently sitting in a low income bracket, there's the Roth IRA. It functions the same way, except you pay taxes on your contributions today instead of on the withdrawals in the future. It's a handy way to take advantage of your lower tax bracket when you're in an entry-level position at the onset of your career. Later on, when you're loaded up on all that investment income in retirement, you'll withdrawal the money tax free.
These accounts are an absolutely sweet deal, and everyone should take advantage of them. By combining a retirement account with a sharp eye for avoiding unnecessary expenses, you'll find the journey to riches to be much easier -- and hopefully much faster!
