You know you ought to save. But with so many choices about where to put your money to work, how can you pick the right place to start?
Nowadays, young investors have a lot of competing demands for their money. If you're like many people, you have debt to repay, whether it's a mortgage, a student loan, or those nasty credit card balances. Investing for long-term goals like retirement is important, but you also have more immediate money demands that you don't want to put off forever.
First things first
That's the dilemma that Eric Wright is facing right now. He posed the following question to us via The Motley Fool's Twitter feed:
"I'm a young Fed who'd like to retire in 40 years. Where to invest after paying off debt? TSP, Roth IRA or brokerage account?"
Eric's situation is similar to that of millions of young investors right now. With so many choices, figuring out how to prioritize where you put your money can be tough.
But even though each person's situation is a bit different, some general guidelines apply for everyone.
1. Some debt is OK.
Eric noted that he didn't plan to invest until after he paid off his debt. For some debt, such as high-interest credit card debt, that makes a lot of sense. You can't expect to be able to earn a 15% to 20% return on your money, and so banking the equivalent return by paying off a credit card balance with a 15% to 20% interest rate is the smartest thing you can do.
With other debt, though, it's a trickier question. With interest rates extremely low, some student loan debt that's tied to federal loan programs charges relatively little interest. Mortgage rates are incredibly low right now, with 30-year mortgages quickly approaching 4.5%. Most people even get a tax break on mortgage interest. Paying down that debt before investing doesn't necessarily make as much sense.
By dividing your debt into "good" and "bad" based on rates, you can easily figure out whether you should make it your top priority. In some cases, you should start investing first.
2. Get the match, then take tax freedom.
As a federal employee, Eric has access to the Thrift Savings Plan or TSP. Most of us don't have that option, but the TSP is similar to -- and in many ways better than -- the 401(k) accounts that many people do have.
Your top priority should be to contribute whatever you can to earn any employer match you may be entitled to. Not all federal employees get a match, but if Eric's one of them, he should definitely contribute enough to his TSP to take full advantage.
After that, though, your priorities shift. When you're just starting out, most people earn relatively little and are in low tax brackets. That makes current deductions worth less and a Roth IRA much more valuable. In exchange for giving up a small tax break now, you'll set the stage for a huge break down the road.
Once you've maxed your match and put the full $5,000 into a Roth, anything left over can go either to your TSP/401(k) or into a regular brokerage account. How much you put where depends on your needs; if you have other non-retirement ideas to spend your money down the road, a brokerage account keeps your options open better than putting everything into retirement accounts.
3. Make smart investments.
Finally, once you have money in your various accounts, you need to know how to invest them. Your TSP has five broad investment options that give you exposure to stocks, bonds, and a stable-value account. With time on your side, you can be aggressive here.
With your Roth or a brokerage account, you can invest in individual stocks. Here are some long-term ideas:
- Dividend stocks might sound conservative for those in their 20s, but their returns have been phenomenal over time. Start with PepsiCo
(NYSE: PEP) , Altria Group(NYSE: MO) , or Procter & Gamble(NYSE: PG) . These make great stocks for beginning investors as their products are well-known and their business models are easy to understand. And by reinvesting dividends into additional shares, you'll build your wealth over time. - At the same time, though, you can also make aggressive investments. One strategy is to get in on promising trends before they catch on. Clean technology, for instance, is in vogue after the BP oil spill, with niche players First Solar
(Nasdaq: FSLR) and A123 Systems(Nasdaq: AONE) attracting attention. Even giants like General Electric(NYSE: GE) and 3M(NYSE: MMM) have jumped on the clean-tech bandwagon.
Dividing your portfolio between easy-to-understand big companies and aggressive long-term bets can give you the best of both worlds. Even if you make a bad call in the aggressive part of your portfolio, you still have the secure side to fall back on.
The smartest thing you can do is to get a jump on your investing early in your career. By asking questions like Eric, you'll put yourself in the best position to reap the benefits for the rest of your life.
Don't stop here! Check out Nathan Alderman's article on the best stocks for young investors.