Investing for the 20's (Part 2)

Originally posted 2019.08.11

 

Continuing from the previous post...

So this was the spreadsheet I shared last time, and I'm going to explain what these numbers mean.

 

 

There are 4 different scenarios, each with a pair of "investment" and "balance". The two scenarios on the left half are investments with Traditional IRAs, and the other two on the right are with Roth IRAs. Traditional IRA is an investment with "before-tax" money, which means you get a tax break in the year you put money in. So, some people invest money into Traditional IRAs to reduce the current year's tax. That's when you only look at "now" instead of the entire big picture.  On the other hand, the Roth IRA is an investment with "after-tax" money. The fact you put money into Roth IRA doesn't have any impact on calculating the current year's tax, but when you withdraw from the Roth IRA after you retire, all the money will be tax-free. There are some factors to consider which one is more beneficial, but for young people in their early career, the Roth IRA will most likely be the better choice. It's because I'm assuming that your income tax rate will be higher in your later years than it is now.  I would say unless you're in the highest tax bracket, Roth IRA is the way to go. The tax rates in cells J5 and K5 are the variables. For the screen capture of the spreadsheet I attached, I set the earning year's tax rate as 18% and the retirement year's tax rate at 30%. This is actually not a realistic scenario because your tax rate will keep changing throughout your life, most likely ascending, and the difference between the Traditional and Roth probably will be reduced if the earning year's tax rate gets closer to the retirement year's tax rate. Anyways, I will focus only on the Roth IRA side for the breakdown of the spreadsheet. 

 

Here comes what those numbers mean:

1) $1,002,910 (yellow) vs. $302,412 (blue). This is the reason you need to start investing early. $4,800 per year ($400 per month) from age 25 to 34 will become over a MILLION dollars by the time you hit 60. But instead, if you start investing at 41 years of age and invest twice the amount (for 20 years) until you're 60, it will only grow to be $302,412. It's not bad, but when compared to the earlier scenario, it's a sad outcome.

 

2) $48,000 (yellow) vs. $1,002,910 (yellow & bold). This is the reason you MUST invest. The compound interest I explained in my previous post did the magic over time, and the total invested amount of $48,000 grew more than 20 times.  If you had instead put that money in a savings account earning 1.5% annual interest, that same $48,000 will only become $76,792 (total return of 60% on the principal), and you will also have to pay income tax on the return because it was not in a tax-advantaged investment instrument such as IRA.  

 

For the presentation purpose, I entered 10% for the rate of return, because I firmly believe that it is a reasonable number. When I first created the spreadsheet, I started with 12% because when you look at the history of the U.S. market (S&P 500 or Nasdaq) 12% is more than reasonable. But I scaled it down a bit because you have to consider diversification and risk management, which means that I have no problem putting more than 90% of investment in the S&P 500 or the Total Stock Market index fund in my 20s or 30s, but as I get older, I will have to decrease the portion I invest in the stock index and put more money into bonds or other instruments with less risk and less return.  

 

I also want to share how to start investing, but this post is getting longer than I expected, and will have to make this into a 3-part series. And for that next post, I don't know whether I should write in English or Korean, because it's going to be one of the most important subjects that I had planned to write about since long time ago, and writing in English was just a temporary thing for these past 2 posts. Maybe I will go hybrid (Konglish) for the next one. Let me know what you prefer.

 

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