Basics… Investing 101

I recently had a friend inquire as to how to get started investing in a SEP-IRA and what investments she should buy. Let’s get down to the most of basic of the basics and take a look at how to get started investing and building your path to freedom – Investing 101.

There are usually 4 retirement savings plans to consider. Three of them are tax-advantaged and 1 is not. I’m purposely leaving out pension plans and some other alternative forms of retirement savings since they are not nearly as common.

  • Roth IRA – You will pay tax on your income before it goes into a Roth IRA. There is no tax deduction up front on your contributions. At age 59.5 you can begin withdrawing your money as qualified distributions, and you pay no taxes on the withdrawals. Tax-free living? Yes sir, it IS possible!
  • SEP-IRA / Traditional IRA – You do not pay taxes on the money as it goes in and you are allowed to exclude your contributions from your income for tax reporting purposes (which will lower your tax bill). At age 59.5 you can begin taking qualified distributions that will be taxed as ordinary income as they come out, so your tax on the money that goes into the account and the growth in the account are tax-deferred.
  • 401k / 403bthese can be set up to be traditional (pre-tax) or Roth (post-tax). Often your employer will match your contributions up to a certain amount. It’s common to see some employers matching you dollar-for-dollar up to 6% of your income. If this is offered you would be foolish to turn it down! One downside of a 401k/403b is you may be limited in your choice of investments.
  • Brokerage Accounts – You will be fully tax-exposed in a brokerage account. It’s basically a bank account that will allow you to buy and sell securities. If you buy & sell stocks in a brokerage account you will need to keep careful records of your trades for tax purposes – you will be taxed on the short term/long term gains (but you can offset gains with any losses). If you own a mutual fund and it pays a dividend you will be taxed on that dividend with taxes owed on any capital gains distributions as well. There is no tax deferment or offset, so plan and trade accordingly.


Where do you start? How do you know how to prioritize? I can only answer this the way I would do it (or have done it). I’ll look at 2 paths:

Path #1 – If you work for an employer with a 401k/403b:

1- Take full advantage of any match in your 401k/403b. Do the full 6% contribution there to get the full match, whatever it may be. Talk with your accountant to be sure you know the best fit (Roth or Traditional).

2 – After 6% in the 401k/403b, open a Roth IRA and max it out. That will allow for contributions of $5,500/year if you are under 50 and $6,500/year if you are over 50. That’s basically $458/month. Put it on auto-draft and make it automatic. This will give you a lot more investing options than your 401k, allowing greater flexibility as you develop your portfolio.

3 – If your 401k/403b is at 6% and your Roth is maxed and you still have money to invest, you have 2 choices:  Open a traditional IRA (the same limits as the Roth apply), OR go back to your 401k/403b and push more money in there since your limit is $18,500/year. Make sure you have access to good, inexpensive investments in the 401k/401b (see below). If not, the IRA may be a better/cheaper option.

4 – If you max out all 3 open a brokerage account and keep going. No limits will apply to the brokerage account.

Path #2 – If you are self-employed:

1 – Start with the Roth and max it out. $458/month. Boom. Done. Make it happen.

2 – Go to a SEP-IRA. For the self-employed your maximum yearly contribution limit is $55,000. Get as much in there as you possibly can.

3 – If you max out your Roth and max out your SEP-IRA, go to a brokerage account and keep going!

What to invest in?

Here is where you will get a million different answers to one simple (or maybe not so simple) question. Again, I can only answer with the way I do it, but I can point to countless big, and I mean BIG investors who will say the same thing.

Start with a simple, low-cost S&P500 index fund. It is the basis by which markets and investing are measured, and it is tough to beat. Very tough. In fact, 95% of ALL professional money managers fail to keep pace.

My suggestions is SWPPX from Schwab. It is the lowest cost retail index fund on the planet @ 0.03% annual fee. I would buy it through an account at Schwab. The folks there are honest, efficient, and offer outstanding customer service. Also, make sure you choose the option to re-inevst all dividends and capital gains – it’s like getting free shares as you go along.

In your 401k find the cheapest S&P500 index fund offered. The “Vanguard Institutional 500 Index Trust” is a fund that is offered in a lot of 401ks and it’s a great option since it’s discounted to around 0.013% for the large 401k institutions.

Do Not:

There is simply no need to pay for financial advice to do this simple investing. An “advisor” will charge you at least 1%/year and then put you in funds that charge 1-1.5%/year. I promise you, it will happen. As a result you’ll have a 2.5% deficit to overcome just to stay even with the market and keep pace with a simple SWPPX investment. The number of advisors who can run 2.5% over the S&P500 year-in/year-out would fit in the backseat of my Toyota Corrolla…

Your plan:

Keep it simple. Rock with SWPPX until you have around $10,000 in assets saved up, at which point you can start looking at some different asset classes that will serve to simultaneously juice your returns and smooth out your ride. I’ve previously covered those asset classes, and will do so again. Even as you diversify, an S&P500 index fund should be the core of your investment holdings…

My Mistake:

One mistake I made – I put too much money into my SEP & Roths during the years I was earning the most. I’m turning 50 this year and I could retire soon – but I can’t touch my retirement savings without paying taxes and penalties until I’m 59.5 . I’ll be ready to take up fishing full time well before then…

Line up your time horizon and plan accordingly. In order to retire in my early 50s I will have to sell my house, downsize, and use that cash from the house sale (which is tax-free by the way…) to fund my retirement until I am 59.5. At that age I’ll be able to make qualified withdrawals from my retirement accounts sans tax headaches. Luckily I am 100% debt free and have a huge asset via my house. The plan will work, it’s just a little wonky. Something to keep an eye out for as you make your moves…

Cheers, thanks for reading!

Disclaimer – this is a very board & general look based on my personal experience. Everyone’s situation & plan is different. Talk to a good CPA and consult with a reputable, fee-based investment advisor as you do your own due diligence. I am long SWPPX and the Vanguard Trust that is mentioned.

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