Should I invest excess income in stocks or contribute to a 401(k)/IRA?
I just graduated college. Would it be better to invest my excess income in stocks, to have access to the money if needed, or put money into a 401(k) or IRA to store the money away for retirement?
Congratulations on graduating. The answer to your question....how about both!
But, before you do either one, make sure you have something built up in your emergency fund in case of unexpected financial events. Not planning enough for the short term could leave you cash poor and reaching for the credit card if an unexpected expense pops up. After you have 3-6 months of living expenses in the bank, I would also urge you to consider what major purchases you might be making in the next 3-7 years, like maybe a down payment on a house or a vehicle. It's important to start saving for these things now so you have enough time to build up your savings. This will help you keep your liabilities down when you go to make those purchases. People get into financial trouble when they are highly leveraged, have no emergency fund, and then something goes wrong. That's when they have nowhere to turn for financial relief.
After getting a comfortable emergency fund in place, i would assess your company's 401(k) benefits to see if they are willing to match your contributions. If so, it is generally a good idea to contribute enough to maximize their matching contribution. After all, that is like getting free money toward your retirement.
After your short-term risks are covered and after you are maximizing your employer match in your 401(k), then take a look at what your goals are. Chances are you have some that are short-term and some that are long-term (like retirement). This is where you will likely do "both" when it comes to stocks vs. a 401(k). However, I will say that I would not advise you to go into stock investing blindly. There is a fundamental way to investing and there is a speculative way. Things like proper allocation, minimizing concentration, and diversification will help you avoid major and expensive mistakes when investing in stocks. So, if you're not experienced with stock investing, then you can enlist the help of an advisor or stick with ETFs and mutual funds, which already come diversified and are not concentrated in a small amount of stocks. This is typical for younger investors with a small amount in their portfolio and there is nothing wrong with using these tools.
Taking a chance on a stock here and there with no overall strategy is no different than gambling and I would never recommend gambling over contributing to your 401(k). However, if done correctly, you could invest in stocks, ETFs, or mutual funds outside of your 401(k) in a brokerage account that is more liquid and accessible, if that is important to you.
Joe Allaria, CFP®
This is a value judgment you have to decide for yourself. The earlier you decide to invest for retirement, the more compounding and better off you will be. But you do lose flexibility and access without hefty penalties. So, your answer lies in how stable your employment picture is, and the odds of you needing the money. The biggest mistake I see is people are always so worried about taxes that they put everything they have into their 401(k) or IRA and then have no money on the outside to do other things, like a down-payment on a house or alternative investments.
So without knowing your personal situation, you may want to consider "splitting the middle" and put some into the 401(k), ESPECIALLY if the company makes a matching contribution. Also, keep some on the outside in a taxable investment account.
Regarding the stock question, at your age, stocks over the longer term are a great option. Especially in this current rising interest rate environment where bonds have a higher than normal risk profile. You can invest in stocks in both accounts, your 401(k) will likely just have stock mutual funds you need to use rather than individual stocks. On the outside, a great way to start out is by using an indexed ETF on the S&P 500 or NASDAQ 100 like "SPY" or "QQQ." This will provide immediate diversification for someone just starting out.
Happy New Year and Best of Luck, Dan Stewart CFA®
This is a good question, and the answer is probably "both."
It's important to outline what you're looking to accomplish, then determine the saving/investing path that gets you to each goal. For example, nearly everyone has the goal of saving for retirement, purchasing a home, paying off debt, etc. Retirement accounts can be very good tools for saving for retirement, but they're not ideal vehicles for funding a future down payment on a house (or any other goal you have before age 59 1/2). Thus, the optimal contribution approach must address these specific goals: how much you think you'll need, and when you'll need the funds.
There is no one-size-fits-all approach to solving these problems. The closest thing that comes to "blanket advice" is, as a general rule, to start with making sure you're taking full advantage of any kind of employer match that exists within your 401(k) plan. If you can be sure to at least take full advantage of this, then you'll have a decent start to your retirement while you continue to fund your shorter term goals.
Adam C. Harding, CFP
First thing I would do is create an “emergency fund” that consists of 6-12 months of your living expenses. After that, start contributing to a 401(k) if your employer provides one for you or a Roth IRA if they don’t. You should be aiming for a 10% savings rate in these accounts.
For someone who is out of college and just getting started with an employer who provides a 401(k), I like the following tiered approach:
1) Contribute the amount to the 401(k) that your company matches (or possibly will match after a brief introductory period). This is "free" money that you want to take advantage of. If your company match is 100% of a certain amount you contribute (e.g., 3% or 5%), then this is an immediate 100% return on your investment. Furthermore, the contributions to your 401(k) will reduce your taxable income and, depending upon your overall situation, may keep you in a lower marginal tax bracket.
2) Build up some cash reserves such as one month of income as a baseline. Many new investors put money into an IRA and then have to subsequently withdraw it at an inopportune time, which often subjects them to having to sell a longer term investment at a loss and/or paying a 10% penalty on an early IRA withdrawal.
3) Start a Roth IRA. Contributions to a Roth IRA can always be withdrawn penalty free (you would have to pay tax on any earnings though), so you have access to the funds, if needed, and if not, then you can continue to take advantage of tax free compounding. Here is a recent Letter I wrote explaining the basics of IRAs in more detail.
4) Think about expanding upon #2, depending upon your situation, to avoid having to take on any high interest or variable rate debt.
This approach provides a young individual with flexibility. It is a good starting point, but will obviously need to be revisited as conditions evolve.
Joshua Hall, ChFC