Steps to Financial Independence: Step 4

Photo: Hiking in Saguaro National Park.

This is the fourth article detailing the steps to reaching financial independence.  To read more about the steps, then click on this page link.  To read more articles in this series click on the following links.  Step 1, Step 2Step 3 and Step 5.

My wife and I are currently at this step. We have paid off all of our debts.  We have an emergency fund of 3 months saved and we have a down payment saved for a house.  Step 4 is the biggest step to financial independence!  This is the step where you are investing tons of money for your future self.  When I mention a savings rate, this includes both investments and savings, but investing will give you higher returns than saving in a savings account.  There is a lot of history and a lot research that shows that the best way to save for the future is to invest.  These investments will grow over time and you will have a substantial amount of money.

Investing is not:

Savings Accounts, Certificates of Deposit, Savings Bonds or Money Market Accounts are not forms of investing.  These accounts make less in interest than the inflation rate.  Therefore, they are a bad investment.  Right now, savings accounts are making around 1% or less in interest.  You just don’t make enough by putting your money in savings accounts. 

My wife and I have currently been using a saving account and not investing as much, because we have been saving for a down payment on a house. So, the only investing has been my wife’s 401k at 8% of her income and my 403b at 4%.  Everything else has been going into a savings account earning 0.75% interest.  We decided to keep this money in a savings account, because we didn’t want to take the chance of losing the money if the market turns down.  This money was going to be used in a year or less, so we did not think that it would be safe as an investment. 

I personally believe that the only time that you keep things in savings accounts, CDs or money market accounts are when you will be using the money within 2 years.  The only other thing that I keep liquid is the emergency fund.  This fund is available at all times for my family to use.  Some people disagree and put part of their emergency fund in investments and some people ladder CDs as emergency finds, so that way there is always money available while the other money is stuck in a CD investment.  I personally like to keep my emergency fund in easy access, so I am fine losing out on some growth for the security of three months of available cash.

Investments are:

Investments are items that you purchase for the long haul.  You have to understand the importance of sticking with the market and not getting scared by any short term decreases in the market.  I consider investments anything that I won’t need in 3 years or more.  Some people may have a different definition but that is my definition.  Each paragraph below lists a different type of investment and explains the benefits of this investment.

Homes are great investments and have a long track record of growth.  You don’t buy a house for only two years and then sell it, because you will lose on the closing costs and realtor fees.  When we buy our house, we plan to live in that house for multiple years and plan to pay the mortgage off early.  Yes, we are planning to go back into debt to purchase an investment that will have long term growth over the period that we are living in the house.  We also plan on purchasing the house on a 15 year fixed rate mortgage.  By choosing a 15 year mortgage over a 30 year mortgage we are saving lots in interest.  I will write more about the benefits of a 15 year mortgage compared to a 30 year mortgage in a later article.

A 401k and a 403b are both great investments.  These two investments are tax deferred.  My wife has a 401k with a 5% match.  Previously we have been investing 8% of her income into this type of investment to take advantage of the pre-tax investing.  Pre-tax investing is when you put money into a 401k or a 403b from your income before your workplace takes out the taxes.   This is a big advantage because you get to invest some money without the government putting their hand on any of it.  Since my wife has a 5% match, her 8% plus the 5% match totals 13% of her income being invested monthly.  My school district does match, but very little.  My match is 0.5% of my income, so with me putting in 4%.  This totals to 4.5% of my income.  I have a 403b which is the same as a 401k, but it is specially used in education and maybe some other fields. You can invest up $17,500 a year in a 401k in 2015 (this can change based on the tax code in different years).  Both of these are great investments, but I prefer the following investment. 

A Roth IRA is an investment that allows tax free growth.  To me that is best type of growth available.  So, this is the exact opposite of a 401k.  You take the money after taxes have already been taken out and then you invest.  So last year, I fully funded a Roth IRA.  This was about 15% of my income, which is pretty good when you consider that I was only putting 4.5% into a 403b.  After we purchase a house, my wife and I will begin investing again into Roth IRAs yearly.  I just like the idea of investing money that will not be taxed later in my life.  You can invest up $5,500 a year in a Roth IRA in 2015 (this can change yearly so make to check the tax code). 

An IRA is a good investment and is similar to a Roth IRA, but a plain IRA gets taxed on the growth.  The government has put a stipulation on individuals and married couples that will not allow them to invest in a Roth IRA if they make too much money, thus leaving you with only the option of investing in an IRA.  The positive of the IRA is that you don’t get taxed on the growth until you take it out in retirement. 

In all of the retirement accounts above, you should be investing in diversified accounts.  This means different things to different people.  Some people suggest bonds, but I prefer to not have any bonds in my asset allocation.  I know this can be more risky, but I’m willing to take the risk, because I know that over the long haul the investments are going to grow and stock investments grow at a faster rate than bond investments.  I will do a more in depth article on investing later on.

Rental properties are also great investments and can bring in great monthly income.  Eventually, my wife and I are interested in purchasing a rental property and using the income as a form of retirement income.  Most research has shown that you should be getting at least 1% of the purchase price for rental income.  If you are not receiving the 1%, then the rental property is not considered a good investment.  Rental property can be a great investment because you are earning income monthly off of the property and the price of the property is growing every year that you own it.

Investment accounts are good investments, but there is no tax shelter at all, so you are taxed yearly on the growth.  I have an investment account with vanguard and have my money invested in a REIT and the Vanguard S&P 500 index fund.  I would not invest in these accounts until after you have fully funded all of your retirement accounts.  Mainly because the retirement accounts have tax sheltered growth and plain old investments don’t.

An Educational Savings Accounts (ESA) or a 529 plan are both good investments to use for college savings.  I also include this investing in this step, because it is important to save for kids college.  This is totally up to you about whether you want to save for college or not.  I have always felt that it was a great learning experience in paying for my own college and I think that has instilled great work ethic in me, because I found a way to pay for school so that I would not have a lot of student loans.  For example, one summer I paid for all my classes from my summer job, this saved me a lot because I didn’t take out a loan for those classes and I didn’t end up being charged interest for any of that cost.  So, I think that it is a great learning experience to work through college, but I also don’t think that it is good to go into debt for college.  So, we will be saving in one of these accounts when we have children, but I still think that I will make them work and pay for some of their college.  These accounts are really good because the growth is tax free if used for college expenses.  I would begin investing in these accounts as soon as your child is born, so you need to make a decision about how college will be paid for when the little bundles of joy are born.

I know that I went through a lot of information in this article and it is not the most exciting topic to discuss different types of investments.  Investing is the thing that will speed up the growth of your money.  This is when compound interest starts working in your favor.  And actually this topic can be exciting, especially if you are interested in making your money grow.  The best way to grow your coin is to let your money start working for you.  You do this by investing.