Personal Finance for PhDs

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Get Started Investing

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Getting started with investing is simple, though perhaps not easy. Many young people, graduate students included, are intimidated by investing. They may even be unaware that you can buy investments yourself; you don’t have to go through a broker or financial advisor.

 

1) Ask yourself if you are prepared to start investing.

Do you have a lump sum of money that you want to invest and/or do you have an ongoing savings rate that you would like to invest? Have you met your other financial priorities, such as saving an emergency fund? Are you emotionally steeled to stomach the volatility that is likely to come with a long-term investment?

2) Determine the timeline for your investment.

Are you investing for retirement, many decades away? Or are you investing for a mid-term goal? The timeline on your investment will influence how much risk you should take.

Further reading: How to Invest Differently for Short, Medium, and Long-Term Goals

3) Research the type(s) of investments that you want to buy and develop an (initial) investing philosophy.

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This is the most daunting step for someone who wants to start investing, but there is plenty of material available to help you do your research. While you should make a few determinations about your personal investing philosophy, you do not necessarily need a fully worked-out plan to start investing, especially if you keep it simple at the start. The important part is to get started, even if you don’t have the perfect, complete plan from the beginning.

Some questions to ask yourself are:

  • What is my risk tolerance?
  • Do I want active or passive management?
  • How important is fee minimization?
  • What are my ethical considerations for my investments?

Great resource: The Bogleheads

Further reading: How to Keep Investment Costs Low (and Returns High)

4) Choose the brokerage firm you want to invest through.

There are many brokerage firms to choose from online for the DIY investor and also many firms that will manage your investments for you through financial advisors. Your investing plan will help you decide which firm to use.

How much money you have to invest may influence your choice of firm. Most firms have some kind of minimum investment necessary to open an account, which may be a lump sum or a recurring transaction.

If you plan to buy mutual funds or ETFs, you must verify that the funds you want to buy are offered through the firm you are considering. Look at the expense ratios of the funds that you plan to buy to compare between firms. (Generally speaking, Vanguard is the industry leader in minimizing expense ratios.)

If you plan to buy single stocks, look at the firm’s trading fee structure (both on the buy and sell) to find the best price for your anticipated volume of trades.

Further reading: Where to Start Investing When You’re Broke; Stocks – Part X: What if Vanguard Gets Nuked?

5) Open your account and buy your investments.

Once you have decided on the brokerage firm you want to use and the investments you want to buy, open an account with the firm. You can choose to open an IRA (only if you have taxable compensation) or a taxable investment account. Once you have your banking information linked to your brokerage account, you can transfer money and buy your desired fund(s). Consider setting up an auto-draft of a regular savings amount from your checking account each month.

Further reading: Stocks – Part XV: Target Retirement Funds, the Simplest Path to Wealth of All, Stocks – Part XVI: Index Funds Are Really Just for Lazy People, Right?

6) Monitor and maintain.

While you don’t have to look at the balance every day, it is a good idea to periodically check up on your investments to make sure they are behaving as you expected (against the relevant benchmarks, etc.). If you are doing your own rebalancing, make sure you stick to your investment plan in terms of how often to check and execute the rebalancing.

7) Refine your philosophy.

As you learn more about investing and through the process of buying and monitoring your first set of investments, you will likely evolve your investing philosophy. Once you have the next iteration of your philosophy well thought-through, you should change your investments to reflect it. In the process, minimize turnover to the extent possible to avoid incurring new fees and taxes. And don’t halt your learning process! Your philosophy and certainly your implementation will probably change many times throughout your life.

Taxable Compensation

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Note: The content in this article is outdated. As of January 1, 2020, there is a new definition of taxable compensation. You can read or listen to the details about the new definition in: Fellowship Income Is Now Eligible to Be Contributed to an IRA!

Not all PhD trainees are eligible to contribute to an IRA because IRAs require “taxable compensation” (formerly known as “earned income”).

“Generally, compensation is what you earn from working” (source) and includes wages, salaries, and self-employment income, among other few other types of income. A few types of income that are not earned are rental income, interest and dividend income, and pension income.

At first blush, it would seem that PhD trainee pay would fall under wages or working for someone who pays you. However, that is only true for PhD trainee pay that is compensatory. Non-compensatory pay may not be eligible for IRA contributions. Publication 590 states that “scholarship and fellowship payments are compensation for IRA purposes only if shown in box 1 of Form W-2.” (See this explanation of how to calculate your taxable income for a discussion of compensatory and non-compensatory pay.)

The question of whether or not you can contribute to an IRA will come down to what kind of tax forms you receive in January. If you receive a W-2, you have taxable compensation and can contribute to an IRA from that income. If you receive a 1099-MISC, a 1098-T, a courtesy letter, or no notifications whatsoever, the form indicates that portion of your income is not eligible to contribute to an IRA.

Further reading: Earned Income: The Bane of the Graduate Student’s Roth IRA

Remember that you can contribute to an IRA up to your amount of taxable compensation for the year or $6,000, whichever is lower. If part of your income is compensation, you can contribute to an IRA from that portion – this may be the case if you switch funding sources between school years or between the academic year and the summer or if you have outside self-employment income. Also, if your spouse has taxable compensation, you can contribute to a Kay Bailey Hutchison spousal IRA (up to $12,000 between both IRAs).

Emergency Funds

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An emergency fund is an easily accessible amount of money that should be tapped for emergencies only. It is up to the individual to determine what kinds of expenses qualify as emergencies.  Most people calculate an appropriate emergency fund size based on a certain number of months of expenses (generally three to twelve), which implies that it is for use in the case of unexpected income loss. Other people may use their emergency funds to pay deductibles on their auto, homeowner/renter’s, or health insurance or to make car or home repairs. Whatever the need ends up being, emergency funds are there to keep you from going into debt when something unexpected occurs.

The most widely agreed-upon place to stash an emergency fund is in a savings account. The argument against investing the money in a more volatile asset is that you don’t want to get hit when you’re down by having an emergency occur just when the market has taken a downturn. You would have to realize your losses and at the same time have less money available for your emergency.  Some people keep their emergency funds at the same bank as their check or even as a large buffer in their checking accounts, but if you have any issues with dipping into the emergency fund inappropriately you should keep it at another institution so the money feels less accessible.

Further reading: Why You Need an Emergency Fund First

Roth vs. Traditional

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You will often hear about traditional vs. Roth IRAs and 401(k)s. In both cases, your contributed money grows tax-free, so the chief difference between the two is when the money is taxed. In the case of a traditional account, you take an income tax break when you contribute the money and are taxed when you take distributions from the account. The Roth is the reverse – you pay income tax on the money when you contribute it, but the distributions are tax-free. The main question to ask is whether you believe your income tax rate is currently higher or lower than it will be when you take the distributions. While this answer cannot be predicted perfectly because tax rates are subject to the political process, many graduate students are sacrificing income in the short-term for long-term income potential, so it is likely that their incomes and tax rates will jump after grad school and increase with time. Therefore, the Roth seems to be the better choice for most graduate students and young people in general. Even the most tax-break-enthusiastic professionals will tell people to contribute to Roth IRAs when they are in the 15% tax bracket or lower.

The other noteworthy differences between the Roth and traditional options are:

  • there are income limits for contributions to Roth IRAs for high earners (contributions start being phased out with a modified AGI above $114,000 for single filers and $181,000 for married filing jointly)
  • you must start taking required minimum distributions from a traditional IRA by April 1 of the year after the year you turn 70.5, whereas there are no required minimum distributions from a Roth IRA
  • you can withdraw Roth IRA contributions at any time without penalty (but not earnings)
  • you can withdraw Roth earnings without penalty in certain situations such as for qualified educational expenses or a first-time home purchase

You should also consider tax diversification. If you are likely to have a higher-paying job in the future and plan to contribute to a traditional 401(k) or similar, you can diversify your tax situation by contributing to a Roth IRA now. That way, in retirement, you will have more flexibility with your distributions, paying tax on some of your income but getting some income tax-free.

Further Reading: Roth Vs. Traditional IRA: Which Is Right For You?; Traditional vs. Roth IRA: Some Unconventional Wisdom on Which is Better for Young Investors; Roth IRA Basics, In a Question & Answer Format; Roth IRA vs. Traditional IRA: The Complete Guide for Wise Investors

Long-Term Savings

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Long-term savings are on a time horizon of at least five to ten years and should be invested to avoid interest rate risk in taxable investment accounts. An example of a long-term savings goal is children’s education funds, which can be invested in tax-advantaged vehicles.

 

Mid-Term Savings

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Mid-term savings have a time horizon of a few years and are larger in scope than short-term savings. Examples of mid-term savings might be a car replacement fund or a down payment on a house. This money may be conservatively invested or kept in cash-equivalents depending on the timeline and the risk tolerance of the investor.