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investing

Fellowship Recipients Can Save for Retirement Outside an IRA

April 10, 2017 by Emily

Congratulations on your fellowship! Winning a fellowship that pays your stipend during graduate school is a great honor and achievement. A fellowship stipend may even be larger than the base stipend provided by the department, giving you additional discretionary income. While you might have an enhanced ability to save for retirement in terms of your cash flow in comparison with your peers, unfortunately you may be excluded from using a tax-advantaged retirement account like an Individual Retirement Arrangement (IRA).

 

The advantage that an IRA offers is tax-free growth on your investments over the several decades until you are of retirement age. This allows compound interest to have its maximum effect of growing your investment balances exponentially, unburdened by the drag of paying tax on the growth and dividends. However, only “taxable compensation” can be contributed to an IRA. As fellowships are not reported on W-2s, they are not considered taxable compensation for this purpose. If your only income in a calendar year is fellowship income, contributing to an IRA is not an option during that year.

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Save for Retirement Outside an IRA

While IRAs confer great benefits, they are not the only way to save for retirement. Instead of opening an IRA at a brokerage firm, you can open a normal taxable investment account. If you like, you can buy the same funds that you would have put inside your IRA. The important component is that you have designated that your investments are for retirement, not whether they have a tax-advantaged status tied to retirement. Your investments will be subject to the drag of taxes while in the investment account, but the burden can be made fairly light.

1) You can choose tax-efficient investments. Plenty of people have long-term investments in taxable investment accounts, so minimizing taxes is somewhat of a solved problem. Taxes on investments are not like income taxes when you have a job; they don’t occur every year like clockwork. Taxes only come into play in an investment account when there is a taxable event like selling an asset or receiving a dividend. Reducing the frequency of your taxable events reduces the frequency at which you have to pay tax. There are also two tax rates, and which one you fall into partially depends on how long you have held the investment (a longer holding period gives the lower rate). One of the best ways to minimize your tax burden is to employ a buy-and-hold strategy. The best investment strategy for graduate students (passive investing) is also a tax-efficient strategy, so you don’t have to sacrifice your returns or more of your time to minimize the tax burden in your taxable account.

2) Your low income tax bracket is currently an advantage when it comes to taxes on investments. The two investment tax rates that apply to capital gains are long-term capital gains (for investments held more than one year) and short-term capital gains. The two investment tax rates that apply to dividends are qualified dividends and non-qualified dividends. Short-term capital gains and non-qualified dividends are taxed at ordinary income levels, i.e., your marginal tax bracket. Long-term capital gains and qualified dividends are taxed at a lower rate. If you fall into the 15% marginal tax bracket or lower, as the majority of graduate students do, your federal long-term capital gains and qualified dividends tax rate is 0%. You may still have to pay state tax on your long-term capital gains and qualified dividends, but your federal tax rate is as low as it can get.

If you employ a buy-and-hold strategy, you can minimize your tax burden on your investments to the point that it is only slightly worse than it would have been inside an IRA (depending on your state tax).

How to Save for Retirement Outside of an IRA

The process for saving for retirement in a taxable brokerage account is very similar. You choose a brokerage firm, open an account (in this case, a taxable account, which is the default, instead of an IRA), and buy investments with a lump sum or ongoing contribution. If you want to make things easy on yourself, use the same brokerage firm and investments for your taxable account that you would have (or do) for your IRA. One of the advantages of saving for retirement outside of an IRA is that you are not subject to the $5,500 yearly contribution limit.

How to Transfer Your Investments into a Tax-Advantaged Vehicle

In a future year, you may have the opportunity or desire to shift the assets in your taxable brokerage firm into a tax-advantaged retirement account like an IRA, 401(k), or 403(b). While keeping your investments in a taxable brokerage account is not a bad short-term solution, over the long term it is more advantageous to keep them inside a tax-advantaged vehicle if possible, especially as you move up in tax brackets and start paying tax on your long-term capital gains and qualified dividends.

In each year that you are eligible to contribute to a tax-advantaged retirement account, determine how much money you would like to contribute from your income. Most people save a set amount or percentage from each paycheck to dollar-cost-average their investment purchases. If you have any contribution room left above this goal amount, sell that amount of your assets in your taxable account and increase your contribution to your tax-advantaged retirement account commensurately.

For example, perhaps later in graduate school you receive W-2 pay and plan to contribute 10% of your income to an IRA, which amounts to $2,500. In that year, you will have $3,000 of additional contribution room for a total of $5,500. At the beginning of the year, you can sell $3,000 of assets inside your taxable account and buy an additional $3,000 of assets inside your IRA. Then, set up an automatic withdrawal to contribute $2,500 over the course of the year.

As another example, perhaps you do not have access to a tax-advantaged retirement account until you start your first post-PhD job. If your salary is $80,000 and you plan to contribute 10% to your 401(k), you have $10,000 of contribution room remaining for your first year (for an $18,000 total contribution limit). You can maximize your contribution rate to your 401(k) and sell $10,000 of assets inside your taxable investment account to supplement your salary during your first year.

Having no taxable compensation in the course of a calendar year does not prevent you from saving for retirement. You can still save and invest in a taxable brokerage account. You will forgo the tax-advantaged status of an IRA, but that is not a big sacrifice when you are in a low tax bracket. Once you have excess contribution room in a tax-advantaged retirement account, you can ‘transfer’ some of your taxable assets into it. Don’t let the type of pay you receive dissuade you from working toward your long-term financial goals!

Further viewing: Webinar: Retirement Investing in a Taxable Investment Account

Are you saving for retirement outside of a tax-advantaged retirement account?

Brokerage and IRA Account Minimums

March 31, 2016 by Emily

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A very common issue for graduate students, postdocs, and PhDs just starting out in their Real Jobs who are ready to start investing is that they have only a small amount of savings to contribute to their investment accounts or they have no savings but have identified some monthly cash flow. While some brokerage firms have minimum account balances of one or a few thousand dollars, others have no minimum or waive the minimum if a monthly deposit is initiated. This post outlines the minimum amounts of money needed to open accounts at various brokerage firms. This information was last updated on 1/17/2018.

Brokerage Firm IRA Minimum Taxable Account Minimum
Vanguard $1,000 or $3,000 for mutual funds; ETF price for ETFs (~$50+) $1,000 or $3,000 for mutual funds; ETF price for ETFs (~$50+)
Fidelity  $0 to open, but perhaps more to buy $2,500
Charles Schwab $1,000, possibly waived with ongoing contribution $1,000 or none with $100/mo ongoing contribution
T. Rowe Price $1,000 $2,500
TD Ameritrade none none

If you don’t have enough existing savings to open an investment account (at your brokerage firm of choice), you should just continue to gradually build up their savings balance until it reaches the minimum or the minimum decreases. You can do so either in cash-equivalents (a checking or savings account) or at another less desirable brokerage firm with no minimum or a lower minimum that you can meet.

My Realistic Career Earnings Expectations Push Me to Save Aggressively

June 1, 2015 by Emily

This post is by Tiffany, a PhD student at Harvard University.

As an undergraduate, my parents pushed for me to become a pharmacist. They had good reason to: I had good grades and loved biology and chemistry. However, after volunteering in a lab, I decided I wanted to become a scientist. My dad was initially against this decision: he made many “personal finance” arguments against it. He warned me about the long hours and comparatively low pay to other advanced degrees, and shared articles about the current “glut of Ph.D.s”. He was worried I wouldn’t be able to find a stable job. He argued that as a pharmacist, I would have a stable, high paying salary (though this is now disputed as well). My undergraduate adviser gave similar advice, “You will not make much money if you go into science: the job market is also tricky depending on what you want. Take your time to decide what you want to do.” I thought about these arguments throughout undergrad and during my two years as a technician. In the end, I decided to go to graduate school anyways.

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Their arguments have given me a strong motivation to save as much as possible for the future. First, it is uncertain what will happen after I graduate. Most biology PhDs continue on to work as postdocs, but the starting salary for a postdoctoral fellow based on the NIH guidelines is only $42,840/year. I could move into other fields outside of academia; however, unlike academia, there is no clear map on how to get training and experience for these “alternative careers” outside your dissertation work. Second, compounding works better if I start saving earlier. Any money I put into investments now will likely do more for me later on in life. Unfortunately, scientists are at a disadvantage since their earning power does not increase substantially until after graduate school and postdoctoral fellowships. By then, a scientist is likely into their 30s. Unfortunately, many major expenses – such as weddings, cars, homes, and kids – rack up during your 20s and 30s.

Below, I’ve tried to illustrate these points using my brother and me as an example.

My brother graduated is an engineer. He currently makes $58,700/year in Alabama. His after tax take-home pay is $3800/month. He manages to put away ~$1500/month into his investment accounts. I started my PhD in 2012 and get $36,800/year for my stipend in Boston, Massachusetts. My after tax take-home pay is $2300/month. I manage to put away ~$600/month into my investment accounts. Assuming that no major life events happen, we can calculate how much our income, savings, and investment accounts will turn out.

In the below chart, I’ve assumed that:

For the engineer:

  • He will consistently get a 10% raise every 4 years.
  • He will consistently save about $1500*12/$58700 ~ 30% of his salary.
  • All of these savings will compound at 7% annually, using the formula FV = P(1 + r)y, where y = # of years it compounds, P = the amount saved that year, and r = rate (7%), and FV = future value at age 65.

For the tenure track scientist:

  • I am using my graduate stipend as the PhD student’s salary.
  • Savings as a graduate student and postdoc will be roughly $600*12/$37,000 ~ 20% of her salary, which is what I try to save now.
  • Once the scientist reaches assistant/associated/tenure professorship, she will save ~30% of her salary.
  • All of these savings will compound at 7% annually.

Please note that these numbers are based off myself and my brother. They also do not take into account major life events or raises or changes in investment portfolio. Please also note that I am NOT a financial adviser and that you should seek a professional for financial advice. This article is based purely on my personal experience and hypothetical projections.

savings_comparison

Looking at the charts above, you can see that the scientist makes about 1 million dollars less in a lifetime, but by saving aggressively, only saves $350,000 less. Still, the largest difference is in the amount compounded by age 65. The $1500/month that the engineer puts away in the first 4 years of his career can potentially become over $1 million by age 65 if the annual rate of return is 7%. Although the engineer consistently saves 30% of income, the amounts saved later in life do not yield as much. In contrast, the scientist cannot put away $1500/month until she is 32, after she has finished her postdoctoral fellowship. Her salary grows much more slowly than the engineer’s: she cannot afford to put more away until later. This results in this difference: although the engineer and the scientist have only a $350,000 in total savings, they have a $2.4 million dollar difference in what is compounded. It’s this point that makes me want to save as much as possible now!

Why should I save and invest?

April 8, 2015 by Emily

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Everyone knows that they are supposed to save money, but not necessarily why. If you are accustomed to living paycheck-to-paycheck, you may not even realize how much peace of mind having savings can give you. In addition, investing your money properly for the long term is one of the best ways to build wealth.

The utility of accessible funds.

The power of compound interest.

Further reading: 2 Good Reasons to Start Investing Now, No Matter How Much Money You Have

Compound Interest

April 8, 2015 by Emily

Even though it’s doubtful that Einstein ever said that compound interest is the most powerful force in the universe, it’s indisputable that it is an incredible tool that can work for or against you.

Compound Interest for Investing

When compound interest works in your favor, an asset that you own earns a return and increases in value. Then that increased asset earns a return and increases by even more. The growth is exponential.

compound interest equation

 

As an example, see how a one-time investment of $5,500 will grow over time if invested with an average rate of return of 8%. After 30 years, the investment balance has grown to over $60,000, with over half of that growth occurring in the last 10 years.

investment one time

 

Investing on a regular basis is how Millennials are likely to provide for their own retirements now that pensions have all but disappeared and Social Security is uncertain. If you max out a 401(k) every year for 30 years with an 8% average rate of return, over 30 years you will have contributed $524,880 but your investment balance at the end will be $2,172,944.

investment continuous

 

You can create your own projects of the effect of compound interest using Illuminations.

GSF Reader Post: My Realistic Career Earnings Expectations Push Me to Save Aggressively

Compound Interest in Debt

Compound interest can work against you in the case of debt. When you owe a given amount at a certain interest rate, the amount you owe will also increase exponentially unless you make payments that more than keep up with the growth.

Compound Interest in Inflation Risk

One great reason to invest that most people don’t consider is inflation risk. The average historical inflation rate is around 3-4% per year. That means that every year your money goes 3-4% less far in terms of real purchasing power and the prices will double approximately every 20 years. If you don’t invest at a rate that at least keeps pace with inflation, the value of your money decreases with time. To build wealth through investing, you must earn a return that exceeds the average rate of inflation.

Types of Investments and Basic Principles

March 8, 2015 by Emily

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Risk and Return

In general, in investing there is a correlation between risk and return. Over the long term, being willing to take more risk generally results in a higher overall return.

Further reading: Risk-Return Tradeoff

Asset classes

The three primary asset classes are stocks, bonds, and cash. Within stocks and bonds, there are a variety of sub-classes. Within the stock asset class, you can have US vs. international, large-cap vs. mid-cap vs. and small-cap, growth vs. income, etc. Within the bond asset class, you can have various time horizons, risk ratings, and organization types. There are also more minor asset classes (alternative investments), which include commodities, real estate, etc.

Further reading: Stocks – Part II: The Market Always Goes Up

Asset Allocation

Your asset allocation is the percentage of your investments that are in each asset class or sub-class. You can create an asset allocation that reflects your desired balance between risk and reward. A higher-risk, higher-reward asset allocation would be heavier toward stock investments, while a lower-risk, lower-reward asset allocation would be heavier toward bonds and cash. Your asset allocation will reflect your personal risk tolerance as well as your timeline on your investment. Traditionally, an individual with a consistent risk tolerance will move her retirement investments from more aggressive to more conservative investments as she draws closer to starting to withdraw the money.

Further reading: 9 Common Investment Mistakes and How to Avoid Them

Active vs. Passive Investing

Active investing usually involves a lot of activity, such as picking individual investments and trying to buy low and sell high. Passive investing, conversely, applies a buy and hold strategy in which the investments are held long-term. A subset of passive investing is index investing, in which the investor holds a representative sampling of a subset of investments, such as the S&P 500.

Further listening: Planet Money Episode 688 Brilliant vs. Boring; Passive Index Investing is Boring. And it’s Spectacular., Stocks – Part III: Most People Lose Money in the Market

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