At some point in your life, you will realize you don’t want to be working a full time job when you are 70. You would rather be working on your own projects, or pursuing your passion, or just enjoying life a bit more. To get there, you need to build wealth to generate a steady stream of income, hopefully long before you hit 70.
Wealth is about far more than money, but money is part of the equation. Financial wealth can dramatically increase your quality of life. It gives you the freedom to say no to a job and work on what you want. Wealth gives you freedom to do things on your own terms. Money won’t make you happy, but it can unlock doors to other things that make you happy.
Just in case your startup didn’t IPO, you’ll need a plan for building wealth. Investing is the surest path to building wealth so that you don’t need to depend on your day job. There are plenty of other ways that may be faster or easier for some people, but investing can work for everyone. We all deal with money every day, so we might as well learn to make the most of it. Everyone should have a plan for their money.
Many people are graduating college, taking a job, and making real money for the first time in their life. But they have no idea what to do with it. They weren’t taught investing from their parents or their schooling. By the time they realize how to invest, they have missed out on years of growth.
This is my guide to simple investing to build wealth. It’s everything I wish I knew when I was 20. This guide is meant to be a high level plan for investing over the long term. I”m not a professional investor and I don’t think you need to be. I’m just an engineer who is interested in finance and wealth building. I’m sharing what has worked for me and how it can work for just about anyone, particularly engineers. I’m writing this guide partly for myself, so I can document how I invest for future reference and to make sure I stick to the plan. Of course, you should do your own research to figure out a system that works for you.
This guide is written towards engineers, but there is nothing super specific that is limited to engineers. It could easily apply to many other people as well. Engineering just happens to be what I’m familiar with. Though, I think engineers are a bit unique for a few reasons:
- Engineers are highly paid, and often don’t know what to do with all the extra cash. There are a lot of options for how to invest large sums of money.
- High income means different rules and limits for investing that can really cost you if you don’t pay attention
- Engineers often have a lot of investing options, and different pay structures, such as RSUs to consider
- Engineers start their career much earlier than other high paying jobs (such as doctors or lawyers)
Keeping it Simple
The goal of this guide is clarity and simplicity so you understand just enough to take action right away. I”m going to explain specifically how and where I invest, but I”ll leave out the fine print and the mechanics for 2 reasons:
- Going over all the rules and exceptions to cover all cases is distracting. Most people don’t need to worry about it. Focus on what matters the most.
- There are plenty of great guides already out there that show you the tactical steps to set up accounts and systems. Rather than repeat all this, I will provide links.
The Basic Rules
Before jumping in to the specifics, here are a few simple rules I follow when it comes to investing. Once you understand these rules, it becomes much easier to make decisions that will come up.
Investing is important, but it doesn’t have to be super complicated. In fact, the more complicated it appears to be, the more likely someone is taking advantage of you. Nobody cares as much about your wealth as you do, so be cautious about putting it in the hands of somebody else. Or better, don’t.
The most important rule is try to do everything yourself. You don’t need to have a degree in finance, and it doesn’t take a large amount of time. If you spend only 2 days a year focusing on managing your finances, that might be the highest return on investment you’ll make each year. I guarantee you it is worth it and you’ll be better off than 95% of your peers. Don’t outsource wealth building!
That said, if you still really don’t want to do it yourself, it’s better to pay a financial planner than do nothing. But you should strongly consider doing it yourself. Give it try for a few years and then switch if it really isn’t working out for you.
Don’t Mix Investing
The second rule is don’t ever mix investing with other products. I have a lot of “friends” that are in the business of selling insurance that is disguised as investing. The investments are usually terrible, with limited options, and long contracts that are impossible to leave. The insurance is very expensive and usually not the right kind. When you bundle everything together, it’s difficult to tell how much each thing costs and where the money is flowing. But once you figure out what the commissions are for selling these products you will know where some of the money is flowing. Stay away. Buy term insurance if needed and keep investing separate.
Investing should be boring and easy
Finally, investing should be boring. I follow the “buy and hold” strategy. It’s not sexy, but it works. And more importantly, it’s easy. Any strategy that becomes too complicated with the promise of better returns also risks failing because I didn’t stay on top of it. I want to be able to set up something once, and automate as much as possible, with check ins every year or so. A system that is stable is not likely to fail.
Here’s why buy and hold works. The stock market is completely unpredictable, but one thing seems to hold true: Over the long term, the overall stock market goes up. This makes sense because society is generally growing and building. The stock market averages about 7% growth each year. The key here is “average”, meaning it might be up 20% one year and down 30% the next, but over the long term we care about, we can expect about a 7% return on average each year.
The most important place to invest first is retirement accounts. This is money that generally can’t be accessed until your late 50s, but there are a lot of tax and other benefits that allow this money to grow much faster than other investments. Here how I invest in retirement accounts, in order:
Total: $19.5k + employer match
The 401k is usually the best account to contribute to first. Most companies that aren’t cheapskates (also known as startups) will do matching, which is free money you get right away. It’s like an instant return on your investment. My current company matches 50% of my contributions up to 7% of my salary. So as long as I contribute the max amount, I get an additional 3.5% of my salary. Not a bad deal.
You can only contribute to a 401k through your employer. Set this up your first week at your new company so you don’t forget. The money is taken out of your paycheck before you even see it, so it’s easy to run this on auto-pilot.
The maximum amount you can contribute to a 401k is currently $19.5k (2020), but the government increases this every few years to keep up with the times.
There are two types of 401k, both are tax advantaged, but in different ways.
Traditional 401k: You are not taxed when you contribute, but you will be taxed when you take it out during retirement. Good if you are currently making a lot of money in a high tax bracket, and can reasonably expect to be in a lower bracket during retirement.
Roth 401k: You contribute after paying tax, but then the money grows tax free and you can take it out in retirement without any additional taxes. The inverse of the traditional 401k means it’s good if you aren’t making much now and expect to make a lot more in retirement.
At first, it looks like the traditional 401k is better for high earning engineers. But, if you are able to contribute the max amount of $19k, the Roth 401k is actually slightly more efficient, since you can shelter more money. In short, the money you would save on taxes with the traditional 401k is taxed itself, which limits the upside.
Harry Sit over at the The Finance Buff has written some really good articles comparing the two (here and here). His conclusion is that the Traditional 401k is better for most people who don’t contribute the max, and the Roth 401k is better for those that can hit the max. But even then, the differences are extremely small and his analysis makes assumptions that might not be true for everyone. So, don’t stress out too much about choosing, or do some of both. I’m partial to the Roth 401k because I’d rather be done paying taxes and don’t want to have to think about it later, especially if tax rates change in the future.
Once you have maxed out the 401k, you should next put your money to work in an IRA. An IRA is very similar to a 401k, but it is not tied to your employer at all. You must open a specific account and contribute directly to it. Like a 401k, there is also a Traditional IRA and Roth IRA. The contribution limits are much lower – currently $6k (plus an extra $1k if you are 50+). There are some other minor differences between an IRA and 401k, but most people don’t need to worry about it.
The only other “issue” is that there are income limits to be able to contribute. Currently, you must make under $124k (single) or $196k (married) to be able to put in the full $6k. This is potentially a problem for engineers, but luckily there is a workaround. There are no income limits for non-deductible contributions to a Traditional IRA. Or in other words, there are no limits if you pay income tax on anything you put into a Traditional IRA.
This means we can take advantage of the Backdoor IRA. If you are above the income limits, you can’t put money directly into a Roth IRA, but you can indirectly do this using the Backdoor IRA. Though I normally associate the term “backdoor” with illegal activities, in this case it is perfectly legal (Maybe we should think of a new term for this then?). Basically, you put money into a Traditional IRA without any deductions allowed, and then roll it over into a Roth IRA. If that sounds like you are jumping through a lot of hoops to arrive at the same end state, it’s because it is. No, the rule doesn’t make sense. Just do it. It’s worth the hoops. Again, here is a great article that explains the specifics.
Make less than the income threshold? Put it directly into a Roth IRA. You get to go through the front door.
Make more than the income threshold? Use the backdoor method above. Put it in a Traditional IRA without deductions and roll over to an IRA.
Side note: There are a few different strategies for when to make these IRA contributions. Most smart people I know contribute the entire $6k to a Traditional IRA at the beginning of the year, wait a month, then roll over to a Roth IRA. This follows the idea that time in the market > market timing.
Max After-Tax 401k
The final piece of the retirement investing is the After-Tax 401k. This is gold, and most people aren’t even aware of it. It allows you to potentially contribute an extra $37.5k to your 401k. That’s a huge boost to your tax-free-growth 401k. The reason many people haven’t heard of it? It’s tied to your employer, and many employers don’t allow it. (Insert side rant about investing options being tied to your employer).
You need to check if your employer allows after-tax non-Roth 401k contributions. Then, you should check if they allow for distributions while you are working and rollover to a Roth 401k or IRA. The key terms here are “in-service distribution” and “in-plan roth rollover”. If so, you are in luck and can take advantage of the Mega Backdoor. Good news is that many tech companies, especially larger ones, have this option available. Here’s a non exhaustive list of companies that are known to have the Mega Backdoor available:
With the Mega Backdoor, you contribute after-tax dollars to your 401k (not Roth), and then convert those to a Roth IRA periodically. After-tax 401k is different than a Roth (which is also after tax) because you will pay taxes on the earnings on your non-Roth after-tax contributions between the time you contribute and the time you roll it out to your Roth IRA or Roth 401k.
As long as you roll over often, your earnings will be very small, and it quickly becomes very similar to contributing to a Roth 401k. My employer has a plan through Fidelity, and there is an option to automatically roll over daily. Makes it super easy.
The reason this is all allowed is because the “real” limit (employer + employee) to 401k contributions is currently at $57k. The $19.5k limit mentioned earlier applies only to the standard Traditional and Roth employee contributions. It may seem a bit unfair that some people can’t access this because of their employer. I agree, but I also don’t make the rules. Hopefully you can take advantage of it!
Watch it grow
If you contribute the max to each of these accounts, you can invest up to $62k dollars toward retirement every year. All tax-free growth and tax advantaged. All of these numbers are per person as well, so if you are married you could potentially double that amount.
Let’s look at how this would grow over time for just one person.
Assuming a modest 7% growth rate, you would have over $2.7M in just 20 years, with your total investment being less than half. If you were able to start investing the full amount right out of college, say at 22, you would be looking at about 40 years of growth until retirement at 62, giving you $13M. Even if you started late at 30, you could retire at 60 with $6.2M.
The best part is all of this requires very little effort with extremely low risk. Nearly everyone is capable of managing this. It’s a guaranteed way to set yourself up for retirement.
Where to invest?
For your employer-tied accounts (401k), you will be limited to the brokerage they use. My company uses Fidelity and it works well.
But what about IRAs and non retirement investing?
The most important things to look for in a brokerage are low fees, ease of use, and fund selection. My recommendations are Schwab, Fidelity, and Vanguard. I personally use Vanguard & Fidelity for the majority of my investments but all are great options.
The internet is full of lengthy discussions about which is better based on minor details, but the truth is it doesn’t matter that much. It is far more important that you get started. Choose the one that looks the best; you can always switch later on if needed.
What to invest in?
Keep it simple. Invest in diversified mutual funds. I can’t tell you if a specific stock will go up or down, but I can tell you the market as a whole will go up. So if we invest in a little bit of everything, we can be pretty sure that our account will be growing in the right direction.
I minimize investment in international stock for 2 reasons.
- Our society is far more globalized than ever before. Most large US companies have international presence, and are affected by global markets already. Even small companies often have ties to other countries. Investing in domestic stocks will get you plenty of international exposure.
- The US is a power economy. No country anywhere near its size produces so much innovation and growth. For the long term, I can’t imagine a better place to invest.
Here are my 3 recommended portfolios (also recommended by many other people)
The Easiest: Single Balanced Portfolio
- Target Retirement Fund (Vanguard – VFIFX)
It’s only one fund, but it is balanced across stocks and bonds. The balance changes as you get older and approach the retirement date of the fund. The balance right now is heavy on stocks that will be more volatile, but overall stronger growth. As you approach retirement, the balance will shift slowly to be heavy on bonds, which are less volatile and smaller growth. In other words, the risk decreases as you get older. Only downside here is that you don’t get to control the shift in balance and I tend to think the timing is too conservative.
The Standard: Three Fund Portfolio
This is my favorite and what I recommend for most people. These 3 funds will get you exposure to almost the entire market of stocks and bonds. Allocate stronger on stocks for higher risk/higher returns.
- US Total Stock Market (Vanguard Total Stock Market Index Fund – VTSAX): 60%
- US Total Bond Market (Vanguard Total Bond Market Index Fund – VBTLX): 20%
- Int’l Total Stock Market (Vanguard Total International Stock Index Fund – VTIAX): 20%
The Stretch: The Five Fund Portfolio
If you want to diversify even more, add in international bonds and real estate. I don’t think this really adds much upside and it’s more funds to juggle, but it’s a popular alternative. Although I do like the idea of adding in real estate, I would rather invest more directly in real estate than through a large fund.
- US Total Stock Market (Vanguard Total Stock Market Index Fund – VTSAX): 40%
- US Total Bond Market (Vanguard Total Bond Market Index Fund – VBTLX): 20%
- Int’l Total Stock Market (Vanguard Total International Stock Index Fund – VTIAX): 20%
- Int’l Total Bond Market (Vanguard Total International Bond Index Fund – VTIBX): 10%
- Real Estate (Vanguard Real Estate Index Fund – VGSLX): 10%
What not to invest in?
Gold and other precious metals.
Here’s the problem with gold: You can’t build anything with gold. You just own some rocks. Rocks are only worth what other people are willing to pay for them. You have no control over the value, so you can’t grow the value. You are completely dependent on what the market is doing. It might go up, it might go down. You can’t come up with ways to increase the value. You are investing in materials, not people and their ideas.
A company is the opposite. When you invest in a company, you are investing in someone’s idea and their ability to execute it – to build and to grow. When I invest in Tesla, I’m not investing in the materials that make up the car. I”m investing in the company’s ability to assemble the materials into the finest electric car on the planet. That’s not an easy job, and it’s difficult for someone else to copy. That is far more valuable than the materials. And as they add more features and reduce costs, they create even more value, allowing the company to grow. That’s where I want to put my money.
Summary and Action Steps
Here’s a summary of retirement investing and what you need to do to get set up. Once you have everything set up, it should run on autopilot, with some tweaking from time to time. Remember, these are in order, so fill up a 401k before putting a penny into an IRA (especially if you have an employer match!)
- Max 401k: $19.5k (plus employer match)
- Traditional or Roth – doesn’t matter too much
- Max IRA: $6
- Below income limits? Contribute to Roth IRA
- Above income limits? Contribute to Traditional IRA -> Roth IRA using IRA Backdoor method
- Max after-tax 401k: $37.5k
- Does your employer offer after-tax 401k? Contribute to after tax 401k -> Roth 401k using Mega Backdoor method
What about investing after you fill up these buckets? What if you want to access money before retirement age (non retirement investing)? We’ll cover these next.