Strategies for Young Investors

Christine Benz: Hi, I'm Christine Benz for Morningstar. Younger investors still have a long runway to retirement, but they have to balance that long-term goal against shorter-term objectives like buying homes and paying down debt. Joining me to share some strategies for younger investors just getting their plans off the ground is Maria Bruno. She's head of U.S. wealth planning research at Vanguard.

Maria, thank you so much for being here.

Maria Bruno: Thank you. Good to be here.

Benz: We talk a lot about retirees, you and me. But I'd like to talk about the younger set, people who are just kind of getting their plans up and running, maybe have that first job. So, let's kind of start at the top of the pyramid, what is most important for folks at this life stage, and that's really kind of balancing competing priorities. You've got a lot of folks coming out of college with significant amounts of debt. They know they should get started on retirement planning. They know they should have an emergency fund. So, how do they figure out where to deploy their money?

Bruno: I think you nailed that. That's the big one, it's resource allocation in terms of, well, how do I invest my next dollar, if you will, across these different options? So, I think it's fairly straightforward, but it can seem overwhelming. First, you want to think about, what are my high-return type opportunities? And at the forefront of that I would put, if you have a 401(k) with an employer match, for instance, an employer plan, where the company matches, certainly that should be your first source. Because if you give that up, then you're basically leaving money on the table. That's 100% return right there. So, that's the easy one. From there, then you might want to think about what type of debt, or if I'm dealing with some high consumer-type debt that has a high interest rate, that might be the next place that you want to look at in terms of paring that down. So, those would be probably the top two.

Then you want to think about emergency savings. Do I have that rainy-day fund in case of an emergency? And I'd like to spend a little bit of time on that because when you think about what this emergency savings looks like, a conventional rule of thumb has been three to six months' worth of living expenses in a cash account. Well, that may not be the best thing for a young investor given limited resources. One way to think about it might be ... one is spending shock. So, if something were to happen, if the car breaks down or ...

Benz: A big vet bill or something like that.

Bruno: Yes, something like. Yes. Do I have liquid cash to pay those expenses? And maybe there you're talking half-a-month to a month's worth of expenses. And then, the other thing would be a loss-of-income shock. So, what would happen if I lost my job? Do I have enough to live off of? And those are probably more accounts that are marketable, money you have access to, but not necessarily sitting in cash. And one avenue I'd like to explore there is a Roth IRA, for instance. We talk about this a lot as well. The contributions that you would make to a Roth IRA are after tax, so the money has already been taxed, but you can access those contributions income-tax-free and penalty-free. So, you can think about that as something up your sleeve if you need to then access some relatively quick money. Certainly, you want to preserve that for retirement. But it is a multitasking type of thing, I think you've used that word in the past as well in terms of being able to be there in case you need it.

Benz: I'm thinking of that as kind of my income-shock fund. If in a worst-case scenario, I lose my job, and I stay out of my job for a while, that Roth IRA, tapping my contributions tax-free and penalty-free might be a pretty good way to go.

Bruno: What's nice about that, too, is, hey, you're setting the retirement clock already, but that money then there is if you need it, and certainly can save in a nonretirement account as well. What I like about the Roth is that it offers tax-free growth versus a taxable account that grows potentially but at cap-gains tax rates. So, there's a little bit of a difference there. But certainly, nonretirement taxable monies are prudent as well. And then, from there, you really want to think about the other sources; around there, I would say balancing down debt with also saving for retirement as well. Or you might have other goals. So, balance. It's not all or nothing, but it's a little bit of a seesaw in terms of balancing those two types of goals.

Benz: You referenced Roth IRAs, very attractive from the standpoint of flexibility and being able to pull those contributions if in a worst-case scenario you need them. But how about that sort of fork in the road if I'm contributing to my employer plan, and I have the traditional 401(k) make the pretax contributions and I also have the Roth 401(k), where I can make after-tax contributions. How should people approach that decision?

Bruno: Well, that's a good question. For younger investors, if their plan sponsor offers the Roth option, not everyone does, but we're seeing an increasingly higher number of plan sponsors offering that option. Young investors might want to consider that in terms of their deferrals for their contributions. And the reason is, when you're young, you're most likely in a lower tax bracket than you will be later. So, the key then is, when do you pay tax on those monies? You want to do that when you're in a relatively lower tax bracket. And for young investors, the value of the tax deduction that they might get with the contributions in a traditional deferred account are probably far outweighed by the tax-free growth that they would get with the Roth over those number of years of compounding. So, that's very attractive.

We talk about tax diversification for investors and holding different account types. With the 401(k), you may direct your contributions to a Roth, but your company match must go into the traditional deferred account. So, right off the bat, you get tax diversification right there. So, that's a nice feature as well.

Benz: Another vehicle that might come into play would be a health savings account, if you're covered by a high-deductible healthcare plan, which is increasingly common. How should younger folks think about funding those HSAs?

Bruno: Right. So, healthcare is needed for all of us. What's nice about the HSA plan--as you mentioned, you have to have a high-deductible healthcare plan, offers the health savings account. The premiums are typically lower, they might be higher out of pocket; however, there are caps on that amount as well. But that money is unique in that it's got triple tax benefits. So, you made the contributions with pretax dollars, the account grows tax-deferred, and then when you pull that money out for healthcare reasons, it's tax-free. So, it's a very attractive tax vehicle. And you can almost think about it as a retirement savings vehicle if you have the means to do so. That would probably be the rosiest of situations in terms of, hey, I'm going to put money into this account, and I may have other monies that I may use for my healthcare expenses if I were to incur them. The reality of it is, many young investors or those with limited means may not be able to do that. But even putting the monies into the health savings account, you're taking advantage of the tax benefit because the monies are made with pretax dollars and then tax-free distributions.

Benz: So even if my plan is to use my HSA just as a basic kind of spend-as-I-go vehicle, it's still wise to run it through the HSA and pick up those tax benefits?

Bruno: Yes. I mean, it can be. Absolutely, it can be. That's more of a transactional type of account. Now, the thing I will say is, you want to look in terms of what type of investment options do you have within your health savings account and just make sure you understand how--what the plan offers, what the cost of those investments might be, and make your choice there as well.

Benz: Maria, always great to get your perspective. Thank you so much for being here.

Bruno: Thank you. Good to be here.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.