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Sunday, August 30th, 2015


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Bang for Your Buck: Investing on a Modest Salary

People’s financial habits these days are as diverse as the foods they like or the music they listen to. Gotta-have-it materialists max out their credit cards to live far beyond their means, family-oriented folks stockpile funds to pay their unborn children’s college tuition, and single-income, underpaid workers in expensive cities struggle just to cover all their bills each month.

No matter what your fiscal profile, saving money is one of the greatest challenges modern-day consumers face. In fact, for people who feel as if they’re living paycheck to paycheck, setting something aside each month is often not even on their radar. According to financial advisors Melinda Donovan and Richard Lee, however, even individuals who earn a modest income—say, $50,000 or less per year—can learn to make smart savings and investment decisions that won’t break the bank.

Save It for a Rainy Day

Donovan, a senior vice president and trust officer at Cambridge Trust Company in Cambridge, Massachusetts, says, “The first, most critical rule for every American is, you have to save. You might be making only $30,000 a year and living in a pricey part of the country, but you should still make it a priority to conserve some portion of your income every month—even $100 makes a difference. Saving money is just like exercise—three minutes a day is better than nothing.” Donovan adds that people have all kinds of motives for opening savings accounts: making a big purchase (such as a new car or a house), preparing for an emergency, or taking a trip for pleasure. No matter what your reasons, any incentive is a good one. Beyond its obvious financial advantages, saving money is psychologically beneficial as well; Donovan explains that the sense of autonomy it provides, as well as the knowledge that you have some measure of control over your fiscal future, will not only bring you peace of mind but also make you more self-confident.

Workers’ Comp

If you work for a company that offers a 401(k), you’re in luck—this type of tax-deferred plan is one of the most effective money-saving vehicles. Donovan advises, “Contributing the legal maximum is ideal, but even a tiny fraction thereof is preferable to nothing, especially if your employer will match your amount—it’s like throwing money away not to take advantage of that, because it can be an incredible investment return.” However, she also points out that even a matchless 401(k) is valuable, since the interest, dividends, and capital gains accumulate tax-free.

If you’re self-employed or your employer doesn’t offer a 401(k)—or even if you do have a 401(k) and simply want a second retirement account—an alternate option is to open an IRA, another type of tax-deferred savings plan. A Roth IRA—for which you’re eligible if your taxable income is less than $110,000 as a single filer or less than $160,000 as a joint filer—may be more convenient than a traditional IRA because it has fewer withdrawal restrictions and requirements, but either type is an excellent means of growing money for your golden years.

Take a Chance – Play the Stock Market

Although a personal savings account and a tax-deferred plan are the most necessary building blocks of your savings structure, you might also consider investing some of the money you set aside each year in the stock market. According to Donovan, the primary consideration for aspiring investors of modest means should be diversification—and “the only way to achieve a diversified investment portfolio is to invest in a stock mutual fund.” Stock mutual funds, also called equity mutual funds, are ideal for younger people who have a long-term horizon (i.e., anticipate living for another fifty years) and a tolerance for some risk—because, as Donovan points out, “if you invest in stocks, you have to be prepared to lose money.”

Decisions, Decisions

Selecting a stock mutual fund may seem overwhelming, but there are plenty of resources available to help you make the right decision. First, Donovan suggests asking anyone you know with investment experience about fund families that have a good reputation, or consulting a Web site like Morningstar, a useful source of information about many different fund families. Lee, a retired investment manager, recommends buying the Kiplinger annual mutual fund magazine, which contains phone numbers, Web sites, and details about all the different families’ funds, as well as information about the widely varying minimum amounts of money required to invest in each fund.

Donovan and Lee concur that all prospective investors should steer clear of brokers, who work on commission and will recommend only mutual funds with front-end or back-end loads, broker fees that generally comprise 5 percent of the total investment amount. To avoid these pitfalls, start by googling “no-load mutual funds,” funds that don’t require investors to pay a sales commission (though all mutual funds, whether load or no-load, do assess management fees and expenses). “Three examples of leading firms with lots of no-load merchandise are Fidelity, Vanguard, and T. Rowe Price,” says Lee.
He points specifically to broadly diversified, market-oriented index funds, such as Fidelity’s Total Market Index Fund, as a good starting point for new investors with modest incomes. However, he also cautions against investing in any equity mutual fund if you’re not committed to it for at least five years, or if you’re naive enough to think this type of fund is a get-rich-quick opportunity.

When to Save, When to Invest

Before you even consider investing in a stock mutual fund, Donovan and Lee both stipulate that you should have plenty of cash (relative to your income) at your disposal in a money market or bank savings account; these types of accounts allow for no-fee withdrawals, as opposed to 401(k)s and IRAs, which charge early-withdrawal penalties. Lee notes that people should typically have six months’ worth of living expenses in their savings, but that “in times like these, with high unemployment rates and job scarcity, it’s worth erring on the side of more reserves.” Once you have set aside your emergency supply, contribute the maximum you can to an employer-sponsored tax-deferred fund. Only after you’ve covered these two bases should you allocate funds for other investing—though not all savings goals are best met through stock-based funds.

For example, if you’re saving money for a purchase in the relatively near future, such as a car or a home, it’s better to stick with cash savings. On the other hand, if you have a one-year-old child and want to initiate a long-term savings plan for his or her college education, investing in the market through a mutual fund can provide big payoffs. Down the road, however, as you get within a few years of the time when you need to start paying tuition bills, Lee recommends that you shift at least 50 percent of the money in your mutual fund into a money market fund or short-term CD; that way, if the market plummets rapidly, you’ll still have some cash to cover tuition, as well as enough time for the market to rebound and your mutual fund to replenish itself.

A Penny Saved Is a Penny Earned

If you’re subsisting on a moderate income, your knee-jerk response to the prospect of saving money may be, “But I don’t make enough to set any aside.” However, before you accept that defeatist stance, take a careful look at your overall monthly spending and identify any areas where you could “trim the fat.” For instance, if a Starbucks run is part of your morning routine, all those venti lattes you order add up to quite a chunk of change every year; try brewing coffee in your own kitchen instead. If you treat yourself to a biweekly mani-pedi, buy your own nail polish, and then put the money you’d have spent at the salon into your savings account. And take public transportation, rather than driving to work; not only will you save a bundle on gas, but you’ll also be able to catch up on all that reading you’ve been wanting to do. Once you focus your energies on ways to cut fiscal corners, you just might discover that you have more disposable income than you’d ever suspected. Just don’t go blowing it on a spa weekend to congratulate yourself—take it straight to the bank. Your financially secure future self will thank you.

First published December 2009 on Divine Caroline.

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