Today’s guest post is brought to you by Doug Nordman, a military retiree who’s been financially independent for over a decade. He wishes he’d known this stuff over 30 years ago when he was just getting started, but he learned enough to overcome his mistakes– and you will too.
Decades later, these words still send a thrill down my spine: “Raise your right hand and repeat after me…”
You’re starting your military career. You’ve just finished your initial training, and maybe you’re still going through some advanced schools before reporting to your first unit. You’re getting a paycheck. Life is a lot better than last month.
Your life will be pretty busy for the next year, and you need to stay focused on learning your job. That’s the path to professional skills, to greater responsibility, and eventually to promotions (and, oh yeah, more pay). Maybe you want to spend time with your family & friends, too.
However you also need to set up a few habits in your personal life. This post will get you started without drowning you in the details. Read this post, spend an hour signing up on a couple of websites (see the end of this post), and go enjoy your liberty.
The very first thing you should do is start tracking your spending. Every penny you spend should be worth your labor that it cost you to earn it, and you don’t want to wake up next week wondering where your money went. Start tracking it now: on a piece of paper, on a smartphone, in a small notebook, on a computer spreadsheet or Quicken, online with Mint.com– anywhere that works for you. You’re building a habit that will last for years, so start tracking now and figure out what suits your lifestyle. Just track it. Don’t criticize yourself, don’t go on a spending diet, don’t waste hours setting up a “system”. After a few months of tracking your spending, you’ll be able to decide what’s important to you and you’ll develop your first budget. Just gather data for now.
Savings will be a part of your budget. While you’re gathering the data that will develop a budget, try to start saving now. Keep it modest: $50/paycheck? 10%? Pick a number and start the process– you can tweak it later when you refine your budget. You’ll be saving lots more in a few months after you develop a budget. You’ll decide what spending has meaning & value to you, and you’ll eliminate debt from your life.
But everyone has to start somewhere, so let’s start with a little savings now. Where should you invest it?
Two basic concepts should guide all of your investment decisions: minimize expenses and minimize taxes. There are hundreds of different investing techniques and asset classes, and thousands of different investment funds, but study after study has shown that minimizing expenses and taxes are the two most critical aspects. With these two fundamentals, other advanced techniques might improve portfolio returns. However without them almost nothing else can overcome the drag of taxes and expenses.
Let’s talk about the military options.
The Thrift Savings Plan
If you can invest money before you have to pay taxes on it, then you can put more money in your investments. The less you pay in fees, the more money you have compounding for you. And the longer you can avoid paying taxes on an investment’s profits, then the more money you have and the longer it can compound.
This military benefit applies both “minimize” concepts. The federal Thrift Savings Plan (for both the military and for federal civil-service employees) is a tax-deferred account combining the world’s largest index funds with the world’s lowest expenses. Better still, the fund’s expenses have been dropping as their assets have been growing. After starting the 21st century with expenses of only 0.03%, the TSP expense ratio was as low as 0.015% in 2007. Even Vanguard’s expense ratios are higher than the TSP.
The TSP comes in two tax choices: the traditional TSP and the Roth TSP. The traditional TSP’s contributions come from your pay before it’s taxed, and the Roth TSP contributions come from your pay after taxes. Both choices invest in the same funds and with the same low expenses. The major difference between the two plans (for where you are now) is that the traditional TSP will reduce your taxes by a few dollars now while the Roth TSP will offer much more convenience later in life.
When you’re just starting your military career, your pay is very low and your taxes are even lower. There’s not much of a tax difference between the two TSP choices now, but there’s a big difference in convenience (and maybe taxes) a few decades later. I recommend that you put all of your contributions in the Roth TSP. If you’re still not sure, then put half in the traditional TSP and half in the Roth TSP. You have a year or two to tweak your strategy as your pay rises.
The TSP has a number of different funds to choose from, and right now that can be pretty intimidating. Keep it simple: put it all in the Lifecycle 2050 fund and plan to read more about it another day. You can always change your mind and move your funds around later.
The TSP is your ultimate savings autopilot. Download the form, sign up, and set your contribution level. (You can stop that contribution at any time.) You can send over 90% of your base pay to the TSP, and you may be able to contribute special pay & bonuses as well. You can change it every month. When you meet the annual limits ($17,500 in 2013 for most servicemembers) then the TSP will automatically stop deducting contributions from your pay for the rest of that year. It’ll automatically resume contributions next year.
Individual Retirement Arrangement (IRA)
The TSP is the preferred retirement savings system for the vast majority of servicemembers because of its pretax contributions, its tax deferral, and its low expenses. But once its contributions limits are reached, what next?
When you can invest more money then you can put it in an Individual Retirement Arrangement (IRA). (That link downloads the IRS PDF.)
There are two basic types of IRAs: conventional and Roth (named for the sponsor of the enabling legislation). Each type has its own advantages and disadvantages, and you may be able to contribute to either or both. For most savers, the 2013 limit is a total of $5500. Conventional IRAs are similar to the TSP because both will grow tax-deferred and have very specific withdrawal rules. (Roth IRAs share some features of the Roth TSP, too.) The difference from the TSP is that you have to select your own IRA account custodian (a financial company like Fidelity Investments, Vanguard, or the banks & credit unions named below) and choose from a much wider range of assets and funds. The main advantage of an IRA is that it’s another way to save for retirement. IRAs have lower contribution limits and higher expenses than the TSP so they’re usually a second choice to that program, but you have more control over your IRA and more choices over its investments.
Remember: while you’re in the military, try to maximize your TSP before contributing to your IRA. After a couple years of pay raises (and promotions) you’ll be able to do both.
When you’re in your teens and 20s, focus on contributing to the accounts. Let them compound and grow for at least 20 years. Don’t worry about future withdrawals. Your TSP/IRA goal is to build the accounts without being tempted to touch them before you’re retired. You’re always able to tap some of the funds in an emergency (although some methods have hefty penalties). There are other ways to tap some money for education or a first-time home purchase. (While you’re in the military, there are better benefits to use for those life decisions.) There will be plenty of time to design a withdrawal plan when you’re ready to retire, and there may be plenty of changes to the withdrawal rules before then. These possible changes are far less significant than the benefits of decades of tax-deferred compounding.
Now let’s learn how to set aside other funds to handle emergencies or short-term goals.
Taxable investment accounts
After setting up TSP and IRA contributions, a servicemember’s next priority should be funds for emergencies and short-term goals. An “emergency” is a car repair, fixing a home’s broken water pipe, or a short-notice round-trip plane ticket to help a loved one. Emergencies are not a new truck, an outfit for a business/social event, or concert tickets– those are short-term goals. A short-term goal is paying off debt, or a savings program for anything in the next 6-36 months. It includes a house down payment, college tuition, a wedding, or even a fantasy vacation. Your budget includes short-term savings goals for entertainment as well as lifestyle upgrades.
These funds should earn more interest than a checking account, but there should be zero risk of loss. The two most popular types of accounts for this fund are money-market funds or certificates of deposit (CDs). The best rates for these two accounts are usually found at credit unions like Navy Federal Credit Union or Pentagon Federal Credit Union. The best military-friendly bank CD and money-market rates are at USAA. If you’re a servicemember then you’re eligible to join these financial institutions. You can join PenFed even if you’ve never been in the military!
The size of the fund is up to you and your goals– anywhere from 1-8 months of pay for an emergency fund. The fund may need to be bigger if you’re transferring to a new duty station or leaving the military, but as long as you expect a biweekly paycheck then you can minimize the size of your emergency fund.
You pay a price for financial security. Your money-market funds and CDs are insured against loss but you receive a much lower rate of return than you would in high-yield bonds, tech stocks, or other riskier investments. It can really hurt to park your money in a 1.5 percent CD when everything else in the world seems to be paying 4 percent, and it’s tempting to chase a higher yield.
Don’t do it. Don’t chase a higher yield with your safe money. You’re saving it for emergencies and for important short-term goals. This is not the account to be used for maximum returns by risking short-term losses– that’s for long-term accounts like the TSP and IRAs. A short-term account may earn a lower return, but its payoff comes when you need the money. It’s much easier to sleep at night if you know that you have the money available to cover an emergency without using a credit card. And although a CD may only pay a percent or two, the real savings come from the discounts given to those who can pay cash. You want to be the buyer who can swoop in on a bargain with money in hand, not the desperate seller who needs the money to pay for an emergency. Your cash makes sellers and contractors very happy to give discounts, and that’s the ultimate payoff for short-term savings.
You’ve made it this far, and now you’re ready to do something about it. Get started!
- Get a piece of paper or open a spreadsheet and start tracking your spending. In three months you’ll be ready to make (or refine) your budget.
- Sign up for the TSP (try $100/month or 10%). Raise that when you’ve made a budget.
- If you’re already signed up for the TSP, then log in and choose the L2050 fund.
- Check the CD rates at the financial institution where your pay is deposited, and decide how much you want to save in your emergency fund. Compare those CD rates to NFCU, PenFed, and USAA.
Ready to learn more about the details? Read The Military Guide to Financial Independence & Retirement. All royalties are donated to military charities. You can also read more posts, ask questions, and share your own stories at The-Military-Guide.com.