As a 2nd Lieutenant, if you invest $1500 a month combined in your TSP and IRA, you can easily accumulate a Million Dollars in a twenty year Army career.
The below is a concise guide of what you really need to know and understand to start saving.
- Shield your income from taxes.
- Understand your pay.
- Optimize your return on investments.
- Why you actually make more than your Leave and Earning Statement shows.
The example is a new 2LT on CY17 pay scale, but the concept can be used for any rank.
Understanding your pay: You get three forms of payment: Base Pay, Basic Allowance for Housing (BAH), Basic Allowance for Sustenance (BAS). Only Base Pay is taxed, which means you get a tax advantage (we’ll talk about that later). If you are in a certain location you may also get Cost of Living Allowance (COLA) to offset higher costs of goods.
For a 2LT with less than 2 years of service:
Base Pay: $3,034.80 (Monthly), $36,417 (Annual)
BAH (Fort Bragg, NC): $1122.00 (Monthly), $13,464 (Annual)
BAS: $246.24 (Monthly), $2954 (Annual)
Total: $4,403 (Monthly), $52,836 (Annual) – Pretax
Taxes: The Federal Government has three forms of taxes that affect your Base Pay only. Federal Income Tax (see table below for %), Social Security (6.2%), and Medicare (1.45%).
*If you are a resident of a state where you pay taxes, it is recommended that you switch residency to a state that does not make military members pay taxes. These states are: Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, New Hampshire or Tennessee. You will have to claim domiciliary status in that state. This may involve showing intent to return there, land ownership, driver license, car registration, or having voted there. Typically the burden of proof for this is very low, and it’s pretty easy to do. Go to your local finance office for assistance.
Federal Tax Bracket:
Single Person Tax Bracket (Annual):
$0 to $9,275: Taxed at 10%
$9,276 to $37,650: Taxed at 15%
$37,651 to $91,150: Taxed at 25%
$91,151 to $190,150: Taxed at 28%
So, your $36,417 (Annual) is taxed in three ways:
Federal Income Tax: $4,998.89
Social Security: $2,257.89
Total Taxes: $7,784.84
Tax advantage: So, you’re annual BAH and BAS: $16,418.88 is not taxed. If it were, it would almost all be taxed at the 25% rate because it would put you in a higher tax bracket. Not being taxed on this income gives you a tax advantage of $5,693.23.
Personal Statement of Military Compensation: There are many things that are not shown on your LES, your tax advantage being one of them. You will need to provide your annual income statement when applying for loans, credit cards, or cell phone service. Provide your pre-tax total with your tax advantage, and factor in other expenses such as health and dental care. Your comparable civilian annual salary is significantly higher than what you take home on your LES. In other words, you would have to make a lot more money pre-tax as a civilian for the same standard of life.
Annual Salary: $52,836.48
Tax Advantage: $5,693.23
Health, Dental, Legal, Education: $5,000
Total Military Compensation: $63,529.71
Actual take home pay: $45.051.64
Difference of: $18,478.06
Investing: There are five vehicles you should use to invest:
- Thrift Savings Plan (TSP) (Max $17,500)
- Traditional IRA (Max $5,500)
- Mutual Funds
- Real Estate
BLUF: Maximizing your TSP and IRA is one of the most financially beneficial things you can do. It is protected from taxes, and there are opportunities for extraordinary growth over time.
Remember the $36,417 Annual Base Pay that was taxed? By maxing out the combined TSP and IRA contribution of $23,000, only $13,417.60 would now be taxed, saving you $5,416.63. In other words, you would save over five thousand dollars from being taxed by investing in TSP and IRA.
Lets look at how the TSP works…
Thrift Savings Plan (TSP). This is a defined contribution plan for United States civil service employees and retirees as well as for members of the uniformed services. You’re annual contribution amount is limited to $17,500. You cannot draw from this until you are 65. You will pay taxes on this when you draw it, BUT it will be easier to shield when you’re that age. Also, you can take a loan from your TSP for a very low interest rate if needed while on active duty.
Below are the funds for the TSP: We will only focus on the C, S, and I Fund. The G and F fund are very low risk (bonds), and not a good option for growth.
Recommended Portfolio Asset Distribution: C Fund 40%, S Fund 30%, I Fund 30%.
C Fund – Common Stock Index fund. Replicates S&P 500 index. The S&P 500 are the 500 most powerful companies in the US, and they make up 80% of the stock value in the US. This is what many people refer to when they say “the market”. It has up and down years but from 1928 through 2014 is average return is 10%. Though that number can be misleading because it fluctuates significantly from year to year. Medium risk, medium reward. Historically returns 6-15%. S&P 500 and Why It Matters
S Fund – Small Capitalization Stock Index fund. Tracks the Dow Jones U.S. Completion TSM index. This is the remaining 20% of the publicly traded companies in the US. Medium risk, medium reward. Historically returns 6-16%.
I Fund – International Stock Index fund. Replicates the net version of the MSCI EAFE index. These are international stocks, which many believe will experience the highest growth in the coming decades. High risk, high reward. Historically returns 6-15%.
The below Funds are recommended for people near retirement or if you would like to park your money somewhere in anticipation of an economic collapse.
G Fund: – Government Securities fund. These are very low risk, very low reward government securities backed by the US Government. Historically returns 2-3%.
F Fund – Fixed Income Index fund. Low risk, low reward Tracks the Barclays Capital Aggregate Bond Index. Historically returns 3-6%.
Traditional IRA. Open an IRA through your bank, and invest mutual funds in the IRA. I recommend USAA because I think they are a good company. Plus, they do not charge front end loads, which many banks do. They only charge an annual maintenance fee which is standard and usually very small compared to other index funds. I recommend the USAA S&P 500 which has a 0.25% annual maintenance fee, and requires a minimum $3,000 to open an account. Set a direct deposit to $458.34 per month for a $5,500 annual deduction.
Mutual Funds. If you would like to diversify yourself a bit more, look into mutual funds that are made of different stocks than your TSP investments. Maybe even look into adding some diversity in your IRA.
Stocks. If you’ve made it this far, hopefully you have maxed out your TSP and IRA. The advantage of having a diversified stock portfolio over mutual funds is that you do not have to pay the maintenance fee of a mutual fund. However, you incur some risk, and individual stock trades cost money. Stocks can be very risky, and you really need to know what you’re doing. The key is to be diversified. In other words, don’t invest all of your money in one stock – spread them out among many. These are my favorite stocks.
Also, develop your portfolio in a way that your stocks react in different ways when the market changes. For example, when gas prices go down, people spend more on retail stores. So if you bought shares of Exxon and Amazon, they would react in different ways, when one goes down, the other would likely go up. Some other stocks tend to do very well when the market is down. A company called Eli Lilly makes anti-depressants, this company does well when the market as a whole is down. Gold also does well when the market it down.
I recommend buying a little bit in a lot of stocks, and letting it stay there for a long time. Typically, when you open a new account you are given a significant amount of free trades for a certain period. Take advantage of that and spread it around. Each time I make a new purchase I learn something new. This is why you should be cautious when investing.
Real Estate. Most people view renting as throwing away money, but renting can be a really good option depending on the market, and how long you plan on living there. Buying property for a short three year assignment can be risky. If the market hits a slump, you can be upsidedown in your house, thus requiring you to pay money to sell it when you PCS. Of course, you can offset this risk, by renting out the property, but you will need to have a trusted property manager, or plan on managing it remotely, which can be a headache.
This is why rental property is a bad investment: Let’s say you buy a house for $130K with a VA loan at a reasonable interest rate. You will incur several thousand dollars in closing costs, and when you go to sell, you will have to pay commission on a buyer and seller realtor of 6% total. So, you will have to sell your house at $140k just to break even. Your mortgage and escrow will be around $750 total. Only about $100 a month will go towards principle during the beginning part of your mortgage, so you will only have paid a few thousand dollars of the house over three years. If anything breaks, you are responsible. However, you do get to claim the interest on your taxes which can add up to a good amount during tax refunds. Don’t expect this to be easy money, even if you rent it out, it will require management, and it will take a long time. However, if you can do it, it provides great diversity to your investments.
Emergency Fund: I recommend having a little money set aside in case of emergency. However, if you are active duty, the probability of you needing a large amount it is relatively small. After all, your medical expenses are covered, and your job is relatively secure. A couple thousand dollars, give or take, should be more than enough depending on your situation.