Jim Cramer’s ABC’s of Financial Literacy 1

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Originally published 12/30/15

America’s educational system teaches us a lot of important things, but one thing it doesn’t teach is financial literacy. That’s why I’m offering this peek into my playbook for successful investing.

My first lesson: the dos and don’ts of your 401(k). It’s conventional wisdom that if your employer offers a 401(k) plan you should invest in it and, if possible, max out your contributions at the current limit of $18,000 a year. However, I’m not one of those conventional thinkers because 401(k)s have good features but also some pretty bad ones.

On the plus side, 401(k)s are tax-deferred vehicles, which means you don’t pay taxes on the money you put in or on the capital gains you make. That means if a 30-year-old invests $5,000 a year for 30 years and gets a modest return of 7% a year, the $150,000 investment will be worth $511,000 at retirement. Because the tax rate will be lower during retirement, paying taxes later makes a lot of sense.

Also in the plus column, 401(k)s sometimes have employer matched funds, which is essentially free money, also provided tax free.

But many 401(k)s also severely limit your investment choices, and many of the options include high fees from the few mutual funds they offer as well as fees from the 401(k) plan administrator.

That’s why I only recommend 401(k) plans if they have an employer match. Once the match is met, I prefer investing in individually run IRA accounts where investors are in complete control and can pick individual stocks.

Too Many ChoicesSometimes, too many choices can be a bad thing. That’s certainly the case with investing in a world where the sheer number of mutual funds, hedge funds and exchange-traded funds will make your head spin.

Nearly half of all American households have exposure to mutual funds, which makes picking the right ones pretty important.

I am not a fan of mutual funds overall. Besides their high fees, most fund managers don’t get paid for performance, which explains why most actively traded funds fail to outperform the averages year after year after year. Even if a fund does manage to eek out a gain, chances are its fees will strip you of most of it.

So what do I recommend? I suggest investors look for low-cost index funds whenever possible, something that mirrors the S&P 500 with the smallest fees possible. Investors should especially avoid sector-based funds because those don’t offer enough diversification and most ETFs because those are designed for traders, not investors.

Jim Cramer is one of America’s most recognized and respected investment professionals and media personalities.

He is the Portfolio Manager for the Action Alerts PLUS Charitable Trust.

In 1996, Jim founded TheStreet, one of the most visited financial media websites for individual and institutional investors. Jim also writes daily market commentary for TheStreet’s Real Money premium service and participates in video segments on TheStreet TV. He also serves as the host of the “Mad Money” television program and co-host of “Squawk on the Street”, both on CNBC.

Jim graduated magna cum laude from Harvard College, where he was president of The Harvard Crimson. He went on to earn a law degree from Harvard Law School in 1984. From there, Jim joined Goldman Sachs, where he worked in sales and trading. In 1987, he left Goldman to start his own hedge fund. While still managing his fund, Jim helped start Smart Money for Dow Jones.

Jim Cramer’s ABC’s of Financial Literacy 2

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Originally published 12/30/15

One exception to this rule is the SPDR Gold Shares (GLD) exchange-traded fund, which tracks the price of gold. This fund is an excellent way to easily add gold to any portfolio.

Traditional or Roth?With all this talk of IRAs and 401(k)’s, the question inevitably arises, which type of IRA should I start, a traditional IRA or a Roth IRA?

Investors can open a Roth IRA if they earn less than $127,000 a year and they can withdraw their money after age 59 and a half. The only difference between a Roth and a traditional IRA is whether you pay taxes now or pay them later.

As a general rule, if your marginal tax rate is less than 25%, then a Roth IRA will likely make the most sense. For those in higher tax brackets, paying taxes later on, such as in retirement when rates are lower, typically is better.

Investors may think that taxes are perpetually heading higher, making a Roth IRA the better move no matter what, but I believe our country’s budget deficit can be closed without substantially higher taxes.

In either case, I once again recommended picking five to 10 individual stocks for your IRA or, if you can’t dedicate the time to do the homework, investing in a low cost index fund that mirrors the S&P 500.

Invest in Your Child’s FutureMy last lesson for investors is aimed at parents and focused on saving for college. In the hierarchy of needs, parents should always save for their own retirement first but, if they’re able, paying for as much of their child’s education as possible makes a lot of sense.

College grads have an easier time getting a job than non-grads and, ultimately, they will make a lot more money over their lifetime as a result of their education. The gift of education will pay dividends for a child’s entire working life.

When it comes to college savings, I’m a big fan of 529 savings plans. While these plans have limited investment options, much like 401(k)s, I’m willing to overlook that, as 529s offer tax-free savings after your initial investment.

Parents can invest up to $14,000 a year if they’re single, or $28,000 a year if married and filing jointly. But what makes 529 plans great is the ability to front-load up to five years of investments.

That means for parents who are able, you can invest up to $70,000, or $140,000 right up front, letting that investment compound free of tax for big savings. The earlier parents can get money into their child’s 529 plans, the better.

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