America's education system teaches us a lot of important things, Jim Cramer told his Mad Money viewers Wednesday, but one thing they don't teach is financial literacy. That's why Cramer dedicated his entire show to giving investors another peek into his playbook for successful investing.
Cramer's first lesson, the do's and don'ts of your 401(k). It's pretty much conventional wisdom, Cramer said, 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 $19,000 a year or $25,000 if you're over 50. But Cramer said he's not one of those "conventional" thinkers, as 401(k)'s have both good features and 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, their $150,000 investment will be worth $511,000 when they retire. And, since your 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 401(k)s also severely limit your investment choices and many of the available options include high fees from the few mutual funds they offer as well as fees from the 401(k) plan administrator as well. That's why Cramer only recommends 401(k) plans if they have an employer match. Once the match is met, he preferred investing in individually run IRA accounts where investors are in complete control of their money and can pick individual stocks.
Just Starting Out
Cramer's next lesson for investors was aimed at young people, those just graduating college and starting their careers. He explained that first, money is important, and is something everyone needs to pay attention to. A lousy credit score may not seem like a big deal, but try to get a loan or buy a home or even secure a credit card and you'll quickly see just how much money matters.
Investing is the only way to financial freedom, Cramer continued. But before young people invest anything, they need to first get rid of their credit card debt. No matter what your gains in the markets, the high interest rates of your credit cards will quickly overwhelm them, Cramer said, so a young person's first goal should always be to get debt-free.
After becoming debt free, Cramer said that young investors need to get in the habit of saving. Saving may seem boring, he said, and it is if all you invest in are savings accounts or bank CDs. But if you invest in stocks, you'll be more engaged, you'll follow the news and actually see your investments grow. Investing in stocks can actually be fun, Cramer exclaimed, and that makes wanting to save a lot easier.
Younger investors need to also heed two more bits of advice, Cramer said: Start early and take more risks. It's never too early to start investing in a 401(k) or a Roth IRA and young people can afford to speculate and take more risks, becoming more conservative as they get older.
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Low-Cost Index Funds
Sometimes, too many choices can be a bad thing, Cramer told viewers. That's certainly the case with investing in a world where the sheer number of mutual funds, hedge funds and ETFs will make your head spin. Nearly half of all American households have exposure to mutual funds, Cramer said, which makes picking the right ones pretty important.
Cramer said overall, he's not a fan of mutual funds. He said their high fees are coupled with the fact that 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 gain, Cramer said chances are its fees will strip you of most of it.
So which funds does Cramer recommend? He suggested 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, as those don't offer enough diversification, and most ETFs, as those are designed for traders, not investors.
Traditional IRA or Roth IRA?
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? Cramer offered up his thoughts on the issue.
Cramer said investors can open a Roth IRA if they earn less than $137,000 a year and they can withdrawal their money after age 59½. The only difference between a Roth and a traditional IRA is whether you pay taxes now or pay them later.
As a general rule, Cramer said, 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 Cramer said that he believes our country's budget deficit can be closed without substantially higher taxes.
In either case, Cramer 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.
Retirement First, Then the College Fund
Cramer's last lesson for investors was aimed at parents and focused on saving for college. He said that 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.
Cramer reminded parents that 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, Cramer said he's a big fan of 529 savings plans. While these plans have limited investment options, much like 401(k)s, Cramer said he's willing to overlook that as 529s offer tax-free savings after your initial investment.
Parents can invest up to $15,000 a year if they're single, or $30,000 a year if married and filing jointly, Cramer explained, but what makes 529 plans great is the ability to front-load up to five years of investments.
That means for parents that are able, you can invest up to $75,000 or $150,000 right up front, letting that investment compound tax free for big savings. Cramer said the earlier parents can get money into their child's 529 plans, the better.
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At the time of publication, Cramer's Action Alerts PLUS had no position in the stocks mentioned.