America's education system teaches a lot of important things, Jim Cramer told his Mad Moneyviewers Friday, but one thing it doesn'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. 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 return of 7% a year, the $150,000 investment will be worth $511,000 at retirement. 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.
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Ditch the Debt
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 to which everyone needs to pay attention. 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 that 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 young investors need to get in the habit of saving. Saving may seem boring, he said, and it is if you invest in a savings account or bank CD. 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 noted, 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 and young people can afford to speculate and take more risks, getting more conservative as they get older.
But many 401(k)s also severely limit your investment choices, Cramer said, 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 as well. That's why Cramer only recommends 401(k) plans if they have an employer match. Once the match is met, he prefers individually run IRA accounts where investors are in complete control and can pick individual stocks.
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Too Many Choices
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 exchange-traded funds 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 in addition to 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 eke out a 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.
Roth IRA or Traditional?
With all this talk of individual retirement accounts and 401(k)s, the question inevitably arises of which type of IRA to start, a traditional IRA or a Roth IRA? Cramer offered his thoughts on the issue.
Cramer said 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, 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 taxes are perpetually heading higher, making a Roth IRA the better move no matter what, but Cramer said he believes our country's budget deficit can be closed without substantially higher taxes.
In either case, Cramer 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.
Saving for College
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, and recommended looking at the advantages of a 529 plan.
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At the time of publication, Cramer's Action Alerts PLUS had no position in the stocks mentioned.