I have some questions about investing that I hope you all can help me with. I have a pretty good idea of what I should do, but I want to bounce my ideas off of other people, and none of my friends seem to be very interested in these topics. I realize that I’m in a good financial position, but I want to make sure that I make the best of it.
I make a good salary, and live fairly frugally. Enough so that I save enough to max out an IRA, a 401(k), and have a bit left over for other investments. What I’m wondering is if I really should be maxing out the 401(k), or if I should put some of that money into non-tax-deferred investments.
Here are my reasons for not necessarily wanting to max out the 401(k): My company does not match 401(k) contributions, so there’s no extra to be gained there. The 401(k) plan has pretty high fees. The lowest fee fund (S&P 500 index) has fees of 0.6%/yr (compare to Vanguard at ~0.2%/yr). The other funds are even worse, most over 1% and some over 2%. The way I calculate this, losing an extra 0.4% on the account value each year is considerably worse than losing 15% on the profits when I eventually sell. But, of course, I have to account for the initial ~25-30% reduction due to income taxes, too. For that reason, I have almost all of my 401(k) in the S&P 500 index fund, and try to get diversification elsewhere. I am young, and I believe that effective taxes will be considerably higher in the future due to US government health care/social security/debt obligations, so maybe that tax-deferredness doesn’t help me much.
Other potentially important information. I want to retire early (50 or younger if I can swing it). So I know that I need some investments that aren’t locked in retirement accounts until I’m 59+ years old. I am not planning to buy a house in the near future, but it seems likely that I will want to within the next 10 years or so. This seems pessimistic, but, given my genetics, I doubt I’ll live to be very old. Men in my family have a tendency to get heart attacks in their 50s and die. I have a healthier lifestyle than my grandparents did, but I don’t know how much that’s going to carry me.
I’d continue maxing out the amount you can put into the 401(k). If you want to have additional discretionary money to use for retirement planning, and it has to come from existing sources, I’d ease off on the amount you’re putting into the IRA (it’s not giving you any tax benefits, since you’re eligible for a 401(k)) and funnel some of that money, plus your other funds set aside for retirement planning, into mutual funds.
All this, of course, is assuming you’ve already built up a decent cushion in your savings account. You always want some liquidity without associated penalties.
I’d be surprised if the math ever worked out favorably for the taxed, lower fee investments.
For example, say you have $10k to invest, pre-tax. Say the S&P averages 8.6% growth over the next thirty years. If your top marginal tax rate is 30%, that means instead of having $10k grow by a factor of 1.080[sup]30[/sup] = 10.063 for a final total of $100.6k, you’ll have $7k grow by a factor of 1.084[sup]30[/sup] = 11.243 for a final total of $78.7k. Granted, you paid taxes on $7k of that $78.7k whereas you owe all the taxes on the $100.6k, but that still puts you way ahead with the 401(k).
I think the fee discrepancy would have to be pretty big to overcome the initial tax penalty to your principal.
I agree, and of course, it all depends on your fund performance. I am about in the same situation as you, except I do own a home (and camp), and my life expectancy is slightly higher than yours (but not by much).
My 401(k) performances definitely outweigh any fund costs, especially in the past five years. I have a ROA of 18% in 2002, 20% in 2003, 22% in 2004, 24% in 2005, 23% in 2006, and YTD ROA for this year is currently 34%. Given tax penalties, etc I’d like to keep increasing my balances in the 401(k).
And remember to have the liquid assests, as PP have stated. Home ownership is definitely helpful tax-wise, and depending on your profit upon future sale, you won’t have to pay gains taxes on your profit, which is also helpful. I myself plan on retiring at 50, selling my existing house, using the funds to build another home at my camp, and work part-time (self employed) using the additional write-offs to help balance any taxed withdrawals from my 401(k).
Since your company doesn’t match your 401(K), is your income at a level where you can move your money into other tax deferred investments that might do better, with smaller fees. My company offers a good, but not perfect, range of 401(K) options, and does match it so I of course max it. My wife is self employed, and has a SEP, maxed out every year depending on her income. You might be able to shop around.
I don’t know what your plans are, but I got a good pot of money for taking a package at work, and was glad I had it, since it paid for my kids’ college. You have to balance the better return of the tax deferred investment vs the increased flexibility you have of some reasonably ready cash.
I assume you are diversifying, right? If you’re young, you probably want to be high on the risk scale, but it is good to have some reasonably fixed income money just in case.
“I’d ease off on the amount you’re putting into the IRA (it’s not giving you any tax benefits, since you’re eligible for a 401(k))…”
Are you talking about a Roth IRA? The rule of thumb that I have heard, and that I follow: Max out your contribution to a 401(k) (before tax money) to the limit of your employer’s match. (Although that doesn’t appear to be available for the OP.) Then max out your Roth IRA (after tax money). Then return to your 401(k) to whatever is acceptable to your budget.
The idea as I understand it is to let as much retirement as possible accrue tax-free. When employer matching is available, it is foolish to let that “free” money go to waste. Once you have hit that limit, it is usually a good point to switch to the Roth to max that out; whatever that account grows to when you retire is yours alone with no taxes due. Then back to the 401(k).
I completely agree with wanting to have some savings. The (rather optimistic) rule of thumb is to have about 6 months salary relatively liquid (CDs, short term treasury bills, etc.). You may want to adjust this based on goals (wanting to buy a house, as mentioned), the health of your business in this economy, that sort of thing.
Index funds seem to be the way to go for the bulk of your long term investments. From what I understand, they should all follow the index and perform the same, so the key is to look for low fees. The OP mentions Vanguard, and I have been happy with them for my Roth IRA.
I’m not sure that I feel comfortable answering whether to max out your 401(k) or not (and others have done a good job of this), but there is one thing to consider: Do you intend to stay with this company for a long time? If not, your retirement account can then be moved to another investment group with your new employer. If you find you like your new investment options, you may not be able to catch up to where you want to be as quickly as if you had maxed your contributions all along. Even at a lower return it is accruing tax free. And there is a lot to be said about the tax savings at the end of the year by making large 401(k) contributions.
I agree with you in principle, but the OP set up an either-or situation: Continue maxing out the 401(k), or stop doing that and use some of the “extra” money to invest in non-tax-deferred areas.
I don’t see any point in maxing out IRA contributions if the OP isn’t already maxing out 401(k) contributions. If he/she is looking for a place to cut in order to invest additional money in non-tax-deferred accounts, my recommendation was to cut the IRA.
I failed to mention. I have a Roth IRA, so there are definitely tax advantages to that. I have heard of the rule of thumb that Plynck mentions, and I’m doing it (since step 1, meet employer match is 0).
Thanks. For some reason I was stupidly thinking of the whole value of the taxed account as not being taxed, and not just the original $7K. Clearly the 401(k) is way better even with somewhat worse fees.
I do have a substantial emergency fund, I am diversifying my investments, and I eat right and exercise. Thanks. Any other tips?
If there are other tax-deferred plans available to me as a salaried employee who already qualifies for a 401(k) and has a Roth IRA, I’d be interested. I was under the impression that the other ones were either for the self-employed, or for particular special groups like military, or teachers.
Also, if you laid out your situation in the investing forum at diehards.org, you’ll have the most knowlegable people spell out where you should go with your investments that pertain to your own financial situation.
I love people who quote from Diehards.org. My second home and a terrific investing site.
The OP’s situation isn’t unique, and I think it is much closer than one might think. Given his situation, there are some significant advantages to using taxable investment vehicles, despite the tax drawbacks. If you are shooting for an early retirement you may value the flexibility the taxable investments afford you. Your asset allocation choices are more expansive and you may be able to achieve a better risk adjusted return after fees. You are able to better adjust to your life circumstances with a more liquid portfolio. In addition ETFs and index funds can minimize the tax consequences. Unfortunately having expensive, actively managed funds, with limited choices is the curse of many workers.
I have always puzzled over this response:
I hear it all the time, but I am not sure what the practical implications of your family medical history might be. Let’s say the men in your family all seem to die around age 70. What, practically do you do in response? You can’t plan to be dead at that point, unless you want to take up some heaving drinking and smoking. You almost have to assume a longer than average life expectancy, because the alternative is being old and broke.
I don’t mean I plan to run out of money at 70. I mean that I want to retire early because I don’t expect to live to be very old. That doesn’t mean that I want to plan to run out of money at 70, but I don’t think it will do me much good to have a rock solid retirement plan and wait until 68 to retire.
I suppose everybody wants to retire young. I am trying to plan for it because I really don’t think I’ll get a retirement otherwise.
Thanks for all the responses. I’ll go checkout diehards.org.
By the way, the thought you’ve given it (indicated by your first post) is more than about 95% of others.
And, owning an S&P 500 Index fund. . .you’re already diversified, at least among US Stocks. You might want some bond funds (VBLTX or VBMFX, for instance, are some vanguard bond funds that I own), or some exposure to foreign, or emerging markets (look at VGTSX or VWO for a couple of Vanguard funds for that).
Another thing to toss into the mix: does your employer currently offer a Roth 401(k) and are they considering doing so in the future? That scrambles the tax-savings picture a bit. As I understand it, it basically works just like a Roth IRA except it’s got 401(k)-level contribution limits (15,000+ a year, vs 4,000 a year). Even with the higher fees you mention, that might be an option if available because you’re sheltering money tax-free forever.
Plus, I think that in specific situations you can access your contributions w/o penalty, just as with a regular Roth IRA. I don’t recall what those are - something like after 5 years, or something like that.
My employer will have Roth 401(k) as an option next year. I have to weigh whether we want to put some/most/all of our money in as Roth vs regular. Right now I’m leaning toward regular, as we need the immediate tax benefit (otherwise some deductions / credits start to phase out) but your situation might be different.
