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| Finances: Types of Retirement Investment Accounts |
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| on Saturday, March 03, 2007 - 12:14 AM - 738 Reads |
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I've been recently thinking about whether or not I should put more money into my 401K, or keep funding taxable accounts. Since many of my friends don't know the difference between various investment vehicles, I figured I'd give a brief overview as well. Financially speaking, here is the basic order of importance... 1) First of all, if you make less than $25,000 - check out the details on the government giving you cash back (up to $1000) on your taxes for retirement investing. It is called the Retirement Savings Contribution Credit. This is money you invest in an IRA or 401k. I'm mentioning it specifically, because a lot of my lower income friends should be receiving this tax break and don't realize and/or invest to take advantage of it.
2) 401K up to the matching limit. If your company is going to pay you extra money to invest up to a certain amount (often 1-3%), tax free, you're extremely foolish if you don't invest enough to get it. The disadvantage is that many employer plans don't provide great options for investing. I think most are now offering an S&P 500 Index Fund as an option. That is where I put my 401K money. It is tailored as a long-term investment, and should provide a low-fee, relatively low risk (over the course of 20+ years) investment that effectively matches the overall market performance.
3) Individual Retirement Account. There is an annual limit ($4,000 for single people this year), and you have to choose between two different flavors - the Roth IRA, and the Traditional IRA.
---a)Roth IRA- This is the best choice for most people that aren't near retirement. With a Roth, you pay taxes on your money when you put it in, but when you retire and take it out, both the initial investment money, and all of the interest it has earned over the years can be withdrawn absolutely tax free. It also has a little more flexibility than a Traditional IRA if you need to withdraw some of the money early.
---b) Traditional IRA- you don't have to pay taxes on the money when you put it in (so you get a bigger tax refund), but you do have to pay taxes on it when you take it out, along with all of the interest it has earned. This is often best when you are closer to retirement, and are expecting to have less money in retirement than you are currently earning.
4) This is the one I keep waffling on. I'm still not sure whether I should be investing in my 401K above the matching limit, or in a regular taxable account. There are certain advantages to each.
---a) 401K above the employer matching limit. This applies as well to both a SEP and HSA. This has the advantage of not having to pay taxes on the money when you put it in, so that is like getting an extra 15-25% due to the tax break. It also comes right out of your paycheck, so it is typically easier to just bump up the percentage on this and forget about it. This is also better if you aren't looking to put your money into anything risky, because you likely won't be able to beat the tax advantages without taking some risks. The disadvantages include less flexibility in withdrawing the money, and having fewer options in which to invest it.
---b) Regular Taxable Account. There are no tax breaks with this money, but you have a lot more flexibility to what you can do with it. There aren't the same restrictions or penalties for withdrawing money to use to start a business, to pay for emergencies, or even to put money down on a house (which I don't recommend). You also have more options as to where you can invest this money, including potentially riskier and more lucrative investment opportunities than what companies make available for their 401Ks.
Previously, I'd decided that I could do better with a regular taxable account. I realized, though, that I'd done the calculations with some inaccurate numbers. For my particular 401K fund, the expense ratio (the percentage that the fund takes from you every year to run the fund), is effectively zero. On top of that there aren't any other maintenance fees. So, if I pay a fee only investor 1% to manage my money, and then average a low .5% expense ratio for the funds he recommends, that's already 1.5% off the top. The question then becomes how beneficial the 25% tax discount is to what I can make elsewhere, even with the extra fees.
Let's say I invest $1000 in my 401K. If I were to put it in a taxable account, I'd effectively only be investing $750 since the rest goes to taxes.
In 10 years at 10%, you'd have $2,700 in the 401K
You would need to get a 13% return to have the same amount of money in the taxable account, and with the increased maintenance fees, possibly as much as 14.5%.
In 30 years at 10%, you'd have $20,000 in the 401K
You would only need to get an 11% return in the taxable account, or 12.5% with the extra fees.
It is important for me to look to the long term (which is when I reach retirement age) to evaluate this. With higher risks, I could almost certainly make up the extra 2.5%, and possibly even the extra 4.5%.
This just means that I shouldn't discount either of these options, and the right answer is going to be an intelligent mix of both. If there are tax advantages to putting a certain extra amount into my 401K, I'll do that. If I need to allocate my investments to have more money into the S&P500, I'll of course do this in my 401K to get the tax break. Otherwise I'm going to continue to put money into my taxable accounts for added flexibility and attempts for even higher returns. |
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