Thoughts on Retirement

jjbmstinco · October 2013

H and I are finally stable enough to start saving for retirement. I know we should've started earlier but we just weren't in a place. A little about us. H is 33. He works for IT in a school district. He makes about 33,000/yr. I am 26. I work as a school counselor. I make about 35,000/yr. We work in CO, so we use PERA, which is suppose like a retirement account. We each contribute to our accounts each month (248.99/month). Our school district also puts money into the account as well (515.39/month). These amounts are set by the district, not us.

We both have the option to do 401k or 403b with no matching funds from our employers. H originally thought that mutual funds would be a better investment but now isn't sure. He said that a 401k might be better. Should we consider a Roth IRA or traditional IRA?

Honestly, I am really lost on what would be the best for us. We have about $3,000 that we have been saving to start these funds for us, and would like to start these funds by Jan 1.

What are MM thoughts?

vlagrl29 · October 2013

I had a 401k with both office jobs I had in my 20s and once I left I had to roll it into an IRA so I wouldn't get taxed. I would have loved to put it in a Roth but that would also require getting me taxed and I didn't want to loose any of it. Recently our state farm agent told us once we get to where we can regularly contribute to it again we should start a Roth. Right now I have an IRA I manage myself and an IRA the management team takes care of. Once I diversify all my cash, I may eventually take over my money with the management team. I get overwhelmed easily. DH has an IRA also with TD ameritrade. I'm hoping we can start putting money in it again halfway thru next year. The reason we aren't is because we want to have 3 months efund saved and we are just 2,500 away from it. If I were you I would do a Roth because they take the taxes out now as I understand it, so when you retire you don't have to pay taxes then.

@Hoffse knows alot about this subject and will probably have lots of great info for you

hoffse · October 2013

Lol I don't mind being the retirement person

And this will be long, so I apologize in advance for that.

The retirement account(s) you choose and the order in which you fund them has pretty much everything to do with how they are taxed and when. The reason it's hard to generate a simple rule about them is that we don't know whether the tax code will change in the future, and the younger you are the more time Congress has to change it's mind. That said, I can give you info about what the rules are now.

For H and I, we fund a 401(k) up to the employer match, then a Roth IRA in full, and then a Roth 401(k).

FYI the difference between a Roth 401(k) and a regular 401(k) is that Roths are funded with after-tax money so those contributions grow tax free. A regular 401(k) is funded with pre-tax money, meaning you get a tax deduction in the year you make the contribution. However, neither the original contributions nor the gains are tax free when you withdraw those funds in retirement. This is an extremely important distinction to understand.

Sometimes you might want to fund a regular 401(k) a bit more than the employer match, especially if you need to lower your income any given year to qualify for tax breaks. H and I actually have to do this for 2014 because we will be about $8000 over the income limit to take certain education credits on our tax return. Those are worth a couple thousand bucks, so we're going to break the model above a bit and contribute to the regular 401(k) beyond the employer match for that year.

The reason Roth IRAs and Roth 401(k)s are so great is they grow tax-free. The market grows on average 7-10% per year, some years more and some years less. Roths let you put after tax money in these accounts and they grow tax free until you take the money out. You said you are 26. If you made the maximum contribution to your Roth IRA this year ($5,500) and never made another contribution, you would probably have about $83,000 in that account at the age of 65 with a 7% annual return. Now imagine if you contributed $5,500/year every year until you reach 65. You would have contributed $214,500 and your account would be worth about $1,116,000. All that growth is tax-free under the Roth framework. And it gets better - every few years Congress raises the maximum contribution limits, always by $500/person. So you'd probably have more than that.

I have a slight preference to fund Roth IRAs before Roth 401(k)s for two small reasons: first, Roth 401(k)s are newer and the contribution limits are higher... since not as many people know about them and Congress stands to lose a lot more tax dollars from them, I figure they would be the first accounts to be eliminated if Congress ever decided to change its mind. Second, many employers only offer certain investment options with a 401(k), and sometimes these choices aren't great. An IRA usually has a lot more choices through whichever investment bank you're using, and I think the flexibility is nice to have. Caveat: if you aren't good about making contributions on your own (and be honest with yourself on this), then a Roth 401(k) is better because that money never comes to you directly. So you never have an opportunity to spend it before it goes to your retirement account. That's the one huge drawback with an IRA of any type.

Remember the pro-Roth people (like me) has to assume that Congress doesn't change the rules. On the one hand, I feel like Congress will eventually realize how much tax money it has lost by allowing those gains to be tax-free. On the other hand, Roths are becoming increasingly common, and eventually, changing the rules would start round 2 of the American Revolution. The question is when do we cross that point, and I don't know the answer to that.

Some people are convinced Roths won't remain tax-free so they encourage investing in regular 401(k)s instead. These give you a tax deduction for your contribution year, which means it lowers your income. As you know, with less income you have lower taxes. And as I mentioned above, sometimes a lower income qualifies you for additional tax breaks that you otherwise wouldn't get. I would always contribute whatever you needed to contribute to get free money - either through an employer match or through additional tax breaks.

Still, the anti-Roth will tell you that a bird in the hand (the deduction from the regular 401(k)) is worth two in the bush (the chances that the Roths remain tax-free). My problem with that analogy is we aren't talking about 2 birds with the Roth... we're really talking about a lot more than that because your money will more than double by the time you retire. And eventually, you are talking about such a huge (potential) tax savings that the risk is worth it. I will admit that I'm less risk-adverse than a lot of people, especially while I'm in my 20's. So you may prefer to get the deduction instead.

The anti-Roth people also point out that with a deduction you have more income available to you for extra savings. My response to that is that it is true, but only to the extent that you don't spend your extra disposable income. Most people will spend this extra cash each month instead of savings it. Plus, the difference paycheck-to-paycheck between a regular 401(k) contribution and a Roth 401(k) contribution is relatively minimal. So even if you did save that difference, you probably aren't going to make up for the extra taxes you pay in retirement.

It comes down to how risk-adverse you are and how much you want to hedge against the possibility of change in the future.

Let me be clear: I'm not anti-regular-401(k) at all. I think they are a lot less likely to change than any other retirement account. I also think that they are crucial for people who can't seem to save money on their own. There's a lot to be said for that money never showing up in your paycheck to begin with because the contributions go directly to your retirement account (and many employers don't offer the Roth 401(k) option). Money is really a "know thyself and be brutally honest" thing. I believe it is always better to be more critical of your spending/saving habits than less - because then if you're wrong about what you're likely to do, you end up with more money. Whereas people who believe they're better with money than they are usually end up with less than they are expecting. I know which one I would prefer. So be honest - if you have a hard time with saving, go the 401(k) route - either regular or Roth - to eliminate the temptation to spend.

hoffse · October 2013

Oh and two small clarifications:

First, my understanding is that 401(k)s and 403(b)s function pretty much the same way. The 403(b) is a retirement account for public employees, but you're still making pre-tax contributions that get taxed when you withdraw them in retirement. My understanding is that the primary differences between them is on the employer's end (ERISA stuff). Disclaimer: I don't know as much about 403(b)s as I do about 401(k)s, so somebody with more experience than me can certainly correct me.

Second, you can usually invest in mutual funds with any plan - for the 401(k) and 403(b)s it depends entirely on what options your employer offers.

I like holding several types of mutual funds in my accounts - between H and I we have a large cap, mid cap, and small cap fund, as well as two industry-specific funds that are a bit riskier but have been on a tear recently (like 53% growth last year and 50% growth so far this year. It's crazy). If our riskier funds ever stop performing well for more than a few months we will sell and reinvest in something else at that time. I check it daily, and like I said I'm less risk-adverse than others on these boards. But point is, with 5 funds we're pretty diversified even though most of the funds hold stock and not much else.

We don't have any bond funds yet because we're young. Our goal right now is pretty aggressive growth, and as we get older we will shift to safer, less aggressive funds.

Mutual funds on the whole are less risky than investing in individual stocks. The idea is that in a mutual fund your money is pooled with other people's, and then the fund manager picks a selection of stocks (often 20 or more) to invest in. So when one of those stocks goes down, the growth from the others can counteract the one bad stock. Obviously if you pick a hot single stock and ride it, you can make more with individual stocks. But you can also lose more if your hot stock suddenly turns cold and it plummets before you have a chance to get out. I don't have the time or inclination to research and then track stocks obsessively, and I prefer to leave that up to the professionals. Mutual funds have given us enough growth to feel satisfied with that choice.

I choose mutual funds by researching them through Morningstar.com. I search for their 5-star rated Fidelity funds (that's the investment bank I use). Then, to avoid paying the Morningstar subscription, I search for the funds that Mornginstar gives a 5 star rating to on Fidelity's website directly. Fidelity actually displays the entire Morningstar report for free, so I can see what stocks the fund holds, what kind of growth it has gotten over the last 10 years, and how risky the fund is, compared to others. It's really very clear/straightforward, and even if you don't know much about finance you can get a pretty good sense of the most important points: growth vs. risk. It's really not as intimidating as it sounds.

I also make sure to hold my funds for at least the minimum redemption period. Often this is only 30 - 90 days, but you pay a pretty hefty fee if you sell before that redemption period expires. Redemption periods help keep day traders out, so the funds are a bit more stable.

hoffse · October 2013

Sorry, something else I thought to mention about mutual funds. Like I said, employers often don't give you a huge variety of choices. But the number of choices for an IRA can be completely overwhelming. You will have literally hundreds of options for mutual funds alone. To avoid getting overwhelmed, I stick to some completely arbitrary rules. These might not work for you, but it's what I do:

1) I only invest in 5-star rated funds through Morningstar. It's really the industry standard, and I figure that if they're wrong then everybody else is going to be wrong too.

2) I only invest in funds that have at least 10 years of data. This means I always miss out on the hot new fund, but I can live with that if it means I have 10 years of evidence that the fund either keeps up with or beats the market.

3) I only invest in funds if the manager has been managing the fund at least 3 years. Morningstar reports this, and since the manager is the person calling the shots I want evidence (through growth charts) that they know what they're doing. I figure a fund is only as good as its manager.

4) Even though I'm willing to be a little risky, I always make sure to have more "average" or "below average" risk funds than "above average" or "high" risk funds. Right now we have 3 below average - average risk funds and two above average - high risk funds.

5) Finally, because I'm 27 and my H is 26 we want higher growth right now. So I don't buy a fund if the return over 10 years is less than 10%. This rule will drop off as we get older though.

Wulfgar · October 2013

I would go with a RothIRA for the both of you since this money is after tax the withdrawals are made tax free.

jjbmstinco · October 2013

Thank you for all the great information. I have some serious learning to do!

HarryCanary · October 2013

I also think you should go with the Roth IRA.

A huge benefit about the Roth IRA that I do not think was mentioned is you can always take out the principal at any time without tax implications - you have already paid taxes on it. Because of this, we use our Roth IRAs as part of our emergency funds. In a true emergency, we would be pulling that money out, but if we don't need to pull it out, it will grow tax free!

It also means if we decide to retire early, we have some funds available to withdraw early without penalty.

hoffse · October 2013

Please don't use your Roths as an e-fund. I didn't mention it, because you shouldn't do it. Yes, you can pull out your CONTRIBUTIONS tax-free if we're talking life or death, but any growth you take out early has a huge penalty, and then you lose growth on any contributions you have removed. This is a bad idea all around. Retirement and e-fund should be two different things.

Seriously - funds do not come out of the Roth unless you are absolutely, 100% without other resources, and you really can't live or function without paying for whatever that thing is. I'm talking things like cancer treatments your insurance doesn't cover, repairs to a house after a tornado hits it while you're waiting for insurance to pay out, evacuating yourself out of a country that has suddenly become unstable (true story: my dad had to bribe his way out of Kenya once). But not the types of things that most people use e-funds for.

When people talk about e-funds, we usually mean savings you can tap into for something like your A/C breaking or your car needing a repair... you know, expenses that are too big to really budget for each month, but that crop up once in awhile. I personally don't think these types of things are serious enough to tap a Roth. You should have another, more liquid account for these sorts of things.

jjbmstinco · October 2013

Thanks. We do have a e-fund that is seperate. We put $500/month for the emergency fund that we don't touch in less we have too large of a purchase that we can't use our normal savings account. We want our retirement account be just for retirement.

HarryCanary · October 2013

hoffse said:

Please don't use your Roths as an e-fund. I didn't mention it, because you shouldn't do it. Yes, you can pull out your CONTRIBUTIONS tax-free if we're talking life or death, but any growth you take out early has a huge penalty, and then you lose growth on any contributions you have removed. This is a bad idea all around. Retirement and e-fund should be two different things.

Seriously - funds do not come out of the Roth unless you are absolutely, 100% without other resources, and you really can't live or function without paying for whatever that thing is. I'm talking things like cancer treatments your insurance doesn't cover, repairs to a house after a tornado hits it while you're waiting for insurance to pay out, evacuating yourself out of a country that has suddenly become unstable (true story: my dad had to bribe his way out of Kenya once). But not the types of things that most people use e-funds for.

When people talk about e-funds, we usually mean savings you can tap into for something like your A/C breaking or your car needing a repair... you know, expenses that are too big to really budget for each month, but that crop up once in awhile. I personally don't think these types of things are serious enough to tap a Roth. You should have another, more liquid account for these sorts of things.

Your definition of e-fund does not equal my definition of e-fund. For me it is truly for an emergency - lost job, medical, etc. We have other savings to cover home/car repairs and I recommend that.

It doesn't make sense for us to have a great deal of money that we likely and hopefully don't ever have to touch sitting in a savings account earning little to no interest. Although a good portion of our e-fund is in fact in such a savings account -- it just doesn't add up to 6 months of expenses.

The balance of our 6 months of e-fund is in Roth IRAs. It would truly have to be an extreme emergency for us to pull money out of it, and of course we would only pull out our contributions penalty-free.

Personally, I wouldn't withold valuable information like this (the fact that Roth IRA contributions can be pulled out penalty-free) from folks on the interwebs just because you think they will abuse it. I prefer to give them all the pertinent information and let them decide.

hoffse · October 2013

The problem with mentioning things about borrowing against retirement accounts is that it sounds like an endorsement - and I don't endorse it. Should I also mention that you can borrow against a Roth for a downpayment on your first house penalty-free? Because you can. But it's a really stupid thing to do. I don't bring up possibilities that I think are a bad idea - if people want to learn about all the ways they can borrow from their retirement accounts (and there are many ways to do this), they can google "borrow from retirement" and read one of the 1,509,876 articles on the internet about it. I don't consider borrowing from a Roth to be a perk - which means I don't think it's valuable information - which is why I don't bring it up. It has nothing to do with abuse. It has to do with the fact that I spend a very very long time composing detailed answers to retirement questions, and to avoid composing a novel, I stick to the points that I think are salient. Borrowing from a retirement account is not one of those points for me. Ever.

There are other ways to have growth in an e-fund without 6 months of income sitting in a savings account. I agree with you that 6 months is overkill for some people. H and I are high-income earners and we need our money to work for us. We're not going to have $60,000 just sitting in a cash account somewhere earning no interest. Instead, we keep about $10K cash - which covers 98% of all possible emergencies for us - and the rest in investment accounts that we can liquidate if one of us were to lose our job or we had some other catastrophic emergency. You don't have to have a retirement account to buy mutual funds... you can always just buy them on your own. That's what we do. And it gives us plenty to work through before we would need to tap our Roths as a very last resort.

I understand that it takes time to build up 6 months of cash separate from a Roth, and once in a great while life turns really crappy and whatever you have in your e-fund might not cover you. But I think that while life is not crappy, it's important to keep building your Roth and e-fund separately.

jjbmstinco · October 2013

After doing some research... I have some more questions. I am sorry!

We want to chose how our money is invested but still get the tax benefits with a 401k or Roth IRA.

1. what is the process for making the decision for choosing investments for the accounts.

EX-I would like to invest in index mutual fund. How would I put money into a vanguard 500 fund?

I appreciate all this in advance!

Xstatic3333 · October 2013

From the perspective of someone without much financial background:

When I opened my Roth IRA I went to Fidelity with a check for my down payment. They talked to me about my risk tolerance, willingness to pay fees, etc. and recommended a combination of cash reserves and a medium-risk fund. Now that the total has grown a bit I'm going to go back to reevaluate. I think if I was more knowledgeable about the market, I could also trade online. My old 403(b) worked the same way; work had a financial advisor on-call who could help us decide where to invest the money.

jtmh2012 · October 2013

jjbmstinco said:

After doing some research... I have some more questions. I am sorry!
We want to chose how our money is invested but still get the tax benefits with a 401k or Roth IRA

With the vast majority of 401k/403b/Roth accounts, you're going to setup an account. With all three options, when you login, you will be presented with a group of funds that you can select from. The list of funds available to you in a 401k/403b are selected essentially by your employeer and the financial representative assigned to them.

With an IRA you're still going to pick from a list of preselected funds, but because you can choose where to get your IRA you have some ability to choose what funds you have to select from.

If your school system is anything like mine was, you probably have a financial advisor assigned to your school district. I would advise calling your benefits people and asking to meet with this person before doing anything. Ideally, you and your husband should meet with them directly so you can develop a whole family investing strategy between your accounts and your husband's accounts.

hoffse · October 2013

Exactly what PP's said. I would take the list of pre-selected funds they give you and spend some time over the weekend searching the fund codes in Morningstar's website. Funds have alphabetic codes exactly the way stocks do.

I know that my employer's pre-selected funds range from about a 5% return (pretty crappy for a stock fund) to more than 10%. I chose the higher-return funds because I'm young.

Your employer may or may not have pre-selected a 500 index fund (these funds are usually pegged to the S&P 500 so you do exactly what the market does - no better, no worse). I can just about guarantee you that every major investment bank (Fideltiy, Vanguard, Schwab, Scottrade, etc.) will have a 500 index fund available for IRA accounts. But your employer may not have those available for your 401(k) accounts. I know mine doesn't - which is a shame because the market has done better than those crappy 5% return funds that they do offer.

So step 1: Get the list of available fund options from your employer.

Step 2: See if there's a 500 indexed fund on that list. It should be obvious. If so, great - call the investment bank who services the accounts (Vanguard?) and they will talk you through it step by step. Vanguard has an excellent reputation. Don't be shy to ask them questions - they are there to help you and I promise they talk to people who are just starting out all the time. I call the Fidelity people often, and they've always been able to answer my questions clearly. They also have always been able to understand what my question actually is - even if I'm asking it poorly. I find that reassuring, and I call them all the time as a result.

Step 3: If the 500 index fund isn't on the list, get on morningstar and research the ones that are available to you. Your list of available funds is likely to be relatively small, and there will probably be some obvious good choices and some obvious bad choices. If it's a larger list with several good choices, then I would generate some "rules" to help you decide. I gave you my (arbitrary) rules in an earlier post - those work for me, they may not work for you.

It's probably a good idea to talk to somebody at Vanguard about risk if you aren't sure how well you tolerate it. Personally, it doesn't bother me to watch the market go down because I have faith it will go back up. So far, that's always been true, and I'm young enough to ride those dips without any issue. I won't need that money for a long long time. So I tolerate risk well. Others don't, despite their age, because they can't stand to see money they have put into an account be lost at all. The investment bankers will talk to you about this. If you really have no idea how you will react, start with a low-risk fund and watch it to see how much the dips bother you. If you're good to with fluctuations (and I 100% guarantee there will be fluctuations - sometimes large ones - both directions), then you might want to think about adding a higher-risk account. Those tend to have higher returns. If the fluctuations really bother you, then stick to lower-risk accounts which tend to be more steady.

Also consider how often you check your account. Some people check every day (raises hand). Some people forget about it for a few years (my BFF raises hand). If you check it often, I think you're likely to manage higher risk accounts a bit better because you can get out if/when you decide a particular fund isn't going to continue performing the way it has been. If you don't check it often, then you might ride that high-risk fund down the drain simply because you've forgotten about it. You really don't want to do that. If you don't typically check accounts often, I would pick a lower-risk account so that you can set it and forget it for some period of time. I do actually chase hot funds because of my age, my risk tolerance, and my attention to it - but it's probably a bad idea for most people.

I do think a 500 indexed fund is a great place to start, because it really does match the market. But if that's not available, or if you want to buy more than one fund, consider risk tolerance and how often you check your other bank accounts, etc. before making the plunge.

Step 4: Be prepared with beneficiary info (name, SSN, etc.) if you haven't already given that to your HR person. And remember, it's a very good habit at the end of the year to check beneficiaries on all your accounts to make sure everything is still current. I can't tell you how many first husbands/wives have gotten proceeds from their deceased ex-spouses estates because the ex-spouse never changed beneficiaries when he/she got divorced, remarried, etc. In the case of re-marriage, this usually causes a lawsuit.

I check mine every year and once in a great while I catch something that needs to be updated. Example: last December I changed everything over from my parents to my husband because H and I were getting married. It doesn't matter when you check it of course, but find a time once a year when you make a point to do it.

Step 5: Do yourself a favor and make sure to set up online access, etc. so you can easily track your progress and trade online if you choose to do so. It's kind of a pain to set up, but take the time to do it soon after the accounts are funded. After that, logging in will be a breeze.

You may (or may not) also want to consider giving your H a way to see what is happening on your accounts. I know fidelity has multiple "privilege" levels - ie: you can just view your spouse's account or you can actually trade on your spouses's account. H and I trust each other with money so we decided to let the other trade on our accounts. This is absolutely not for everybody, and I would not recommend it unless the two of you talk about money a lot and have similar perspectives and goals. If you're not on the same page, or if your spouse has a history of bad credit/poor financial choices, then keep it entirely private or limit access to viewing only. Also, if the two of you view money as "mine" vs. "yours" rather than "ours," this is probably not a good thing for you.

But all that said, trading privileges does work great for us. I bought a new fund for his account yesterday because he was traveling and didn't want to log in to his Fidelity account through a different server. So I just traded on his Roth through using my own login info. We initially set it up in case one of us becomes incapacitated, but we've found it to be useful in situations like this as well. Note: we absolutely don't trade on each other's accounts without talking about it first. And we both check our account often enough to know if the other did do a trade behind the other's back.

maple2 · October 2013

A lot of 401k plans are also offering target age retirement funds. The concept behind these funds is that as you age, the type of retirement investments that make sense for you will change. As you get older, you will want less risky, lower return investments to preserve value since you will need to use it sooner. Target age funds are supposed to adjust their investment strategy automatically over time to be consistent with what is appropriate at your age. This type of fund might be worth considering if you think you will be the type of investor who just puts their money in an account and forgets about it rather than someone who wants to be actively managing your investments.

smerka · October 2013

Another very important thing to consider is the fees you will be charged to manage your account. The less the bank/brokerage messes with it, the lower the fees. I am with Vanguard so I have pretty much drank their Kool Aid on the fees. Frontline did a show about this and in fact I think it was on last night. Anyway, index funds usually have lower fees. The higher the fees, the more it will eat into your returns. And they won't really show you that on your statement. Also when you get to $10,000 in a fund, vanguard will give you an Admiral rate which is even lower fee. My DH and I are in a similar situation salary wise and it works best for us to fully find our Roth IRAs first because we currently don't have any tax liability (part of the 47%) so we wouldn't get any of the tax advantages to a 403b.

smerka · October 2013

Here's a link to the Frontline episode. Very worthwhile watching. http://www.pbs.org/wgbh/pages/frontline/retirement-gamble/

jjbmstinco · October 2013

Thanks everyone!

HarryCanary · October 2013

hoffse said:

The problem with mentioning things about borrowing against retirement accounts is that it sounds like an endorsement - and I don't endorse it. Should I also mention that you can borrow against a Roth for a downpayment on your first house penalty-free? Because you can. But it's a really stupid thing to do.

You don't have to have a retirement account to buy mutual funds... you can always just buy them on your own. That's what we do.

When choosing between different types of retirement funds, the fact that contributions to a Roth IRA can be taken out penalty free is extremely useful information for a variety of circumstances. I never said anything about borrowing against retirement funds.

Since you have mutual funds outside of your retirement accounts, you must be maxing out your tax sheltered retirement investments. Congratulations! I am excited for the day we get to that point.

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