You are contributing to your 401(k) to get the full company match. Because you live beneath your means, you are still generating excess cash each month and would like to invest it. Where is the best place to do so?
Option 1: Roth IRA
While a 401(k) is set up through your employer, an IRA is a retirement account that you’ll have to open by yourself through a financial institution. It stands for Individual Retirement Account. An IRA allows us to make additional investments in a tax-advantaged way. A contribution to a traditional IRA can be tax-deductible and will grow tax-deferred. Meaning, you don’t pay taxes on the money you make while it’s inside the IRA, but you’ll have to pay taxes once you withdraw it.
A Roth IRA is another type of IRA. It one of the best place to invest your savings, because your future earnings will be tax-free! Let’s say you invest $5,000 a year in a stock mutual fund through a Roth IRA that generates an average annual return of 6%. In 30 years, you will generate about $250,000 in earnings – all tax-free!
Not everyone is eligible to contribute to a Roth IRA. You can contribute the full amount ($5,500) in 2018 if:
You have earned income (you receive at least $5,500 in wages via W2 or 1099); and
Your adjusted gross income is less than $120,000 if you file your taxes as single, or less than $189,000 if you file married filing jointly.
Option 2: Roth 401(k)
If you have excess cash to invest, you can increase your contributions to your 401(k) up to the maximum allowed by law ($18,500 in 2018).
Better yet, think about contributing to the Roth portion of your 401(k) plan, if it’s available.
There are no income eligibility requirements for a Roth 401(k). Meaning if you’re single and make $150,000, you are not eligible for a Roth IRA, but you are allowed to contribute to a Roth 401(k) via your employer’s 401k plan (if your employer makes it available).
Question: When would you want to contribute to a Roth 401(k), instead of the traditional pre-tax option?
Answer: If your tax bracket is particularly low, given the new tax law. In the figure below, the grey column represents the old tax bracket for married couples, and the orange is the new tax bracket. For example, if your combined taxable income is $250,000, your tax bracket just dropped significantly from 33% to 24% starting 2018.
By switching your contributions to a Roth 401(k), you are able to pay lower taxes now. Note, however, that your paycheck will be reduced by the taxes. You’ll have to adjust your budget, making sure that any changes is in line with your priorities.
Option 3: Taxable Brokerage Account
If you’re maxing out your 401(k) and IRA contributions and still have excess cash to invest, you can create an individual or joint taxable brokerage account. But you’ll get a 1099 each year on the dividends that you will earn and include in your tax return. You may also have to pay capital gains tax each time you sell a fund that has risen in value.
The upside is, there are no withdrawal restrictions.
Are there termites in your investment funds?
Each fund in your 401(k) or IRA charges a fee, mostly to cover hiring & overhead costs of running the fund. It’s called Expense Ratio. It typically ranges from 0.03% to 2%.
Question: How much difference does it make, if we invest in a U.S. stock fund that charges 0.2% versus another U.S. stock fund that charges 1.2%?
Answer: A whole lot! In the graph below, we can see that we lose more than $30,000 to fees in the higher-cost fund, given a $10,000 investment that makes an average annual return of 6% (before fees) over 40 years.
Fees are like termites. They’re tiny, we can hardly see them, but they’re eating away our retirement savings!
Within each investment category, look for a fund that has low fees. If you see the word “index” in the name of the fund, that usually indicates lower fees. That’s because their hiring costs are lower. Studies consistently show that over 90% of these lower-cost funds outperform their expensive counterparts over a 15 year time horizon.
Investing is like gardening. It takes a lot of patience and due diligence. You need to choose the right type of seed (asset class) and soil (tax-advantaged vehicle). You plant a seed (initial investment), water it frequently (monthly contributions), and you’ll be rewarded to see it grow over time.