As I cozied up to the dinner table with a tasty single malt Scotch (Oban 14 year old), I got a question I can’t seem to avoid.
There I was, at a small party with some old high school buddies. The hosts married a couple years ago and had a son a little over a year ago.
April was peppering me with questions and clearly nervous. Her husband, Malcolm, was mildly interested, but was more focused on the Oban. Priorities, priorities…
I’ve been in this situation many times before. I knew a conversation over drinks would end up being confusing and hard to remember, even for otherwise brilliant and successful college-educated professionals.
I asked her to send me an email with her questions. Everyone who is getting serious — or needs to get serious — about saving for retirement needs to see my response.
It is shocking how little people are taught about their options, and how little changes now have profound effects down the road.
If you know anyone like April and Malcolm, who are just getting started and lack the resources to make informed decisions, forward this email to them.
If you know anyone of any age that just pumps money into their 401(k) and ignores their options, show them how easy it can be to set up something better.
Professional investors thrive by keeping people in the dark. It makes it far easier to sell them costly plans and enrich themselves at their clients’ expense.
There are even options that experienced investors are unaware of because brokers and professional investors do not want you to know about them, which I’ll cover below.
This information is absolutely crucial to long-term success and financial security.
What Everyone Needs to Know
Here is her message, which skips a bit of what we started to discuss:
About those IRA options, do you think a Roth is better than a 401k after the match because you can control what you buy? Or because you think the Roth’s pay taxes now and not later option is better? Can you pull from a Roth for college tuition?
Thanks,
April
Here is my response…
Hey April,
Thanks again for dinner the other night. As you’ll soon see, there is a whole lot to consider here.
Either IRA, traditional or Roth, will allow you far greater flexibility in where you invest compared to a 401(k). Most 401(k) plans will cost about 1% of your funds per year. Over decades, that adds up to a whole lot of money due to the compounding nature of investments.
Most IRAs cost absolutely nothing to open, have no annual fees and only charge trading fees of about $10.
Your 401(K) probably has a set list of less than ten options. With an IRA, you can choose between thousands of options: stocks, ETFs that track an index like the S&P 500, mutual funds, CDs, and bonds.
You don’t even need to do much with an IRA after it is set up. Just to put in a trailing stop loss after you allocate funds to an investment, if possible. This is essentially a clause that says, “If the share price drops X% or more at once, sell the position.”
Just don’t set the limit too close to the current price. A 5%, or even 10%, drop can completely reverse in a matter of days.
Your funds will rise and fall, but you can skip the absolute worst of it. Never panic and remember that you haven’t profited or taken a loss until you sell.
Massive Advantages
The main reason I brought up IRAs the other day is because 401(k)s consistently underperform the stock market. Plus, there are steep tax penalties if you need to pull money from a 401(k).
Max out the amount your employer matches and stop there.
Forbes recently published an article showing, after some balancing, that a low cost total index fund beat actively managed funds (such as common 401(K) options) 77% of the time from 1995 to 2012.
Our retirement plan has matching funds, but isn’t a 401(k). I turned to my brother to get a real world example.
His 401(k) has an annualized return of a little over 7% since the market bottomed out after the recession. The market has an annualized return of about 28%.
In a situation like this, it can be far more profitable to match the employer contribution, then open an IRA and invest in something like the SPDR S&P 500 ETF Trust (NYSEARCA: SPY).
Another great option is the SPDR Russel 3000 ETF (NYSEARCA: THRK) which invests in the largest 3,000 U.S. companies, representing roughly 98% of the investable U.S. equity market.
You can even mimic a classic retirement fund allocation using ETFs like the Vanguard Total Bond Market ETF (NYSEARCA: BND) which is based on a wide index of government, corporate, and international dollar-denominated bonds.
Before we go further, you should know there are some limitations for both types of IRA:
- If you are single, you can open an IRA if you have less that $114,000 in adjusted gross income. For married couples filing jointly, the cap is $191,000.
- You can open one of each, but the $5,500 limit applies to the total amount contributed to both IRAs.
Contributions are capped at $5,500. If you are 50 or older, the limit is $6,500.- Roth IRAs contributions are taxed going in, withdrawals are tax-free. This is reversed for traditional IRAs. There are some conditions and exemptions for both.
As for which is a better choice between a traditional vs. Roth IRA, consider the flexibility you want and the taxes you will have to pay.
If you contribute $5,500 per year from 2004 to 2014 into a Roth IRA, you could access the $27,500 you put in from 2004 to 2009 tax-free, but that is the limit for a tax-free withdrawal. You can only tap into contributions made at least five years ago.
Any withdrawals that would pull from capital gains or contributions from the last five years would be hit with a penalty tax.
Say you allocate $5,000 of your salary — pre-tax — to put in to one of the options this year. If you have a 20% income tax rate, you’ll have $4,000 to put in a Roth, or the full $5,000 for a traditional IRA. That will have a large impact on the compounding effect over time.
However, you won’t have a back-up “rainy day” fund you can pull on with the traditional IRA. That may negatively affect how much you are willing to put in a traditional IRA.
To make it even more complex, the income taxes you pay before contributing to a Roth IRA today won’t be the same as the taxes you pay when you pull money out of a traditional IRA in the future. Consider this:
- The government is chronically underfunded and/or spending too much. Something has to give. Precedent suggests higher taxes instead of fiscal restraint.
- By the time you retire, your success will work against you with a traditional IRA. Young workers who are making more when they retire will be in a higher income tax bracket and will be forced to fork over a much higher percentage of their income.
There are college saving plans with tax advantages too. A 529 college savings plan can be paired with either IRA account.
Carefully plan how these options can be mixed into your personal finances. When you like what you see and are comfortable with it, start thinking about implementing everything and adjusting your budget.
Let me know if you have any other questions and I’ll help as much as I can. I’ll see you soon,
Adam English
Information is Being Suppressed
I’m constantly shocked that otherwise well-educated and driven people don’t know their options or how to optimize the benefits of them, but I’m not surprised.
Investors don’t have direct access to the stock market. They have to go through brokers, and there isn’t much money to be made off of investors pursuing low cost investments through IRAs.
The real money is in playing on a potential client’s insecurities and ignorance. Professional investors spit out a whole bunch of jargon and purposely muddy the waters, then sell their actively managed funds, rife with all sorts of crippling fees.
To make matters worse, the government is playing along. For example, the SEC is complicit in censoring IRM(72) plans in particular. Even experienced investors are unaware of these plans’ massive benefits.
The Outsiders Club’s Jimmy Mengel recently uncovered all of the information on IRM(72) plans possible. You can find out more by subsribing to his premimum publication, The Crow’s Nest.
