How to Invest and Save for Retirement

20 Jun
June 20, 2014
For background, here’s the original lecture video.
And here’s the accompanying slides.

QUESTION: I understand that I should invest in lifecycle funds. But should I do so via a Roth IRA, Traditional IRA, Roth 401k, or Traditional 401k?
(Click here to skip the explanation and go straight to the summary)

To recap, IRA and 401k are the vehicles by which you invest, whereas lifecycle funds/index funds/etc. are where your money actually goes. In other words, first you decide what type of account you want to open (IRA, 401k, or a standard brokerage account), then you decide what funds you want to buy in that account.

For the latter, I recommend putting all your retirement money in a single lifecycle fund corresponding to your expected year of retirement (ex. Vanguard Target Retirement 2055 Fund). Hopefully I made this clear enough in the lecture.

However, I did not devote enough attention to the former. Generally, an IRA is preferred to 401k, because you get to choose what provider you want to use for your IRA, and therefore you can choose the one that offers the lowest-cost lifecycle funds (ex. Vanguard). In contrast, a 401k provider is chosen by your company and therefore might not offer lifecycle funds, or might be more expensive.

Therefore, conventional advice says to prioritize like this:

1. Contribute through your 401k account up to the company match limit. If your company does not offer a match, you can skip this.
2. Next, contribute through your IRA account up to the IRA contribution limit ($5,500 in 2014). Make sure you qualify for an IRA based on your income (more on that below) — if not, then skip this.
3. Then, contribute through your 401k account up to the 401k contribution limit ($17,500 in 2014).
4. BONUS: If you still have any leftover money to invest, contribute through a standard brokerage account, which has no tax advantages, but also no contribution limits (this is sometimes called a “nonretirement account” or “taxable account”). Note that you can use the same provider (ex. Vanguard) for both your IRA account and your brokerage account.

That’s the generally-recommended order, but if the company’s 401k plan is good (ex. it offers low-cost lifecycle funds), then it’s OK to switch Steps 2 and 3 — in other words, to start with a 401k before an IRA. I like switching these steps because it’s a lot more convenient to start with a 401k — your company will send you a link to sign up for your 401k account, you’ll choose what fund to buy, and you’ll choose how much to auto-deduct from each paycheck. And you don’t have to worry about income limits, which apply to IRAs but not to 401ks.

Finally, to make things a little more complicated, both the IRA and 401k have two variants — a “traditional” version (ex. traditional IRA, traditional 401k) and a “Roth” version (ex. Roth IRA, Roth 401k). The difference lies in tax advantages — the traditional version allows you to save taxes NOW, but you have to pay taxes when you withdraw the money in retirement. The Roth version makes you pay taxes now, but you DON’T pay taxes when you withdraw the money in retirement. Generally, if you’re in a high income bracket, you should choose the traditional version and get tax savings now; but if you’re in a low income bracket, you should choose the Roth version since tax savings now isn’t as valuable. One caveat is that for IRAs, the income limit to qualify for a traditional IRA is much stricter than the income limit for a Roth IRA, so you may need to take that into consideration when deciding which one to choose. 401ks, on the other hand, don’t have income limits.

SUMMARY: To wrap things up, my opinion is that “most people” at PaperG should do this:

1. Open a 401k account through the company. Pick Traditional 401k if you’re in a high tax bracket, pick Roth 401k if you’re in a low tax bracket.
2. Through your 401k account, invest in the lifecycle fund that corresponds to your expected year of retirement (ex. Vanguard Target Retirement 2055 Fund).
3. BONUS: If/when you reach the $17,500 annual contribution limit in your 401k account, open up a Roth IRA account through Vanguard (or a traditional IRA if you qualify). Through this Roth IRA account, invest in that same lifecycle fund.
4. DOUBLE BONUS: If/when you reach the $5,500 annual contribution limit in your Roth IRA, open up a brokerage/non-retirement account through Vanguard. Through this brokerage account, invest in that same lifecycle fund.

Disclaimer: I am not a financial advisor and this presentation is not financial advice. The opinions expressed here are intended purely to provoke discussion.