Mechanics of Investing: A Lazy Man’s Guide I

This is going to be a 2-part series. In this first part, I’ll talk about the basics of common retirement accounts and in the second part, I’ll discuss investment choices. As always, I’ll try to keep it simple and easy to follow.

One of the greatest concern for most people when it comes to investing is the ability to defer withdrawing their money until retirement. Now, retirement is at different ages for different people. Most people in America consider retirement age to be age 65, which is also the age when one qualifies for Medicare. Most newly settled immigrants to America cannot come to terms with this because for most tax-deferred retirement plans, if you attempt to withdraw your money early (typically before age 59.5 years), you will incur a penalty (typically 10%). The government puts this penalty for a good reason: so you don’t liquidate your nest egg even before you get to your retirement. It’s like helping to save you from yourself.

I have seen otherwise extremely intelligent people, avoid using a retirement plan, for this very reason of delayed access, and instead invest their money in non-retirement taxable accounts. This makes little sense. But when you actually organize your finances well, you will realize that there’s really no reason to ever want to withdraw money in your retirement accounts until retirement.  Why? Because….

A. You should be out of consumer (non-mortgage) debt before investing

B. You should have your emergency fund in place before investing

C. You should have your basic insurances in place to help protect you from financial catastrophes

If you do the above 3 things, you should be able to withstand whatever financial difficulty that comes your way (or at least most of it).

So now, lets talk about the common retirement accounts you can use to invest. Please should understand that these retirement accounts are like baskets or empty boxes for holding your investments. The investments (stocks, bonds etc.) you put inside of these baskets are what will help you build wealth.

The commonest defined contribution plans (retirement plans) include 401(k), 403(b), 457 and TSP plans. There is also the Profit-sharing plans, Cash balance plans and Employee Stock Ownership Plan (ESOP) but for the purposes of simplicity, I would not discuss these less common plans here. Technically, there is another plan called 401(a) and it can get you more confused, so I will not discuss it here either. You can read a little bit about the differences between 401(k), 403(b) and 401(a) here. You can have either a 401(k) or a 403(b) but you can also have in addition a 457 plan if your company offers it.

A good book to learn all the nitty gritty of retirement plans, which also helped me in preparing this blog post is the Bogleheads Guide To Retirement Planning.

Basics of 401(k), 403(b) and TSP Plans

These plans are all very similar. The 401(k) plans are offered by private companies, 403(b) plans are offered to public education and non-profit employees (like some non-profit hospitals) and the Thrift-Saving Plan (TSP) is offered to federal government workers (including those in the military). These plans all have essentially identical contribution limits, withdrawal requirements and other terms. Employees select the funds they want to invest in from a list of options available in the plan (usually a list of about 10-20 different mutual funds). The employer may offer matching contributions for some or all of the employee’s contribution. For example, if you put in 10% of your gross income, your employer may match 50% of what you put in, essentially pitching in an extra 5% of your income to your contributions. This is free money and every employee should, at the minimum contribute the minimum in their company’s plan to get the full match, if available.

For 2018, the IRS limits for 401(k) type-plans is $18,500. For those above 50 years, the IRS allow catch up contributions. For 2018, this figure is $6,000. So if you’re 51 in 2018 and contributing the match in your 401(k), you can put in a total of $24,500. These limits are reviewed yearly by the IRS to reflect inflation.

Defined contribution plans are always fully funded, meaning you own the money as soon as it is deposited in your account. Your employer cannot take it back. You are also responsible for funding and selecting investments in your account. Some companies provide help and offer to help employees select funds in the plan, often for a small fee.

Rollovers: You can take your money with you when you leave a company (you roll it over to a Roll-over IRA). This is a good fit for the modern workplace where most people will have 5-10 different employers over a career. Unfortunately, some 401(k) and 403(b) plans have atrocious investment options and it makes sense when you leave such companies to take your money with you. The TSP plan is truly one of the best plans available in the country in terms of management, fees and investment options.

Withdrawals: You can withdraw your 401(k) or 403(b) or TSP holdings without penalty at age 59.5 or at age 55 if you leave your employer then. Ordinary income taxes are due on all withdrawals.

Loans and Early Withdrawal: You can take a loan from a 401(k) account for up to $50,000 and five years. If you do not repay the loan on schedule, or if you leave your employer prior to repaying the entire loan, it converts to an early withdrawal. Early withdrawals from a 401(k) incur a 10% penalty in addition to ordinary income taxes due. It is not advisable to take a loan or do an early withdrawal from your 401(k) or 403(b) account because it distracts from your compounding and slows down your wealth building significantly.

Opt Out Option: Employees have the option to opt out at any time. Most companies these days offer automatic 401(k) enrolment to their new employees to help nudge them towards good behavior. This is a good thing. However you have the right to opt out if you do not want (this is not a good thing).

457 Plan Basics

These plans are a way for government and non-profit employers to offer additional tax-deferred retirement opportunities, generally in addition to an existing 401(k) or 403(b) plan. They allow early withdrawal without penalty (you still have to pay the ordinary income taxes) but do not allow loans. Some 457 plans (and indeed 401(k) and 403(b) plans) have high fees and investment choices are poor or limited. Most 457 plans do not offer a Roth component, unlike 401(k) or 403(b) plans. Also most non-governmental 457 plans cannot be rolled over to an IRA or to a similar 457 plan, so you have to take it with you when you leave your employer and pay the taxes on it.

Generally, it is preferable to first contribute and max out your 401(k) or 403(b) and your IRA or Roth IRA, and if you have more savings to spare after that and your employer offers a 457 plan (many employers do not), then you can contribute to it. It is a great alternative to saving in a taxable account.

TSP Specifics

The federal thrift savings plan, or TSP is a retirement plan for civilians who are, or previously were, employed by the U.S. government and for members of the uniformed services. In most ways, the plan resembles the dynamics of 401(k) plans. The government also matches generously each employee’s contributions. TSP plan provide index funds covering domestic stocks (large and small), international stocks and bonds. They also have target retirement funds. The fees are very low. This is truly the best defined contribution plan in the country.

401(k), 403(b) and TSP plans can have Roth options (this means that you contribute after tax money, not pre-tax, and your money grows tax-deferred and you don’t pay taxes when you withdraw them penalty free after age 59.5). The 457 plan generally do not offer Roth options. Every individual’s financial situation is different, so you can decide to do a regular 401(k) or 403(b) and save on taxes now, or do a Roth 401(k) or 403(b) and pay your taxes now, but allow your money to compound and never pay taxes again.

Individual Retirement Arrangements (IRA)

An IRA is one of the best ways an individual can save for retirement, even though the maximum amount you can save here ($5,500 for 2018) is much less than the maximum deferrals for 401(k) type plans ($18,500 for 2018). You don’t need to depend on your employer to open one of these (you only need an earned income). For those whose spouses stay at home, you can open a spousal IRA (or spousal Roth IRA) for your spouse even if he/she does not have earned income.

With an IRA, you can minimize two of the biggest drags on investment returns: taxes and expenses. Vanguard founder, Jack Bogle said it best, “In investing, you get what you don’t pay for. Whatever future returns the stock and bond markets are generous enough to deliver, few investors will succeed in capturing 100% of those returns, simply because of the high costs of investing – all those commissions, management fees, investment expenses and taxes”.

The two commonest IRAs available are the Traditional IRA and the Roth IRA

Traditional IRA

There are many rules guiding money going in and out of this account. You must have US taxable compensation (earned income) to contribute to this account. The money must be received during the same year as the contribution, although you can make the contribution as late as April 15th of the next year (this rule applies to all types of IRAs). You cannot contribute to this account and take the deduction if you make more than a certain amount (the IRS uses the modified adjusted gross income or MAGI to determine if you make too much to use an IRA). For 2018, this amount is $73,000 (single individuals) or $121,000 (married filing joint returns). These limits do not apply if you do not have a retirement plan at work. Also, even if your MAGI is above those limits, you can still contribute to a Non-deductible IRA (you do not get the tax deduction). Although the limit you can put for 2018 is $5,500, for those 50 and older, there is a catch-up contribution of $1,000 you can put in. Remember that this account is for retirement. Although some exceptions are made, you really shouldn’t plan on touching this money until you are at least 59.5. When you turn 70.5, Uncle Sam wants you to start taking out required minimum distributions (RMD) from this account, just like with your 401(k) or 403(b).

Roth IRA

Roth IRAs were introduced as part of the Taxpayer Relief Act of 1997. This is perhaps the greatest gift ever given by Uncle Sam to the individual investor. Everybody should have a Roth IRA account. It helps with tax diversification in retirement. The income limits (using MAGI) for Roth IRAs are much higher than for traditional IRAs. For 2018, they are $135,000 (single individuals) or $199,000 (married filing jointly). Some of the rules of the Roth IRA are slightly different from a traditional IRA. There are no required minimum distributions when you turn 70.5. You never have to take the money out of your Roth IRA if you don’t want to. In fact, if you leave it in your will to a great-grandchild, that money can grow and be sheltered from taxes for a period of time upward of 150 years. This particular tax-reduction strategy is known as a Stretch Roth IRA and be used for leaving a great legacy. Remember that even if you make above the income limits to contribute to a Roth IRA, you can use a loophole in the tax law and still contribute through the Backdoor Roth IRA strategy. Because of its favorable rules, a Roth IRA should be one of the first places you put money for retirement and one of the last places you withdraw from.

Self-Employed IRAs

For those that are self-employed or independent contractors, the employer-based retirement accounts for a self-employed person function as big IRAs with much larger contribution limits. There are 4 main types that a self-employed investor might consider

1. Solo 401(k)

Also called Individual 401(k), these allow for up to $55,000 (with a catch-up contribution limit of an extra $6,000) for 2018, provided you have income to make that maximum contribution. You can contribute up to 20% of your net self-employment income as an employer (your business income minus half your self-employment tax), though those contributions must be made with pre-tax dollars. These pre-tax contributions lower your taxable income and help cut your tax bill. Read more about the details here.

2. Roth Solo 401(k)

Like a Roth IRA or Roth 401(k), the Roth portion of a solo Roth 401(k) is an after-tax contribution, which then grows tax free and allows for tax-free withdrawals in retirement. The employer contribution however, is always traditional, meaning it has upfront tax deduction and is taxed upon withdrawal in retirement. The income limits and contributions are otherwise exactly the same as with a solo 401(k).

3. SEP-IRA

SEP IRAs are available for a variety of small-business types, including sole proprietorships, partnerships, limited liability companies, S corporations and C corporations. The plans can be an especially attractive option for a small business with few employees. The maximum contributions are exactly the same as with a solo 401(k) for a high income, except that they come from the employer, not the employee. The result is that you actually need a higher income to max out a SEP-IRA than a solo 401(k). Also having a SEP-IRA complicates your ability to do a Backdoor Roth IRA if you’re income is too high to qualify for Roth IRA contributions because of an IRS rule called the Pro-rata rule. You can read more about SEP-IRA here.

4. SIMPLE IRA

SIMPLE is acronym for Savings Incentive Match Plan for Employees. It is a less expensive, less hassle alternative to a typical 401(k) for a small business (<100 employees). The contribution limits are much less than that of solo 401(k) (for 2018, the limit is $12,500). It is extremely easy to open a solo 401(k) plan these days that there is little reason to use a SIMPLE IRA if you have no employees.

Other IRAs

Spousal IRAs (traditional or Roth) require only a marriage certificate and sufficient income to make both contributions for yourself and your stay-at-home spouse. If you are >50, you get the catch up contribution too.

Rollover IRAs is when you roll over your 401(k), 403(b), 457 or other employer-based defined contribution retirement plan to an IRA.

Stretch IRAs is when you stretch your Roth (or traditional) IRA over generations, potentially leaving a great legacy for your heirs down the line. When you combine the magic of compounding with tax-free growth and a healthy disinclination to spend, truly amazing things are possible, all for a mere $5,500. It is possible to invest only $5,500 and stretch over generations over the next 150 years and leave behind billions of dollars. See how it works here.

Nondeductible IRAs are simple the traditional IRAs without the initial tax break. Your money still grows tax-free and when you eventually withdraw the money at retirement, the earning are taxed at your marginal tax rate. Your original contribution is not taxed again. Nondeductible IRA is the first part in the Backdoor Roth IRA strategy for those limited by income to contribute directly to a Roth IRA (the 2nd part is converting the money in the nondeductible IRA to a Roth IRA).

In conclusion, the above is just a summary of the basic retirement accounts with which you can invest. However, when you have maxed out all the available retirement accounts and you still have extra cash to invest, you can open a taxable investment account and put in as much as you can. Bear in mind though, that taxable accounts do not grow tax-deferred like retirement accounts, so they’re not optimal for long term growth. You have to pay taxes on interests and dividends from all investments in your taxable account annually and capital gains distribution from mutual funds. When you realize a gain on the sale of an investment in a taxable account, you also have to pay capital gain taxes.

So it makes sense to open a taxable account and fund it, only if you have maxed out all the available retirement accounts available to you.

In the 2nd part of this series, I will discuss the various investments you can put in these retirement accounts (baskets).

Do you have a retirement plan at work? Are you maximizing it? Do you have a Roth IRA? If not, why not? Comment below.

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