Week 6: Retirement Savings Accounts – 401(k)s and IRAs
Last week we discussed how to easily build a winning long-term strategy using low-cost index
funds. We also briefly touched on an alternate strategy that Sound Mind Investing uses called
“Upgrading.” Whether you use one of these strategies or any other, your next step is to
determine the most advantageous place to implement that strategy.
The best time to start saving for retirement is now. That’s true whether you’re 55, 45, 35, etc.
Compound interest has been called “The 8th Wonder of the World.” The principle is simple —
each dollar you invest makes money, and each of those dollars makes money. The key
ingredient to making compound interest work for you is time.
Consider this example:
When Smart Sallie is 22 she starts saving $300 a month in an account that earns 10% per
year. She does this for six years, stopping when she is 28 and has her first child. Over
those six years, Sally contributes a total of $21,600. She never contributes another cent,
but the money continues to grow at 10% per year until she retires at age 65 with a
Slow Sam takes a little longer to get going, because there’s just so much fun stuff to buy!
He starts saving at age 31, just nine years later than Sallie. Sam also contributes $300 per
month and earns the same rate of return. The difference? He has to makes those
contributions every month until he retires at age 65 to wind up with the same million
Smart Sallie got the compound interest curve working for her early, and as a result only
contributed $21,600 over six years. Slow Sam contributed $126,000 — almost six times as
much! —over 34 years to reach the same end result.
The point is simple: start saving whatever you can, as early as you can. Every dollar counts, and
so does every year. A 35-year-old saving $200 per month will have $452,000 at age 65 if she
earns 10% per year. Waiting just five years longer to start at age 40 will require the monthly
savings to jump to $340 per month to end with the same amount.
Automate Your Investing with Dollar-Cost-Averaging (Chapter 19)
Key idea: Dollar-cost averaging a long-term, systematic strategy that calls for investing the
same amount of money at regular time intervals.
Most investors who earn poor returns over the long haul are victims of their own emotions.
When the market falls too far, they bail out. Then they typically don’t get back in until things
have been improving for some time. As a result, they often “sell low” and “buy high.”
To avoid this common problem, you should “automate” your investing. One helpful approach
is called “dollar-cost averaging.” This simply means that you invest the same amount of money
at regular time intervals over many years, no matter what the market may be doing at any given
time. (What’s the most common example of this for most people? 401(k) contributions.)
Dollar-cost averaging frees you from the worry of whether you’re buying stocks at the “wrong”
time. Your constant-dollar investment means that you buy more shares when the price is low
and fewer shares when the price is high. Dollar-cost averaging makes it easier for investors to
overcome their fears and their tendency to procrastinate and actually follow through on their
(Example: Mutual Fund selling at $50 per share a year ago. If you invest $100 every month, a
year ago your contributions would have bought 2 shares per month. After the market declines
33%, those shares are now priced at $33 each, so your $100 buys 3 shares rather than 2. This
allows you to buy stock/mutual funds “on sale” when the market declines, accumulating more
shares at lower prices and fewer shares at higher prices.)
Retirement Accounts – Two Main Types
Key idea: Most work-based retirement plans require that each employee makes important
investing decisions. An Individual Retirement Account (IRA) requires even more personal
There are two basic types of retirement accounts in the U.S. One is a “defined benefit” plan; the
other is a “defined contribution” plan.
With a defined benefit plan (sometimes called a “company pension”), the amount of your
retirement benefit is pre-determined by your employer. Employees usually have no control over
how money in these plans is invested.
With a defined contribution plan (such as a 401(k)), the amount of your retirement benefit is
determined by the investment performance of contributions made by the employee (these
contributions often are matched by the employer). Employees usually have at least some control
over the investment choices in these types of plans.
Over the years, Congress has created several varieties of defined contribution plans, including
the 401(k), the 403(b), the SEP-IRA, and the Roth version of the 401(k) and 403(b). (The numbers
and letters refer to sections of the tax code.)
In addition to these company-sponsored plans, you can set up your own “individual retirement
account,” known as an IRA.
These various types of accounts are not “investments” themselves. These account types simply
“set the rules” and offer certain tax advantages.
If you have a defined contribution plan at work, you will have to choose among the various
investments offered by our employer. In addition, you will to choose the amount you wish to
Selecting investments for an IRA is similar, but you will have many more investment choices
available. You can think of an IRA as “personal pension,” for which you have to make all the
Review company-sponsored (401k) vs individual retirement account (IRA)
Traditional vs. Roth IRAs
Very simply, the choice of a Traditional IRA vs. a Roth IRA comes down to a decision whether
to take your tax benefits now or take them later.
Traditional IRA – Contributions can be “deductible” or non-deductible, based on your income.
With a deductible contribution to a Traditional IRA, you get a tax benefit the year you make the
contribution. In other words, you might make a $1,000 contribution to the IRA, then get a $150
tax benefit on your taxes that same year. Sweet! Your money then compounds on a tax-deferred
basis, meaning no taxes are due until you begin to withdraw money from the IRA. The
downside is that when you reach retirement and start taking money out, you will owe tax on all
of the money as you withdraw it, both your original contributions and all the gains they have
generated. This is how traditional 401(k) plans operate as well.
Roth IRA – Your contributions are made with “after-tax” income, so you get no tax benefit from
your contributions initially. But the advantage is that when you take your contributions out in
retirement, all the money coming out of your Roth IRA comes out completely tax free!
The key question to determine which IRA you should opt for, assuming both are available to
you, is whether you expect your tax rate to be higher in retirement than it is presently.
Most people have lower income in retirement than they do while they are working. As a result,
they would rather get a tax benefit now when their tax rate is higher, and pay tax on the income
in retirement, when their tax rate is lower.
However, if you are starting to save at a relatively young age, the prospect of getting many
years of tax-free growth is very appealing. Also, many people expect tax rates to rise across the
board from today’s levels (for a variety of reasons). If that happens, paying tax at today’s levels
and escaping tax in the future may be a good deal.
Rules, rules, rules
In exchange for these tax benefits, you agree to certain rules with IRAs (and other retirement
You agree to leave the money in the account until you are at least age 59 ½
With a Traditional IRA, you agree to start pulling money out no later than age 70 (this
restriction does not apply to Roth IRAs)
Penalties for not doing either of the above are steep, so only put money in an IRA that
you expect to be able to leave alone until retirement. One big exception — Roth IRA
contributions may be withdrawn without tax or penalty (but not any earnings in the
Contributions are limited to $5,000 per person, per year. Those age 50 and older can
contribute an extra $1,000 per year. These amounts change
Unfortunately, not everyone is eligible for every type of IRA.
Where to set up your IRA?
The best place to set up your IRA depends on what strategy you’ll be pursuing.
For indexing, setting up your IRA directly with Vanguard makes sense. They charge nothing to
buy and sell their Vanguard index funds when your account is set up directly with them.
For Upgrading, your choice depends on whether you will be upgrading on your own or
investing in one of the SMI Funds (where the Upgrading is handled for you).
Discount brokerages (also known as “Fund Supermarkets”) are attractive for those who want to
upgrade on their own. They also are attractive if you want to use multiple strategies. Discount
brokerages allow you to buy stocks, bonds, and mutual funds from many different fund
families from the convenience of a single account. Charles Schwab, Fidelity, and TD Ameritrade
are all good options, each with their own pros and cons. (See the March 2008 Cover Article at
www.soundmindinvesting.com for in depth coverage of these pros and cons, as well as
assistance determining the best discount broker for you.)
The SMI Funds are available through the discount brokerages, but you’ll pay a transaction fee
each time you buy or sell them. To avoid these transaction fees, you can set up your IRA
directly with the SMI Funds. See www.smifund.com for details.
Because no one can know the future, no portfolio of investments can be perfectly positioned to
profit from upcoming events. Instead, you should develop a plan that realistically faces where
you are now, looks ahead to your goals, and has a high probability of fulfilling those goals
within your desired time frame.