Should you save the majority of your funds in tax advantaged accounts?
This post started out as a comment on My Financial Journey, and it started getting out of hand, so I decided to write up my own post on the topic.
The question of the day: should you invest most of your savings in tax advantaged accounts. Most defined as having almost no savings outside your tax advantaged accounts.
Some useful background that comes into play is that you can withdraw 100% of your contributions to a Roth IRA without penalty. From what I can tell, the same is not true for your Roth 401k. I don’t know much about the Roth 401k, or anything really, so may be you can.
Let me take a moment to mention, if you take any information found on this blog as financial advice without doing your own research, running it by your accountant, tax lawyer, financial advisor, significant other and any higher beings you believe in, you are responsible for all damages to your mental and financial well being that may occur. I have no advanced training in anything, and lack enough knowledge to tie my own shoes. So please don’t take my advice on anything, especially financial matters.
Now I will continue dispensing useless advice.
Let’s say you contribute $4k to your Roth IRA every year for the next 20 years. Paint fumes and stock picking turns out to be your forte, so you are a billionaire at 45, ready to retire. You can take out $80k from your Roth IRA. In 2026, that will probably buy you a Honda Accord. What it won’t do is last you the 14.5 years you need until you can tap the rest of your retirement funds.
That sucks, so where do you put the money? You don’t want to pay taxes. No one wants to pay taxes. But you have to pay taxes unless you run Enron.
So places to consider investing for taxable accounts? How about ETFs? You are looking for investments that have a low immediate return and a high long term return. ETFs are a good vehicle, because you have a lot more control over the tax side effects vs. mutual funds, bonds and individual stocks.
Benefits of index etfs over mutual funds
You control when capital gains hits
You have a good idea what the dividend rate is going to be, and can plan better for it
Highly liquid and transferable
That is my initial suggestion for maintaining tax deference in a taxable account.
More importantly, there is a long list of reasons I think you want to keep that money available.
In the future, you may want to start a business and need capital. Your taxable account is something meaningful on your balance sheet when you go to the bank. This is helpful if you are looking into buying investment property, a running business or financing a new business. Maybe the business is small enough, and low risk enough that you could finance it as simply as writing a check against your margin account. Will the cost of college cost more than you can hide in a 529? Then there is that whole early retirement thing.
There are a lot of reasons why you would want easily accessible liquid assets. Having that available also opens you up to litigation as your assets grow. If you have a million dollars sitting in a taxable account, you are a target. Somewhere between now and then, you definitely want to make sure you are properly insured.
And finally, if you are going to be rich you have to have a taxable account. You can only put so much money into tax advantaged accounts per year. As your income grows, you will be able to put less and less percentage wise in tax advantaged accounts. Inheritance, lottery winnings, or any cash that might fall in your lap should also end up in that taxable account, because it won’t fit in the tax advantaged account. Most people solve that problem by buying a Porsche and playing rich for a year. Play rich for half a lifetime.
March 21st, 2006 at 9:26 am
You don’t mention index mutual funds. I think they are a great investment if you don’t have a lot to invest. They are not as liquid as ETFs but for long-term investments that shouldn’t matter. They do however have extremely low expense ratios. The Vanguard Total Market Index mutual fund has an expense ratio of 0.19%. And if you look at distributions they have not had a capital gains distribution in over 2 years, just dividend distributions. How do ETFs compare?
So let me qualify my statement that index mutual funds are great if you don’t have a lot to invest. I figure the average investor has a very small amount of money to invest each month. Let’s say you have $500 to invest every month. If you went the ETF route you would probably purchase $500 of a single ETF each month. This ETF might change from month to month to diversify. Assuming really cheap commissions of $7/trade you would be paying 1.4% in commissions. That’s awfully high considering the avg index fund expense ration is in the 0.20% range. I guess the question then is: “How much does it really cost you to buy $500 of mutual fund X?”. This part of mutual funds has always been confusing to me.
So another thing to consider is whether your employer will match contributions to your 401(k). If they do then it seems wise to at least put in enough to get the entire matching from them. If an employer will match 50% up to 6% of your salary can you really just let that money go? Let’s assume you make $100,000/year salary. You contribute 6% of your salary to the 401(k) and your employer will match that at 50% (some match 100%). That’s $3000/year you would be giving up if you did not contribute. We’ll assume that you are or will be fully vested for those contributions.
There are also various loop holes for getting your money out of a 401(k) (and maybe the same goes for IRAs too) before you are 59.5 years old without penalty. Here is the one that looks like it fits your “I’m super rich” scenario:
* You are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59 1/2, whichever is longer.)