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 Beyond Your 401(k): Matching Your Money to Your Goals by Carrie Schwab-Pomerantz, CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc. January 17, 2008 Dear Carrie, My husband and I are 30 years old and we each contribute the maximum pretax allowable to our employer-sponsored 401(k) plans…. Our companies allow us to make after-tax 401(k) contributions beyond the $15,500 pretax allowable and I am wondering if you recommend doing this. What are the pros and cons of these additional after-tax 401(k) contributions? We do not qualify for a Roth IRA, we will be debt free in one year when we finish paying off student loans (we still have a mortgage), and we hope to start a family soon, as well. Other options for investing would be paying extra money toward the mortgage, opening taxable investment accounts, or even purchasing whole life insurance…. We also contribute to an "emergency fund" monthly which is a savings account with 5% interest rate, so that we have some easily accessible money in case of an emergency. Thanks for your advice! —A Reader Dear Reader, What an impressive couple! You're only 30 years old, you've got most of your working life ahead of you and, from the sound of it, you've made a terrific start on building wealth to fund your retirement. Equally commendable is the fact that you are thinking seriously about your financial challenges now. Too many people in their 20s and early 30s are sticking their heads in the sand about issues such as retirement—and this is a serious mistake. Now, let's dig into your actual situation and I'll give you some food for thought. You don't mention any exact figures, but if you're both able to put the maximum into your 401(k) plans now—and you continue to do so over your working lives—you should amass a substantial retirement fund. Whether that amount will be sufficient, of course, depends on the lifestyle you want to achieve. So where to put additional savings? As I’m sure you know, one of the most powerful benefits of 401(k) plans is the fact that most contributions are made with pretax dollars. If you're in a 28% bracket, a $1,000 investment only "costs" you $720; pretax dollars mean your savings go further. And if you add in an employer match, the deal is even sweeter. Once you no longer get that benefit, a 401(k) may not be the best place for you to place additional savings for a couple of reasons. First, you're locking that money up for a very long time. In your case, you would not be able to access it for at least 29 ½ years (you can start taking distributions penalty free at the age of 59 ½). The other issue is taxes on withdrawal. We can't forecast what future tax laws will be, but under current regulations all withdrawals from qualified retirement plans are taxed as ordinary income. So even though you do have the advantage of tax-deferred growth while your money is invested, you give up the ability to withdraw funds at the (current) long-term capital gains rate of 15%. For a lot of taxpayers, that's a significant issue. So for these reasons, I recommend thinking about two possibilities:
A second possibility is a nondeductible IRA (if your income is too high to qualify for a Roth IRA, you also wouldn’t qualify for a deductible IRA), primarily because a tax law change will allow you to convert that IRA into a Roth IRA in 2010. The ins and outs of this conversion are a bit complicated, but I can refer you to an excellent detailed article by Rande Spiegelman, “Is a Roth IRA Right for You?” An additional thought is that because you are already building substantial retirement funds through your 401(k)s, it might make more sense for you to funnel your additional savings into a taxable account, thereby further diversifying your portfolio. Deciding how to invest As with any investment portfolio, how you actually put the money to work will depend on your goals, your time horizon, and your tolerance for risk. Your actual investment choices will depend on all those factors, but if you decide to go with a taxable account, you may want to consider using tax-efficient instruments: stocks with the potential, for example, to generate long-term gains or stock funds that don't have a lot of short-term turnover (which could potentially generate investment income taxed at your current marginal rate), and/or stocks or funds that pay qualified dividends. (Most corporate dividends are "qualified" for tax purposes while real estate investment trust dividends, for example, are not; your financial advisor can help you find appropriate stocks or funds.) You'll also want a high degree of diversification, which at the beginning could mean low-cost mutual funds or exchange-traded funds. You can make investing in a taxable account as easy and automatic as your current payroll deductions for your 401(k) plan contributions: just arrange an automatic transfer from your checking account into your brokerage account. You can even have these transfers directed automatically into a fund or a set of funds. The opportunity cost of your emergency fund I was also pleased to read that you've been diligent about building an emergency fund. That’s great; everyone should have access to some “rainy day” money stashed away in a safe and liquid account. My only caution: Don't over-fund this account as you are giving up some potential return in exchange for that safety and liquidity. How much should you keep in your emergency fund? Conventional wisdom says three to six months' worth of living expenses is ample. You might go a bit higher if you fear a layoff or a downturn in your industry. Other options You mention two other possibilities: investing in a whole life insurance policy, which combines a life insurance benefit with an investment component, and paying off your mortgage. Whole life policies are generally expensive, and while they have some utility (e.g., for estate planning), in my view they aren't usually the best way either to get insurance or to invest. Instead, think about term insurance (which you might want now, but should definitely have once you have children), and you can build your own investment portfolio at the same time. As for paying off your mortgage, that's depends a lot on the size and terms of your loan. In recent years many homebuyers committed themselves to hefty monthly payments with the potential to adjust even higher. But if your payments are manageable (now and in the future), it comes down to how your mortgage interest rate (i.e., after considering the tax deductibility of the mortgage interest payments) compares to the rate you think you can earn in the markets. Finally, I know you haven't started a family yet, but given that you have excess cash, you're in an ideal position to start investing for your kids' college education as soon as they are born (well, as soon as they have a Social Security number). Consider opening a 529 plan or other college savings account once you become parents. That's a great way to put your savings to work—the ultimate investment in the future. All things considered, I'd say you definitely deserve a pat on the back for your diligence and foresight—and for your aggressive approach to saving and investing. Frankly, I wish more people in their 20s and 30s would embrace long-term financial challenges like retirement; you're in the best position to take advantage of the long-term growth potential offered by well-constructed and diversified investment portfolios. Keep up the great work and good luck with your investing future. Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling 800-435-4000. Please read the prospectus carefully before investing. Investment value will fluctuate, and shares, when redeemed, may be worth more or less than original cost. Exchange-traded funds are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. As with any investment, it is possible to lose money by investing in a 529 Plan. Before investing, carefully consider the plan's investment objectives, risks, charges and expenses. Additionally, before investing in a 529 Plan outside of the state in which you pay taxes, you should consider your own state's 529 Plan to determine if you can obtain any tax or other benefits offered by your own state's plan. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction and investment strategy for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past performance is not a guarantee of future results. Investment strategies such as diversification do not ensure a profit and do not protect against losses in declining markets. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. (0108-3911) Return to Top |
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