IRA, 401K, IDK: The Decision Process
If you are new to investing, the number of retirement account options that you can deposit money into can be overwhelming. You see articles about brokerage accounts, 401Ks, and IRAs. Meanwhile, your friend keeps talking about how much money he made on Nikola, the next Tesla. Anyone can get lucky on a random stock, but building a high net worth over the long run requires a sound decision process and a well-thought-out plan.
As you start constructing your plan, you might begin with the 401K. That is, until your employer hands you a 50 page packet that goes into all the nitty-gritty details. Nobody has time to read 50 pages of material that is about as interesting as a Merriam Webster’s dictionary. As any individual in the 21st century, you will likely move onto Google for assistance. Before you enter this rabbit hole, I highly suggest you get a firm grasp of the terminology and the important underlying themes in this decision process.
Terminology
- Dividends- a share of profits paid to a stockholder (e.g. Disney paid $0.88 per share to its shareholders on 01/16/2020)
- Broker- is an individual or firm that charges a fee or commission for executing buy and sell orders submitted by an investor
- Tax loss harvesting- the selling of securities/stocks at a loss to offset a capital gains tax liability
Key Descriptors
- Tax-advantaged- an account with tax advantages that can lead to higher growth over the long term because they are only taxed once, upon entry or withdraw; typically, have penalties for early withdrawals
- Taxable- an account that taxes dividends received each year, allows tax-loss harvesting, and taxes the sale of an asset
- “Roth”- roth accounts have tax advantages where the contributions are taxed as they enter the account, but never taxed after that
- “Traditional”- traditional accounts have tax advantages where the contributions are pre-tax as they enter the account and only taxed once the funds are withdrawn
Retirement Account Options
- Brokerage account- an investment account that you open with a brokerage firm, could be taxable or a tax-advantaged account
- 401K- a tax-advantaged retirement account that is sometimes offered by your employer, to which the employee and employer contribute towards
- 403B- a tax-advantaged retirement account for certain employees of public schools and tax-exempt organizations
- IRA- an individual retirement account funded by individuals with tax advantages
The basic differences in these account options can easily be found all over the web, including this IRA vs. 401K article or this Roth vs. Traditional discussion. However, most of these websites will ignore the most important element of any retirement plan, uncertainty. As a statistician, I am constantly making decisions under uncertain conditions. My thought process for how I allocate my contributions to these retirement accounts is constantly evolving, but it always revolves around the following themes.
Themes
Flexibility
In this context, I define flexibility as the ability to withdraw funds from the account for any reason and without a penalty. Some of these accounts allow you to withdraw funds whenever you want, while others will penalize you for withdrawing funds before retirement. In a world of uncertainty, you cannot plan for an unexpected, large medical expense just around the corner. Neither can you plan for a real estate collapse that presents perfect timing to purchase a house at a huge discount. A brokerage account has funds that can be accessed at any time without penalty, while a traditional 401K penalizes you for early withdrawals. In a world of uncertainty, you need flexibility to withdraw funds if necessary.
Spending vs. Saving
Financial advisors, the FIRE crowd, and most online advice will constantly pressure you to contribute as much money as you can towards retirement (Ramit Sethi is an exception). While I agree that this is critical, it is important to consider the tradeoff of investing versus spending money now. There is a clear value to spending money today, even if it is hard to quantify. Traveling in your twenties presents limitless opportunities. You could hike a national park, explore cities without easy access to elevators, or try out sand surfing on a moment’s notice. Imagine trying to do these activities when you are older or retired. There is a loss of value and happiness to consider since your health may limit your options in life as you grow older.
Diversification
Don’t put all of your eggs in one basket. This famous idiom is always referenced because of its simplicity in depicting the importance of diversification. For investing, diversification is applicable via cap size, geography, risk, asset type, and retirement account type. In this context, we will focus on the latter. The account type is an important area to diversify because the tax rate on your assets over your lifetime is unknown. This rate is impacted by legislation, your income level, geographical location, marital status, and more. Even if you make realistic assumptions, there is a risk of the Government taxing assets that were supposed to be tax-free until you withdrew. Any Government that has fiscal problems will look towards taxes to increase their revenue. In 2015, Barack Obama attempted to tax college savings accounts, thereby removing any guarantee that a retirement account is completely safe. The simplest way to prepare for this uncertainty is to diversify the account types that hold your assets. If it is feasible, you should have assets in taxable, roth, and traditional accounts.
My Account Type Allocation
To show you that I am not all talk, below you will see the breakdown of where I hold my assets. My portfolio includes assets in taxable, roth, and traditional retirement accounts. It has 71 percent of its assets in tax-advantage accounts, while 29 percent is in taxable accounts. Recently, I have been considering purchasing an apartment. With a high allocation in my taxable accounts, I have the option of selling these assets to help with my down payment. What is not displayed here is my travel rewards credit card in case I want to splurge on a vacation with my friends or family. Living in the moment is important too!
Conclusion
Most individuals only have a small amount of funds available to invest each year. Therefore, it is critical to contribute towards the account(s) that maximize net worth and happiness. Your specific financial situation will shape a portfolio that could look very different than mine. If your monthly budget has little room to spare, you might prioritize an immediate tax break or an account with more flexibility. Maybe, your employer offers a contribution match. Then, your highest priority should be contributing to get the match. Each individual’s financial situation will be unique, but if you keep these themes in mind, you will have a happier and more secure financial future.