Mutual Fun(d) Decisions: Part 3, IRA What?

Happy [belated] 4^th of July, Readers!

In honor of Independence Day, today, we’ll take a reader question, one that I’m sure more than one person out there has:

Dear Stock Market Chic,

Thank you so much for the great insights! My investing life will never be the same! Anyway, I know you’ve talked in previous posts about 401Ks, but I’ve also heard of IRAs and Roth IRAs. What’s the difference?

Signed,

IRA, what?

 

Dear IRA,

Thanks for your question! With so many different investment account acronyms out there, it can be confusing to get them all sorted, so it’s a great question.

A 401K is a retirement savings account sponsored by your employer. Money may be taken from your paycheck pre-tax to help fund it, and the percentage you want to contribute is typically up to you. Some employers require a certain amount; others don’t. Either way, you should save as much as you can. Generally, your employer will match your savings with a certain percentage contribution, too, but those funds may be off limits until the “vesting period” is over; that is, you might have to stay with your employer for a certain amount of time in order to actually get their end of the contribution.

 

There are limits to how much you can contribute in a year, though. The cut-off varies year to year, but is normally somewhere between $15,000 and$17,000, which is a lot to set aside anyway. You decide how to invest your 401K assets, and none of it is taxed until you take it out of the account. BUT there is a 10% penalty tax if you take the money out of the account before you’re 59 ½ years old, on top of the income tax you’d get socked with (there are some legitimate reasons to not get penalized, though, but they are few and far between). So, to that end, leave your 401K there until you’re ready to retire, or roll it over into an IRA.

For more info on 401Ks, click here.

An IRA, or individual retirement account, is another type of retirement savings account, but is not associated with an employer. You can open an IRA at your local bank or credit union. This account is commonly known as a “traditional” IRA, as opposed to a Roth, which we’ll discuss in the next section. The biggest thing to know about traditional IRAs is that they are tax deferred, so you don’t pay any tax on contributions now, but you will when you withdrawal the funds during retirement.

Let’s say you have a 401K at your current job, but you plan to change jobs soon. You can either keep the 401K where it is or you can roll it over into an IRA. The latter option allows you to keep contributing to it, tax-deferred. The more you can shove into a traditional IRA or 401K now, the lower your taxable income will be, but contribution limits are considerably lower for IRAs, so don’t think you’re getting over on the IRS. In 2013, it’s $5,500 ($6,500 if you’re over 50).

For more info on traditional IRAs, click here.

A Roth IRA is almost the exact same thing as a traditional IRA, except that you contribute to it with after-tax income. Since you’re paying The Man now, you don’t have to pay him in the future! You might still be subject to a penalty when you withdrawal the funds, though, depending on your reason for taking the money out.

That said, there are strict income limits on Roth contributions, but most people qualify easily. Maximum contribution also has a bit of a low ceiling, at $5,000, but you can contribute to a Roth even after you’re retired.

For more info on Roths, click here.

I hope that clears things up a bit! I’m happy to take more questions!

Wishing you rich returns,

Vonetta

401K/403B Mutual Fun(d) Decisions: Part 2, Fund Allocations

*My apologies for the brevity of this post. I’m feeling terribly under the weather (thanks, DC, for being 80 degrees one day and 40 the next). More on this topic to come.

Now that we’ve gotten what fees and expenses to look for out of the way, it’s time to talk actual funds. Please note again that I am not an investment professional (yet!) and can only educate on the types of funds out there. I’m not selling funds until I get some commission. ;)

For starters, you already know about equity (or, stock) funds and bond funds. (More on bonds in a future post.) Depending on the financial advisor, advice will range from “go 100% equity” for young people to “keep it 50/50 stocks/bonds.” As stated in previous posts, your choice depends on your risk tolerance, but know that risk aversion, or a very high allocations to bonds, can lower your returns potential over time.

That said, look for stock funds that have the broadest range of stocks possible, like an index fund that reflects the S&P 500 or Wilshire 5000. If you find an index fund that has every stock available (more than 5,000), go for it, for maximum equity diversification.

Next, throw in a good mix of U.S. Treasury, and maybe corporate, bonds. The longer the maturity, or length of time until you get the principal amount back, the higher the yield, to compensate you for the risk you’ve taken of giving your money to the government for such a long time (the longest maturity available for U.S. Treasury bonds is 30 years). 

Don’t forget international stocks and bonds! They provide great diversification to a U.S. investor’s portfolio. 

I recommend finding index funds for all of these asset classes. If you have to go with an actively managed fund (as you would have to do for bond funds), go with one with low fees and high ratings on Morningstar.com, a well-respected finance research website.

401K/403B Mutual Fun(d) Decisions: Part 1, Expenses

Anyone my age or younger will probably never know what a corporate pension looks like. And, sadly, Social Security will have likely run out by the time we retire. So, saving for retirement is a burden we bare all to ourselves. Employers try to help by offering 401Ks or 403Bs, but this gets overwhelming when there are typically approximately 80,000,000,000 mutual funds and ETFs to choose from.

How do you know a good fund from a bad one?
What the hell is the difference between a "core value" fund and a "large cap blend" fund, anyway?
Should you go for gold, just because a metals and mining fund is available?

Don't pull your hair out over your 401K. Remember that it's there to help you. Over the next couple of posts, we'll talk through some high-level details to consider when selecting funds for your portfolio.

--

One of the biggest things to keep in mind are fees and expenses. These dollars can set the best of funds apart from the worst because of simple math: the more you pay in fees, the more your investment has to return to make up for those fees. God only knows that you don't want to just go around giving your money away for free. So, here are some brief explanations of the fees you'd typically see from mutual funds.

Mutual funds will typically have 4 types of expenses: operating expenses, a front-end load, a back-end load, and a 12b-1 fee.

Operating Expenses
Operating expenses are costs necessary to run the fund. Fund managers have to pay electricity bills like the rest of us, plus employee salaries. Operating expenses are generally hard to get around because they're just a part of doing business.

These fees can be as low as .06% (also known as 6 basis points) of invested assets and as high as 1.5% or greater. Index funds generally have the lower fees, as it doesn't take as much work on the part of the fund manager to run the fund, since it is supposed to just be a reflection of an existing stock or bond index. You might also see this style of investing called passive management. It's sister, active management, is much more expensive. Actively managed funds are typically trying to outperform the overall market or a certain index by investing in specific stocks. In order to do that, fund managers are much more involved in the fund, handpicking stocks or bonds. As a result, these funds wind up being much more expensive; unfortunately, they don't always meet their goal of beating the market, either, meaning that investors are charged more for worse performance, potentially. 

My advice to you is to go for a passive index fund that will reflect an index like the S&P 500, or even better, every stock in the market (more on that next week) for lower expenses.

Loads
Now, the front- and/or back-end loads, on the other hand, are not so necessary. A "load" is basically a sales fee charged to you when you first buy the mutual fund ("front-end" load) or when you sell, or redeem it ("back-end" load). Then there are no-load funds, mostly from a company called Vanguard, which is extremely well respected in the finance community.

These expenses can run from 0% to 8.5%. The load is especially important to note because it can be total robbery of your investment. When you pay a load, especially a front-end load, you really are just giving your money to a fund manager and not asking for it back. You do expect for the return on your investment to be greater than the load, but you've put yourself farther in the hole from the start.

Example from my own life (glad I learned these things the hard way, so you don't have to!). When I switched jobs to my last job before business school, I rolled over my previous 401K into an IRA (we'll talk about those later, too). I was curious about active management, so my retirement advisor at my bank recommended that I go with a Goldman Sachs fund that had a 5.25% load. I started with about $4,000. After the load, I was only investing $3,800. I needed the fund to return me my $200 (AT LEAST), plus the 1.25% annual expense.

Let's just say, after the market spun itself around in 2010 and 2011, I was lucky to finish right back where I "started," with $3,800. I could have lost much more. But had I invested in an index fund that reflected the S&P 500 with a no-load fund, I would have gained about 15% over that same time period. You live and learn.

12b-1 Fees
12b-1 fees are optional fees the fund can charge so investors pay for part of the fund's advertising costs. Funds do charge them, but again, if there's no need to just give your money away and dig yourself further into a hole, don't do it.

--

So, now you know some the key expenses to look for when selecting a mutual fund. (Remember to go cheap!) Next week, we'll look at some of the types of funds that will help you diversify and grow your retirement savings.