Financial planners occasionally squabble over whether or not to invest in a 401(k) or open a Roth IRA.  Most agree that passing up matching funds in a 401(k) plan makes little sense, so it’s probably best to start there.

After taking advantage of those matching funds by investing through the company match, it most advisers recommend investors turn to the Roth IRA to take advantage of tax free growth opportunities.  After that, you are on your own, and left with a lot of questions.  Do I return to the 401(k) plan and max out my annual contribution there?  Do I invest in company stock?  Do I park anything left over in cash, or single stocks?  Let’s take it one step at a time.

Invest In 401(k) Through Matching Funds

Let’s assume your company offers to match the first 3% of your annual salary if you contribute to the plan.  If you earn $50,000 a year, and agree to participate at a 3% contribution, your annual contribution amount will be $1,500.  Your employer will kick in another $1,500, bringing your total contribution each year to $3,000.  That $1,500 contribution from your employer is almost like free money (nothing is completely free – you will owe taxes on it when you withdraw it down the line).

Max Out Roth IRA Contribution For You and Spouse

If you are living frugal, and haven’t buried yourself in house and car payments, you can probably afford to kick in another few thousand dollars each year to saving for retirement. Assuming you are eligible to contribute to a Roth IRA, it probably makes sense to turn your investment dollars above your employer’s 401(k) match here.

Contributions to a Roth IRA won’t help with your taxes in the year they are made, but earnings grow tax free over the life of the investment.  If your $5,000 contribution this year turns into $40,000 by retirement, you get to keep all $35,000 growth tax free, assuming you withdraw after reaching retirement age, or for a narrow list of specified qualified withdrawals.

Another beauty of Roth IRAs investments is that Roth IRA contributions may be withdrawn at any time, without penalty.  So theoretically, you could park money in a Roth IRA to grow for three or four years, and then only withdraw contributions, leaving the earnings untouched and continuing to grow.

Max Out 401(k) Contributions or Taxable Investing

At this point you’ve invested in a 401(k) through the company match, and maxed out contributions to a Roth IRA for you and your spouse (if married).  If you still have money to invest for retirement you have a choice:  return to your 401(k) plan and invest up to your annual maximum contribution, or invest in non-retirement, taxable accounts.

The path you ultimately take here depends on your goals for the future, and your overall financial picture. Personally, I would begin to invest in low-cost, low-turnover, taxable investment vehicles such as a broad index fund.  I have plans to “retire” early from full-time employment, and to do so will need access to savings prior to the IRS-defined retirement age (currently 59 1/2). If I planned to work well past the currently defined retirement age, I would probably plow more money back into the 401(k) plan to lower my taxable income and defer those taxes to retirement.

If you do decide to invest in taxable accounts go with a low-cost brokerage such as Vanguard or Fidelity.  These brokerages are widely recognized as two of brokerages with the lowest expense ratios in the industry.  Inside those brokerages, look for mutual funds with low turnover.

Remember, each time an investment inside a mutual fund is sold or exchanged, or “turns over,” it is a taxable event.  Those taxes will be distributed to mutual fund owners at the end of the year, and can create quite a tax hit, even if your overall mutual fund performance is down.

If I had to pick one fund to invest in it would the Vanguard Total Stock Market Index fund, which owns a little piece of every stock listed.  As you can imagine, there is not a lot of buying and selling happening here, which minimizes your tax hit.  It is also about as diversified as one could get within the domestic equities market (the Total International Stock Index fund is the international investment equivalent).

Additional Resources:

• 2009 401k And IRA Contribution Limits
• Roth IRA Investment Account Basics
• Retirement Saving After 401(k) and IRA
• Find the best stocks to buy in today’s few hot industries
  

My daydreams about retirement have evolved over the years.  When I was younger I thought retirement meant spending most of the day on the fairways and the afternoons at the 19th hole. Or maybe trolling the waters of a big lake in a nice fishing boat sharing stories with an also-retired friend.  So saving for retirement was centered around these same activities.

Photo courtesy of danperry.com

When I got a little older my dreams graduated to a grand retirement played out in an expensive condo on the beach, or a million-dollar cabin in the mountains.  After I got a job, got married, and had two kids I quickly realized this idea of a luxurious retirement was not very realistic. My early ideas were shaped more by the movies than the real world.

Now that I’m a “thirty-something” (and old enough to remember the television show by the same name), my dreams for retirement are more centered around spending time with family. I’d like to do a little traveling (nothing glamorous, and mostly domestic), and spend some time working with young people by either coaching or teaching, or some combination. While my retirement plans are still a little vague, I am certain that I do not want to still be working in the corporate world in my old age.

To make my dream of financial independence a reality, I need to put a number on it, and devise a plan to hit that number in a reasonable amount of time.  Lots of theories out there on how to calculate your “number,” and depending on the formula used there is some fluctuation in the amount required. However, this is a case where being in the same ballpark is close enough for me, so I don’t overly concern myself with the math.

The 4% Rule

To demonstrate the 4% rule I’ll use a fictitious 30 year-old worker named Dan.  Dan works as a software engineer by day, and builds decks and fences on the weekends.  He earns $80,000 a year for his combined efforts. Ideally, Dan would like to reach financial independence at 50 years-old and spend his time modifying homes for those with disabilities – things like building wheelchair ramps, widening doorways, and similar accessibility features.  The service would represent a combination of his love for carpentry and a call to service Dan has wanted to fulfill his entire life.  What kind of nest egg would Dan need to pull this off?

The rule of 4% uses a couple assumptions, some of which are hard to justify in our current market conditions. In a typical market, it is not unreasonable to expect a 10%-12% annual return on a portfolio of stock market investments. That means you can safely withdraw 4% of your portfolio each year and not reduce your principal balance, even after accounting for inflation.

Anything earned above the 4% withdrawal and the rate of inflation grows your balance even higher (with the idea that you may have to increase withdrawals later to cover increased medical costs, insurance premiums, etc. as you get older).

To figure out the number required to maintain your current style of living, divide your current income by a factor of 0.04. In Dan’s case, maintaining an $80,000 yearly income would require a $2 million nest egg. But Dan is a frugal guy, and he and his wife plan to pay off the mortgage early – in their early 40’s. They buy older, used cars and trucks with cash, and have managed to pay off credit cards they ran up in their twenties.  They could easily live on $50,000 a year.

Running the formula again reveals Dan would only need $1.25 million to become financially independent.  He could withdraw a guaranteed $50,000 a year, or in years where his new business earned money he may not have to touch the nest egg at all.

Is 4% Too Much To Expect?

As I mentioned, the 4% formula uses some long-held assumptions about investments that may or may not be true in the coming decade.  I personally look for things to turn around in the next two years, but that doesn’t mean we’ll see a repeat of the “irrational exuberance” of the last 90s in the market. I think going forward investors will slowly have their confidence restored, but because it will take some time we can probably expect lower rates of return than in previous periods.

I also expect inflation to rise at a faster pace in the next few years.  Actually, I expect currency deflation to occur, but the net result is the same – future dollars will be worth much less than they are today.  The rise in inflation, coupled with lower expected yields from the market, mean it might be asking too much to expect to withdraw 4% from your nest egg without lowering your principal.

So What’s My Number?

My lifestyle lines up pretty well with Dan in that I hope to be living completely debt free by 50 – no credit cards, no car loans, and no mortgage.  If I can get to that point, my lifestyle needs will be fairly basic, and we could live very comfortably on $40,000-$50,000 per year (in fact, we could probably live on much less, but I’m being conservative here).

Reducing my expected withdrawal rate to 2-3% means I would need between $1.5 million and $2 million to live comfortably on $40,000-$50,000 a year.  I’ll split the difference and make my goal for financial independence $1.75 million.  Looks like I’ll need a few more side hustles.

Short post today as I’m home sick with a nasty bug.  Since I find myself at home on a workday, it reminded me of a great post I read at Bible Money Matters just yesterday on the subject of retirement.  Pete specifically asks, “Do You Ever Plan To Fully Retire?”

It’s an interesting question for a couple reasons.  “Retirement” means different things to different people, and that idea can change over time.  When I was a kid, retirement meant sitting on a lake fishing several hours a day, and basically being able to do whatever you wanted, whenever you wanted.  I suppose that is still true, to a certain extent.

Today my definition of “retirement” is centered more around continuing to find ways to contribute to causes you believe in, regardless of compensation.  In other words, I look forward to “retiring” from working for money so that I can begin working for something I believe in.  Not that I don’t believe in the mission associated with my current job, but let’s face it, most of us are not lucky enough to be able to wake up every single morning totally inspired by our 8-5 jobs.

At this point I’d like to turn things over to readers, and offer up the following question for discussion in the comments below.  What does retirement mean to you?

One of my shortcomings here at Frugal Dad is that I do not provide much investing advice, and when I do, it is fairly generic and focuses more on providing broad strategies rather than specific recommendations. I intentionally avoid the subject of in-depth investment advice for two reasons.  One, I confess to not being that smart on all the various investment types, and there are others out there with stronger backgrounds on the subject.  And two, I like to keep things simple.

Target Retirement Funds

Following that theme of keeping things simple, I have been able to assemble a very modest portfolio of well-diversified mutual funds in my 401(k) account and a Roth IRA. For the Roth IRA, I decided to give target retirement funds a try. Target retirement funds are basically a collection of mutual funds offered by brokerages to provide the right allocation mix based on your anticipated retirement date.  If I was working with short time horizon of say five years, I would select something like a 2015 targeted retirement fund which would be comprised of mostly conservative investments.

Since I have a few years (decades) to go to reach retirement, I selected a 2040 target retirement mutual fund. Who knows, I might not be ready to retire in 32 years, but when I am five to ten years out I want to slowly move towards a more conservative allocation to avoid losing all I’ve worked to save the 25 years prior.  Ideally, I would like for this to happen automatically, without requiring me to log in and make transactions to move funds to conservative investments, rebalance my portfolio, and manually change allocation percentages for new investments.  Target funds are designed to handle all of those chores for you. However, they are not a totally “hands free” investment strategy.

Do your homework before investing in target retirement funds.  Some have fee ratios higher than that of individual funds. Targeted retirement funds have one other potential drawback: they may become more conservative than your risk tolerance is at the predetermined life stage you are in.  For instance, if I am nearing 60 years-old, but love my job, am in good overall health, and would like to work another ten years, I might like to extend a more aggressive mix of equities to maximize growth potential.  That is not possible with money locked away in a targeted retirement fund.

It is possible to invest in a well-diversified mix of low-cost mutual funds on your own, and manage them accordingly as you near retirement. However, it might make sense to make a targeted retirement fund part of that portfolio to further your diversification even more, and give you one less thing to micro-manage related to finances.

TheWriter blogs over at The Writer’s Coin on all things personal finance and about the craft of writing.

So the markets are in a tailspin. If you have any money invested in the stock market, you’re probably not very happy right now. With all the panic and commotion going on, what can a regular investor do? If you’ve heard the advice to go out and buy more stocks right now because they’re so much “cheaper” than they were earlier in the year (and even last year), then you already know what to do.

The Roth IRA Debate

At the beginning of the year, there some debate online about how and when to fund a Roth IRA. I wrote about it at the end of June, claiming that dollar-cost averaging was the way to go. That means putting in a portion of the Roth IRA limit ($5,000 this year) throughout the whole year. 

But a lot of people thought that the best option was to fund the whole $5,000 right away. The reason? There were a few, but mainly it was to give their money as much time to compound as possible and to just get it all done right away and not have to think about it the rest of the year.

Well, the markets are WAY off their January numbers and it’s one of those rare times I get to look back at something I wrote earlier in the year and go, “I was right.” I just hope karma doesn’t come back to bite me in the butt.

If you put the whole $5,000 in your Roth back in January and invested in index funds (like the S&P 500), you’d have around $4,100 right now, that’s a loss of around 18%. But the worst part about it is that you can’t buy any stocks right now even though they’re “cheaper”! You’ve reached your limit and lost all flexibility. There is nothing you can do.

On the other hand

If you put $1,000 into the market in January, then in April, and then in July, you’d have around $2,641 left, a drop of only 12%. And you’d have the flexibility to put more money ($2,000) in at these lower prices, which would reduce your losses if the market keeps going down.

I know that we’re talking a few hundred dollars and, in the grand scheme of your retirement it’s not “that much.” But for me, my retirement is a big deal and if I can do a little maneuvering here and there to save me a few hundred bucks, that’s great. That’s another couple hundred dollars I can compound for 30-some years, and now we’re talking some serious money (around $25,000 compounded at 8%). And don’t forget that you’d be buying more stock at a lower price.

For those of you that find it more convenient (and you have $5,000 laying around in January) to contribute the whole amount right away, I won’t argue with you. But for those of you out there that like to squeeze every last penny out of important things like retirement accounts and that have the time to send money to your brokerage four or five times a year, dollar-cost averaging is a no-brainer.

A Marathon

Since it’s a retirement account, I know it doesn’t really matter how much money you have in your Roth today – you care about how much money you’ll have when you retire. It’s a marathon, not a race – so what happens over the course of one year shouldn’t be too important. But if you can do a little bit every year to make your overall returns that much better, isn’t that a good thing?

P.S. What if the market is going up, smarty pants? Well, then this whole argument needs to be re-evaluated. Maybe when the market is actually going up I’ll revisit that side of the coin.