Investment Vehicles

Which investment vehicle should I use?

Now that we know how much we should be able to save every year let us look at the different investment vehicles that are available. There are only a few different options for where to invest so let’s run through them quickly.

401K/403B: Many employers offer a 401K or 403B plan, with 401K plans offered by for-profit companies and 403B plans offered by non-profit and government employers. Both account types have the same rules and limits. There are no income limits for making contributions, but as of 2020 employee contributions are limited to $19,500 if you are under 50 and $26,000 if you are 50 or older. Employers also typically contribute to these plans, and for 2020 there is a combined employee/employer contribution limit of $57,000 if you are under 50 and $63,500 if you are 50 and older. The IRS revises the contribution limits on an annual basis and has been increasing the limits by roughly $500 per year.

Contributions to a 401K or 403B are typically made on a pre-tax basis, with your contributions lowering your taxable income for the year, providing an attractive benefit. Account values grow tax-free and are taxable when the money is withdrawn in retirement. To make withdrawals from your account, you must be age 59.5 or older, although there are a couple of exceptions for financial hardship and for a first-time home purchase. You are also required to take distributions once you reach age 72. 

Some employers also offer a Roth 401K or 403B which has the same contribution limits and distribution rules, but contributions are made by the employee on an after-tax basis. In this case, you would not get a tax benefit now, but your contributions would grow tax-free and then are withdrawn tax-free in retirement. 

IRA’s: There are several different types of IRA’s, Traditional, SEP and Roth. For W-2 employees you may be able to set up a Traditional or Roth IRA depending on your income, as we will discuss. A SEP IRA is offered by employers and can be set up for sole proprietors as well as for corporations. Unfortunately, there are income limits to contributing to an IRA. For 2020 you can make a full contribution if you are income is below $124,000 and a partial contribution if your income is between $124,000 and $139,000. If you are married and filing jointly you can make a full contribution if your income is below $196,000 and a partial contribution if your income is between 196,00 and 206,000. For 2020 the contribution limits are $6,000 if you are below age 50 and $7,000 if you are above age 50. The withdrawal rules are the same as for 401k’s/403B’s, you can withdraw without penalty once you hit age 59 and a half and you are required to take distributions once you reach age 72. 

Traditional vs. Roth

If your employer offers both a Traditional 401K and a Roth option, you have an important decision to make. Tax rates will likely be higher in the future as income tax rates are currently at their lowest levels since the early 1930’s as shown in the chart below and the U.S. Federal government’s budget is in a massive deficit. Marginal tax rates were as high as 94% in 1944 and 1945 and remained at 50% or higher until 1987. 

top marginal tax rate

Source: Tax Policy Center

You know what your marginal tax rate is now, but not what what your average tax rate will be when you retire. So how should you allocate your contributions? The chart below shows my recommendations based on marginal tax rates in 2020.

The best retirement vehicle for most people to contribute to a Tradiational IRA or 401K. I believe most financial advisors are misinformed on this topic, as most recommend contributing to a Roth 401K regardless of tax bracket. The higher your current marginal tax rate, the lower the chance that your average tax rate in retirement will be as high. If you are in the 22 or 24% marginal tax bracket, I would lean towards contributing to a Traditional 401K, but you should make the decision based on your expected income in retirement. If you plan on a modest retirement lifestyle with a lower income, then you would opt for a Traditional 401K now. Likewise, if you expect to have a high income in retirement then a Roth 401K would be the better choice. Traditional 401K/IRA’s also give you more flexibility, as you have the option to roll them into a Roth 401K/IRA in the future and pay the corresponding penalty. 

top marginal tax rate

Emergency Funds

Before moving on I want to highlight that you should contribute the full allowable amount to both your 401K or 403B and IRA due to their substantial tax benefits before contributing to a brokerage account. Additionally, you should make sure to have an adequate emergency fund of cash held in a checking or savings account. Opinions on how much cash to hold vary by financial advisor. The generic advice given is to hold 6 months’ worth of cash. However, as with every topic in personal finance the answer should really be it depends. Please see the chart below for my recommendations based on various circumstances. 

top marginal tax rate

The reason why I don’t recommend 6+ months of cash in an emergency fund is due to the high opportunity cost of holding cash in this low interest rate environment. The depressing chart below from J.P. Morgan Asset Management shows that currently a savings account with a $100,000 balance would earn $280 in interest for the entire year! This compares to $4,510 of interest income earned as recently as 2006 and close to $5,000 in 2007. As a result, holding excess cash in a checking or savings account above potential emergency needs is a poor financial decision.

cash account returns

Source: J.P. Morgan Asset Management

Brokerage account: After maxing out your tax advantaged retirement accounts you will need to contribute to a brokerage account, otherwise known as a taxable investment account, to be able to retire before age 59 and a half. Brokerage accounts can be set up through most major banks and online brokers such as E*TRADE, TD Ameritrade, or Charles Schwab. There are no contribution limits for brokerage accounts and a wide array of investment options are generally available. Additionally, you can access the funds in your brokerage account at any point in time without any penalties or fees.

However, brokerage accounts do not provide any of the tax benefits of a 401K or IRA. Contributions are made on an after-tax basis and you will need to pay capital gains taxes on any gains if you sell your investments. Any investments that are sold at a profit will subject you to capital gains taxes. If the investment is held for more than a year you are subject to Long-term capital gains tax and if held for less than a year than you are subject to short-term capital gains tax. Current Long-term capital gains tax rates are shown below. Short-term capital gains are levied on any sale of holdings less than a year and are taxed at your federal marginal tax rate whether you are a single filer or married, filing jointly. Short-term capital gains taxes are set at a higher rate to incentivize long-term investing and disincentivize short-term trading. 

top marginal tax rate

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