Investing 001: 401Ks, IRAs, and Roth IRAs

You might be asking yourself, how should I be investing? What are the differences between 401K, IRA, and Roth IRA? What funds should I invest in? These are the types of questions family members and friends would ask me ever since I started working at a Financial Services Company. I am not a Certified Financial Planner (CFP), so I want to share my experiences with these investment vehicles. Make sure you consult your CFP and/or CPA for tax planning and investing advice specific to your goals and needs.

401Ks
There are different types of 401Ks (Traditional, Solo, Simple, Roth), but I want to talk about traditional, as that is the most common option available through your employer (Note: you will probably not have this option if you are a contractor receiving a 1099 form). A traditional 401K is an employer sponsored deferred investment vehicle in which employees can allocate funds from their paycheck before taxes are calculated. This means that taxes on any contributions and gains in the 401K are deferred (not eliminated) until a later period (usually retirement or withdrawal).

Typically, employers will work with investment management companies such as Vanguard, Charles Schwab, and Fidelity (to name a few), to create a plan that is suitable for their employees and offers the most benefits. Once you sign up to participate in the 401K plan, you will be given an account with an investment management company where you can select mutual fund allocation (I will post another blog on my asset allocation and reasoning).

These funds remain with the custodian bank and accrue contributions, gains, dividends, etc. until it is time for withdrawal (early or retirement) or some plans may allow for loans. There are pros and cons to investing in 401Ks:

Pros: 
-Lower your tax liability
-Defer taxes on gains and dividends
-Employer matching (depends on the employer)
-Shelter from creditors
-Greater contribution limit compared to IRA ($18,000 in 2017)
-401K loans (Taking a loan and paying yourself back in principle + interest) for general purposes or for a downpayment on a property purchase

Cons:
-Restrictions on assets (early withdrawal penalty of 10% and taxes before age 59.5)
-Limited choices on asset allocation (mutual fund choices set by the employer)
-Vesting of employer matching/profit sharing
-May not realize tax liability reduction allotted to a traditional IRA

Overall, I believe 401Ks are a great tool to save early and often and lower your tax liability. My current strategy is to contribute to 401Ks to receive employer matching, contribute to a Roth IRA to the maximum amount allowed ($5,500 for 2017), and if I have any excess savings - make additional contributions to the 401K to lower my tax burden. Now lets talk about the IRA and why I believe maxing this out yearly is a great strategy.

IRAs/Roth IRAs

Some people may not even have the option of a company sponsored 401K. Thats why the government rolled out the IRA or Individual Retirement Account. As the name states, an IRA is designated to allow one individual to make tax deferred contributions (i.e. no co-mingling of funds for married couples). Below are some pros and cons of IRAs and information on Roth IRAs:

Pros: 
-Lower your tax liability
-Defer taxes on gains and dividends
-Low cost, easy to start - Companies mentioned above like Vanguard, Charles Schwab, and Fidelity are low cost providers who have excellent expense ratios and maintenance fees. I personally use Vanguard for myself and Charles Schwab for my wife.
-Many options to choose from - You can invest in mutual funds, other businesses, and even real estate (Self-Directed IRAs). SDIRAs are slightly more advanced, so I will cover this in a separate blog.

Cons: 
-Low Contribution Limits (See table below) compared to 401K
-Roth IRA may not be available depending on your marital status and income level

What is a Roth IRA?

Simply put, a Roth IRA is a non tax deductible contribution (using after tax money) to an investment account where the earnings can grow tax free (i.e. capital gains and dividends). See the full rules by clicking here: Charles Schwab Roth IRA withdrawal rules.

Planning is Key

Everyone's goals in life and retirement are different. Nonetheless, planning is key. Make sure you take action - December is the perfect time to plan for the new year.

I will wrap up this post by sharing a video from Ramit Sethi, author of the personal finance book "I will teach you to be rich."

Good Luck!