Investing For Retirement: Beyond the 401K comments

By Wendy Mihm | April 11, 2011

If you’re like many people, you count on your employer’s 401k plan to handle your retirement investing.  And if you’re really smart, that plan is already set to take advantage of your employer’s matching contribution, if there is one.  If you’re not taking advantage of your employer’s matching contributions to your retirement fund, you need to get that set up immediately because it’s one of the biggest (and most ridiculous) mistakes you can make – it’s essentially giving away free money.

Find Out Now, Before It’s Too Late

Using your 401k plan, or other employer-sponsored retirement plan, as a primary vehicle to invest for retirement is perfectly reasonable. But whether it will be enough to fully fund the type of retirement many of us dream of is another question entirely.

You can’t know for sure, but you really should get informed about whether the path you’re currently on is enough, while there’s still time to do something about it.  One way you can do so is by using a calculator like the one we link to in our article called “How Much Will I Need to Retire?”  

Once you see what the numbers yield, you can sit with your spouse/partner and “Make a Financial Plan.” That will entail talking in detail about what kind of retirement you envision for yourselves, and how much you think that kind of retirement will cost you on an annual basis.  Can you pay for your lifestyle on $25,00 per year? $60,000? More?  When do you plan to retire?  How good is your health? Do you take care of yourselves now? How long do you expect to live? How much do you expect to pay each year in medical bills? Use the life expectancy calculator on our Power Tools and Resources page to make a guesstimate, then multiply the number of years you’ll be retired times your estimated cost of living.  That should give you a ballpark estimate of your retirement needs.  Now compare that with what you got when you plugged in your current 401k figures into the calculator we recommended up top.

Did you find a gap?

How To Fund The Retirement Gap

If there’s a gap there, read on to learn where you might want to consider investing beyond the 401k to fill that gap so you can fund the retirement you’re envisioning.

Consider Investing In an IRA

Experts typically recommend a couple of places to invest after the employee-sponsored retirement plan.  The first is the Roth or traditional IRA. The reason people love the Roth IRA is because of its tax advantages.  When you withdraw your money in your retirement years, won’t be taxed on that money, which is a pretty big deal.

The problem is not everyone qualifies.  You have to be under a certain income level to participate in a Roth IRA. A quick summary of the income qualifications is as follows: If you’re single or filing separately, you can participate at some level in a Roth IRA if your gross income on your tax return is less than $120,000.  If you’re married and you file a joint tax return, you and your spouse can put money into a Roth if your gross income is $177,000 or less. See more details in the table in our article, “Get Started Investing.”

Convert the Traditional IRA to the Roth IRA

Starting in the 2010 tax year, however, there is a work-around to this rule. Congress passed a law that eliminates the restrictions barring anyone who makes more than the caps mentioned above from converting a traditional IRA to a Roth. That means that, even if you don’t qualify for the Roth IRA, you can open a traditional IRA and then convert it to a Roth at the end of the year so that when you retire, you can take the money out tax-free.  And you can continue to do this, year after year.

There are different types of traditional IRAs, and these in turn have varying tax advantages – both now versus in the future—and in comparison to the Roth IRA.  All of these different types of IRAs and their tax advantages are summarized nicely in a book called “The Boglehead’s Guide to Retirement Panning.”  You can also see a fairly lengthy IRA Primer on Smart Money’s website, which will illustrate why the topic is beyond the scope of this article.

But my point is that investing in an IRA can be an outstanding way to fill the gap between your current 401k plan and your retirement dreams. Don’t be put off if the IRA language sounds confusing.  If it’s what you want to do, do it! Just figure out if you qualify for a Roth and if so, pick one and do it!  If not, read up on the traditional IRAs, pick one, and go!  Remember, the biggest mistake you can make is to do nothing because you’re waiting “to feel like you know enough.”  If you do that, you’ll be waiting forever.  No one knows everything, even the “experts”—markets and investing are uncertain by nature—and if you wait until you have a whole bunch of time to do research, by then you will you no longer have the time to let the market work for you and it will be too late.

Ok, onto the next investment vehicle that experts tend to like:  the index fund.

Investing in Index Funds

What is an index fund, anyway?  An index fund is a type of mutual fund that tracks to some standard market benchmark like the S&P 500. So let’s back up a second and define a mutual fund. Taken directly from our article “Should I Invest in Mutual Funds?” a mutual fund is:

    “…an investment vehicle that pools money from a group of investors and invests it into a group of securities.  These securities can be any number of things, such as stocks, bonds, other mutual funds, short-term money market instruments, or sometimes even commodities sold in the marketplace like steel, paper, wool, or precious metals.  The money in the mutual fund is managed by a team of professionals who follow the rules of the Securities and Exchange Commission, and who try to achieve the objectives of that particular mutual fund.”

What differentiates an index fund from the more generic category of mutual funds, is that index funds are set to track automatically to some index like the S&P 500, which is a large-firm stock index, or the Russell 3000 index, which tracks the whole stock market.  (There are bond market indexes, too, in case you’re wondering).  Because index funds track these indexes fairly automatically, they don’t have traditional fund managers.  In turn, it generally means that these funds also have lower fees, which can mean more of the fund’s overall returns stay in your pocket (which is a good thing). 

Also, because the fund isn’t trading securities all the time – it just buys into its market basket and holds—it’s less likely to incur realized taxable gains that must be distributed to shareholders. For that reason, index funds also tend to be tax-efficient. Woot!

Choose an Index Fund With Low Fees

It sounds really easy to win with these, and it can be.  But you can still make one very big mistake, and that is to choose an index fund with high expenses and fees.
Money Magazine tends to like Vanguard and Fidelity. But for an updated list, you can and should check their Money 70 site to see for yourself.

One final thing to consider is diversification. In investing, it almost always pays to diversify rather than put all your money into a single market niche – otherwise known as putting all your eggs into one basket.  So when considering which index funds to go for, don’t forget that golden rule.

The bottom line is, if you’re contributing enough to your employer’s 401k plan to achieve the company match, and now you’re exploring ways to fully fund the retirement of your dreams, the IRA and the index fund may be good options to explore.  And if you’re exploring these now, while you still have time to let the market work for you, hats off!  You’re well on your way to the retirement of your dreams.

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