Dave Ramsey espouses 7 “Baby Steps” to get your finances back on track. Step #4 is to save 15% of your income in a 401(k), IRA, or other retirement account. A reader recently asked an interesting question about what to do when his 401(k) limits his investments to 10% of his salary and he does not qualify for a Roth IRA. Here’s his question:
Very thorough analysis with 1 exception: those of us that are limited in the amount we can invest. I can only invest 10% of my income in the company 401K and I don’t qualify for a Roth IRA either. What recommendations do you have for the additional 5% to get to 15% overall retirement investments?
This is a great question and raises an issue that I confront. While I can contribute more than 10% to my 401(k) (thanks to a company match), I still have more money to invest after maxing out all of my available retirement contributions. For some, while you may not qualify for a Roth IRA, you may qualify to open a traditional IRA. But assuming that option is either not available or there is still money left to invest after contributing to an IRA, what should you do?
The answer to this question really has two parts: (1) what do you invest in (e.g., stocks, bonds, mutual funds), and (2) where do you invest (e.g., directly with a mutual fund company, discount brokers, full service broker).
What do you invest in after maxing out contributions to retirement accounts?
In answering this question, the first thing to consider is why you are investing. In the case of the reader, he’s trying to put away 15% for retirement. As a result, I’d look to follow my asset allocation plan just as if I were putting the money in a 401(k). In other words, my asset allocation plan would have to factor in both tax deferred accounts (401(k), IRA, etc.) and taxable accounts.
Next, I’d decide what types of investments I need as part of my asset allocation. For most this likely means investing in mutual funds, and maybe even the same funds that are already in your 401(k). For others it may mean investing in individual stocks or bonds. I invest in both mutual funds and individual stocks in my taxable accounts. But whatever is best for you, there is one big gotcha to watch out for–taxes.
I learned this the hard way. Having invested in various mutual funds in a taxable account, I was shocked to see that some pay out substantial dividends and capital gains each year that is taxable, while others do not. This is where buying individual stocks can be a real advantage. Because Warren Buffett does not pay out dividends from Berkshire, my investment in Berkshire Hathaway is tax deferred unless and until I decide to sell my shares.
Nevertheless, you can find tax efficient mutual funds, too. Morningstar is a great resource for evaluating the tax ramifications of mutual funds, and I’ll be publishing a post later this week on how to use Morningstar in this respect. For now, the key is to consider the tax ramifications of your investments in taxable accounts.
Where should you invest?
Only when you know what you will invest in can you decide where to open accounts. If you plan to invest in mutual funds, the best place to open an account is generally with the mutual fund company. I invest in Vanguard funds in my taxable account and have an account with them. My investments in the funds are at no cost.
If you want to invest in individual stocks, I think a discount broker is the best option. You can get low cost trades, and the service, tools, and resources available from most low cost brokers today are really quite good. I have an account with ShareBuilder because I can make low cost monthly contributions to my account and invest in partial shares of a company. In this regard, ShareBuilder may be ideal for getting your retirement contributions up to 15%.
At the same time, I plan to open my SEP IRA with Scottrade. Scottrade has excellent service and tools, and is a better fit for the type of investing I plan to do (periodic trades, not consistent monthly contributions).
As a final thought, keep in mind that you may end up opening more than one account. I currently have taxable accounts with Vanguard, ShareBuilder, Prosper, and LendingClub (with Scottrade soon to come).