I enjoy the honest, straightforward financial advice posted on your website. The lack of excessive brokerage jargon is much appreciated. It has been a useful primer for me as I enter the world of investing for my future as well as my family. I have a barrage of questions that I need answered, some of which I feel may be considered stupid. I apologize for my ignorance, but I just haven’t gotten straight answers. Additionally, I just need some solid financial advice. Before I begin let me tell you a little about myself. I’m 32, I’m in my first year of private practice (physician) and am raking in roughly $250,000 annually (approximately $150,000 post-tax and running expenses). My practice is offering several investment vehicles (a 401 K and a ROTH 401K). Well here are the questions:
Thank you for your question! I’m glad that you like the site!
The important thing is that regardless of past action, you are willing to learn more about the paths you can take to lead towards financial independence.
1. In your opinion are 401Ks and IRA sufficient enough vehicles (considering my salary) alone to plan for retirement? Is it necessary to explore annuities?
Tricky question. It depends on what standard of living you expect during retirement.
While regular donations to your 401K and IRA can be sufficient for retirement, it is equally important to invest in taxable accounts since this will provide you with additional income and resources to utilize before retirement. If your goal is early retirement and an income that if similar to your current income, 401K and IRA contributions will keep you headed in the right direction but additional contributions to taxable accounts will expidite your progress.
An annuity can provide a payout of a specific amount over a specified time period and serve as an excellent investment tool for those already in retirement that are seeking guaranteed income. While the purchase of an annuity can be ideal for specific situations, I would advise against purchasing an annuity during a time when you should be focused on capital preservation and growth. An annuity will not allow you to take advantage of market growth from your current age of 32 through the time you retire.
2. What is the main difference between a ROTH 401K and a regular 401K besides the 401K tax break and tax free withdrawal at retirement for the ROTH?
A 401K is funded with pre-tax contributions while a ROTH 401K is funded with dollars that have already been taxed. 401K contributions are taxed upon withdrawal while ROTH 401K contributions are not taxed upon withdrawal.
The greatest advantage of a ROTH 401K is the tax benefits. The tax benefits alone are enough reason to contribute and other than the tax benefits, the differences between the retirement accounts is negligible. For young individuals that are making retirement contributions early, it makes sense to contribute to a ROTH 401K while in a lower tax bracket so that withdrawals will be untaxed when the investor is in retirement and most likely, a much higher tax bracket. Since you are earning ~$250,000/yr, you are already in the 33% tax bracket (until you make $350,000+ and are taxed at 35%), you will not receive as great of a tax benefit. Still, taking an upfront tax hit and allowing your dollars to compound in a tax free environment is an opportunity that you should take advantage of.
3. Can I contribute as much as wish to a ROTH 401K, unlike the ROTH IRA? Are there income stipulations for a ROTH 401k?
Contributions to a ROTH 401K and a 401K cannot total more than $15,500 in 2008 or $20,500 for those over 50. You could put $5,000 in you ROTH 401K and $10,500 in your 401K or any combination as long as you do not contribute a combined amount greater than $15,500. There are NO INCOME RESTRICTIONS for a ROTH 401K.
4. Would a ROTH 401K be better for me b/c I would anticipate retiring in a higher tax bracket?
The primary case could be made for 401K contributions if these contributions would bring you down to a lower tax bracket. Since even a $15,500 reduction in your taxable income would not bring you down to a lower tax bracket, I would advocate contributing to a ROTH 401K (if your employer offers it) and maximizing those contributions. You should still contribute enough for your company match in a 401K though since your pre-tax contributions. After your company match, put the remainder of your contributions into a ROTH 401K.
5. Do employers match and should they match my ROTH 401K contributions?
Many employers still do not offer the option of a ROTH 401K. I am not sure of the specifics of your employer’s 401K plan but expect that a call to the holder of your accounts (Fidelity, etc) would answer your question.
6. If I file jointly for a ROTH IRA, how much can I contribute because of my income? Also in regards to the income limit quoted for the ROTH IRA, is that a person’s post or pre-taxable income?
Joint filers can only fully qualify for a ROTH IRA if their taxable income is less than $156,000. Once you are making more than $166,000/yr, you are NOT ELIGIBLE for ROTH IRA contributions.
7. My employer uses a vesting schedule. What does that really mean?
When you contribute to a 401K, your contributions are automatically 100% vested. If your employer is using a vesting schedule, this means that your employer does not immediately provide a full 401K match. You would have to work for 5 years before your employer was providing a 20%/year vesting schedule. Employers often use this method to reduce employee turnover, your employer has established a vesting schedule to make sure that if you were to leave the practice in the next couple of years, you would not have been receiving a full company match. The longer you stay, the more your employer matches.
8. For the employer 401K matching amount, does it grow in a separate account that is taxed at withdrawal irrespective of the retirement age?
Your employer match is included in the same account as your contributions.
9. Would you still recommend utilizing Altria in my portfolio. What are it’s current annual returns?
I’m a big fan of accumulating solid dividend paying companies and have found investment in Altria to be rewarding. They are currently yielding a 4.1% dividend which is similar to the rates you would receive from a savings account. Altria has been service the purpose of a ‘long term savings account that generates interest and capital gains’ for me but whether or not you choose to allocate funds towards Altria is a decision you have to make. My current understanding of Altria would lead me to believe that any investment today will be highly likely to leave you with very solid returns over a long time horizon (10-20+ years). Invest over time, reinvest all dividends, and don’t sell it so that the power of compounding and dollar cost averaging can work in your favor.
10. Would you please send me your compounding interest calculator in excel?
I use a couple of different compound interest calculators. The package here is available for free download and includes several excel sheets that contain calculators for compound interest, annuities, and loan amortization.
Download the Compound Interest Packet
11. Lastly, now for your sincere advice. Assuming I am able to invest the maximal contributions annually to a 401K (If I shell out $15,500 yrly) based on your calculator, what will my return be after 30 years with varying rates of returns (love that table on your website)?
According to the Money Chimp Compound Interest Calculator, a $15,500 annual contribution compounding at 8% for 30 years would give you ~$2 million. An 8% return is pretty conservative given long term historical market returns, a 10% return would leave you with over $3 million. If you were to retire in 30 years and put ~50% of your investments into fixed income and 50% into conservative stock investment and get a 5% return, you would have an annual income of ~$150,000. Given your current income of $250,000 and the inflation that will occur in the next 40 years, this would not be sufficient to maintain your current lifestyle during retirement so I would suggest saving more.
Also what do you sincerely recommend for me? I am a conservative investor. I walk the middle road and plan to diversify investments. I have 3 kids and I will be setting up a 529 plan this year. I will assume a modest amount of volatility and risk. What type of taxable accounts would you recommend for me?
Thank you so much David.
If you are fully maxing your 401K contributions of $15,500, with an income of $250,000, your effective saving rate is ~6%. Setting up 529 plans for your children is an excellent way to prepare for the future costs of education. The contribution limits for 529 plans are extremely high (over $200,000) and contributions are deductible in 31 states. College costs are expected to increase at a rate of ~7% although no one knows for sure how accurate this estimate is. If a year of college today would cost $20,000, the total cost for 4 years of college in 10 years will be ~$175,000. You didn’t mention the ages of your children but I’ll pretend your children are 10, 7, and 4 and assume that they are entering college at the age of 18 and will be attending a college that currently costs $20,000/yr
Estimated college costs
For your ‘10 year old’=~$150,000
For your ‘7 year old’ = ~$180,000
For your ‘4 year old’ = ~$225,000
‘Needed’ investment/year to fully cover college costs (assumes 8% rate of return on investments)
For your ‘10 year old’= You would need to contribute ~ $11,000/yr for 8 years
For your ‘7 year old’ = = You would need to contribute ~ $9,000/yr for 11 years
For your ‘ 4 year old’ = You would need to contribute ~ $8,000/yr for 14 years
College is expensive but with savings of ~$5,000/yr per child, you should be able to put a significant dent in the cost of college. With today’s college loan programs, there are plenty of options out there that can help to extend the payment plan and to allow you more time to save. You might also want to consider the gift tax which allows you and your spouse to give up to $24,000/yr to each one of your children (or anyone else you want to give money to) without paying additional taxes. You could put the money gifted into a custodial account in your child’s name. The investments in this account can continue to compound from now until your children graduate college and can be tapped over time to pay off college loans etc. I would recommend talking to a financial planner about the specifics of college planning because this really is a subject worth spending more time on.
Now for the taxable investments that will create your real wealth. Without a direct understanding of your expenses, I’m not sure how much ‘extra money’ you can invest every year. I’m sure that if you make a few changes, you would be able to save at least another 6% of your salary (bringing your total savings rate up to 12%). The additional $15,000/year will provide you with ~$1250/mth to invest in taxable accounts. You’ve said that you have a moderate risk tolerance and at the age of 31, you have plenty of time for growth!
I would recommend putting ~10% of this money into fixed income investments sticking to the rule that the amount you invest in fixed income should be around 120 minus your age. (120-31 = 11%) The remaining money should be split up into various stock investments. You can use a fund screener (provided by most major brokers) to find funds and investments that fulfill your specific needs because everyone will have different risk tolerance and investment expectations.
I would suggest keeping ~30% of your investments geared towards international index funds. A great diversified index fund is the iShares MSCI Emerging Markets Index (Symbol: EEM). ) This is an Exchange Traded Fund (ETF) that has management fees of 0.75% and an annual turnover rate of only 5%. This can serve as a stable base for your international investments with potential additional investments in other ETFs or international mutual funds. I would avoid individual international stock investments in order to maintain diversity until your gain enough experience.
The S&P 500 index fund (SPY)is a diverse ETF that will provide you with a solid domestic stock base. You should allocate ~30% of your funds towards a diversified domestic index fund or mutual fund that has provided consistent performance under experienced management.
Put 20% of your money towards companies that are large, established, and have a solid history of sales growth. I’m talking about companies that will continue to be around in some capacity. The big guys: Coke, Pepsi, Altria, Wrigley, Procter and Gamble, Johnson and Johnson, Bank of America, Alcoa, and many others. Put your investment dollars into these companies over time, reinvest all dividends, and don’t sell them. Large dividend paying companies have outperformed all other forms of investment in time horizons of over 20 years.
You can use the remaining 10% for your fun investing. Interested in investing in the Visa IPO or think that Google or Apple stock is looking a little cheap? Put some of your fun money towards it!
10% Fixed Income
30% International Diversified Funds
30% Domestic Diversified Funds
20% Large Dividend Paying Stocks
10% Fun Investments
The allocations I’ve recommended are totally changeable to fit your investment style. If you love the idea of fixed returns regardless of market direction, focus more on fixed income! If you like the idea of having regular dividend checks that you can choose to reinvest (or even just spend the dividend), then focus on those. The most important thing is to get started as soon as possible!
Dr S, I hope that I have managed to provide you with some useful information.
Please feel free to write me with any additional questions! My e-mail address is firstname.lastname@example.org
Pros and Cons of Annuities - How to Evaluate Annuities
Federal Tax Brackets
Understanding the Roth 401(k)
Wikipedia : ROTH IRA Income limits
401(k) Vesting Basics
529 Plan FAQs
The 529 Plan: College Savings
Tax Benefits of Paying for College