Investing Rules from an Old Guy

The most prudent and easiest investment to get started with are tax-advantaged retirement accounts. You should start and max out your contributions to a qualified Individual Retirement Account (IRA), Roth IRA, or 401K before you get into stocks and other securities.

Traditional IRA

The contributions you make into your IRA (Note; there is an annual contribution limit) are tax-deductible. If you are in the 30% tax bracket, a $4000 contribution effectively costs you $2800 since the tax deduction saves you $1200. In addition, IRAs provide you the benefit of disciplined savings, professionally managed investment options, and your money (including earnings) are only taxed when taken out at retirement which is when you will be paying tax at a lower rate.

As an example, an annual $4,000 contribution into an IRA earning 8% per year over 40 years will grow to more than $1.1M after taxes (thanks to the power of compounded growth), whereas the same contributions without the benefit of the IRA will be worth just a little more than $0.7M.

Roth IRA

With a traditional IRA, tax on your contributions are deferred and are instead paid when funds are withdrawn. With a Roth IRA, the tax treatment is reversed. Deposits are not tax deferred, but all the withdrawals during retirement will be tax-free. Which is better? If you think your tax rate will be lower 40 years from now, then the traditional IRA would be better than a Roth.

401K and 403(b) Plans

Similar to IRAs, employer sponsored retirement plans are even better because the money is deducted from your paycheck before you even see it. It not only “forces” you to save each pay period, but many employers match some portion of the employee’s contribution so that every dollar saved comes with "free" money from your employer. In the meantime, gains from your investments in the 401K are only taxed when you withdraw funds upon retirement.

The only drawback of these plans is that penalties are incurred if you withdraw funds any time prior to retirement.

Optimize your Contributions

With so many bewildering choices, the best strategy to maximize the benefits from tax savings accounts is to prioritize your contributions as follows:

1. Contribute to a 401K or 403b plan first. Contribute just enough to maximize your employer’s matching contributions. Who doesn’t like this?
2. Open an IRA or Roth IRA with your brokerage firm and make deposits into this account up to the annual limit. Yes, one is allowed to contribute to both an IRA and a 401K but just be careful about the annual limits to avoid penalties.
3. Continue to fund your 401K or 403b up to the annual limit.
4. Repeat steps 1-3 every calendar year.