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How to Select the Right Retirement Accounts

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    Saving for retirement and old age is one of the most important things you have to do. There are no pensions anymore. Social security is NOT enough to enjoy the standard of living you are used to. If you want to avoid returning to the workforce when you are old and might no longer have the skills needed in a changing world, you better save for retirement.

    Saving for retirement could mean the difference between lounging around at the beach or working a crappy job to get by. 

    In my last post, I provided you with a guide on how to build wealth. In this post, I will explain the various types of retirement accounts. By the end of this post, you will have learned:

    • What taxes are and how they work
    • The various types of retirement accounts
    • How to optimally save for retirement

    What are taxes?

    “In this world nothing can be said to be certain, except death and taxes” is an oft repeated quote. The conventional view of taxes is to say that they are used for the running of government and to fund public projects. However, this is not the whole story. Viewed in another light, taxes are really a system of incentives that the government provides around stuff they want to get done.

    For example, with the mortgage tax deduction, the government is incentivizing home ownership and real estate investments. By not having taxes on home sales under certain conditions, the government is incentivizing folks to move and buy more expensive homes as they get older.

    Capital gains tax rates are lower than income tax rates because the government wants people to invest for the long term.

    We can debate all day long about how just or correct these tax policies may be. However, at this point, it is what it is so all you can really do is respond to the incentives that are given to you.

    In a similar vein, the government doesn’t want you to depend on it in your old age, and so it has provided a system of incentives around making sure you have a nest egg when you are old.

    Retirement Accounts: How does the government incentivize retirement savings?

    The government incentivizes retirement savings via four special types of retirement accounts.

    Traditional 401k: 

    1. Funded with Pre-tax dollars. So, if you make let’s say $100, instead of paying income taxes on the full $100, you can contribute $20 to a 401k and only have income taxes applied to the remaining $80. This is a super simplification.
    2. An employer-provided account. Put your money in tax-free today and pay taxes on the gains when you withdraw your capital as you grow older.
    3. Companies may choose to match your contributions with some of their own capital. This is the closest thing you will get to a risk-free return. So, if your employer offers you a 10% match for every dollar invested, you are earning a risk-free return of 10%. Truly a great deal!

    Traditional IRA: 

    1. Pre-tax dollars.
    2. An account you open. Put your money in tax-free today and pay taxes on the gains when you withdraw your capital as you grow older.
    3. This account is not tied to your employer, so you have complete freedom to decide where to open this account and which funds you pick to invest in.
    4. Note that for most readers of this blog traditional IRAs are going to be funded by post tax contributions as you will exceed the income threshold for claiming a deduction. You are better off rolling a Traditional IRA into a Roth IRA.
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    Roth 401k:

    1. Post-tax dollars. Going back to our $100 example, you would pay income taxes on the $100, and what’s leftover, you can invest in a Roth 401k up to a cap, and the earnings on your investment will grow tax-free.
    2. An employer-provided account. Put post-tax money in today and pay no taxes when withdrawing.

    Roth IRA:

    1. Post tax dollars.
    2. An account you open. Put post-tax money in today and pay no taxes when withdrawing.
    3. People have done some clever stuff with these. See Mitt Rommney’s Roth IRA account.
    4. We also have a great SVIC article on how you can use your ROTH to minimize your taxes when you invest in startups

    Note that with retirement accounts your contributions are taxed exactly once

    1. Either at withdrawal time or at contribution time.

    For your normal accounts, taxation happens twice due to:

    1. You are investing post-tax money.
    2. And, you will pay taxes on capital gains.

    Thus, retirement accounts save you a lot of money by avoiding double taxation.

    Hypothetically, if you were to make the same income throughout your life and the tax code doesn’t change, both types of accounts will give you identical returns. However, most people are going to see earnings go to near zero when they retire. Thus, it makes sense to put away pre-tax dollars now and reduce taxes as much as possible in the present. If you have more funds left over after that, put those to work in post-tax retirement accounts. This way you get both pre-tax and post-tax diversification. 

    The optimal strategy for most readers of this blog

    It can be difficult to write a “one size fits all” investment strategy, especially for retirement accounts. 

    At the Silicon Valley Investors Club we have decided to focus on STEM employees. 

    The following advice assumes you make at least $100k+ per year, are early in your career, and have minimal obligations, and have the potential to make more money as your career progresses. 

    The goal is to start retirement savings as soon as possible so you can take advantage of compounding

    1. Max out your traditional 401k and get the company match ($19.5k pre-tax dollars)
      1. The company match is free money. In addition, you can almost safely bet that your income is going to lower at the time of retirement than when you are working. So minimizing your tax burden now makes sense.
    2. Backdoor Roth IRA: Contribute to a traditional IRA up to the annual limit and roll over to Roth IRA ($6k post-tax dollars in 2020/2021)
      1. For most readers of this blog, you are NOT going to be eligible to 
        1. Contribute to a Roth IRA.
        2. Claim a tax deduction on whatever you contribute to a traditional IRA .
      2. However, there is a backdoor. You can contribute to a traditional IRA account and then rollover into Roth IRA immediately.  
        1. Most brokerages support this.
        2. Rollover to Roth IRA as soon as possible because if you keep the money in your traditional IRA you will be taxed twice. You already put in post-tax income and you will pay taxes on any gains too.
      3. Find a detailed guide on traditional vs Roth IRA on the college investor.
    3. Mega Backdoor Roth IRA: (Roughly $27k to $32k)
      1. The mega backdoor Roth IRA is available in a few 401k plans. Check if your employer offers them. Google and Facebook have one-click options to get this setup trivially.
      2. Also check that you have zero funds in traditional IRA accounts as you do this. If you have post-tax funds, roll them over to a Roth IRA. Otherwise do a reverse rollover into your company 401k. (The details behind why you need to zero out your traditional IRA are arcane).
      3. You want to make sure that these contributions are AFTER-TAX, NOT Roth 401k contributions.
      4. Once you have made your contributions you can withdraw these “After Tax” funds to a Roth IRA.
      5. Note that Google/Facebook have automated this process so it’s doable in a single click. This makes it a complete no brainer.
      6. Find a more detailed article on the college investor
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    What funds should you invest in?

    401k Accounts: Invest in the lowest-cost target-date fund that you can find. Typically a lot of target-date retirement date funds will have high expense ratios. Anything above 0.25% is too much. 

    If target-date retirement funds are too expensive scroll down all the way to the bottom. This is typically where the lowest cost index funds are present. Pick the ETF with the lowest cost and you should be fine.

    Traditional IRA or Roth IRA: Invest in VTI. You might want to add some bonds to smooth the retirement ride.

    In conclusion, get your retirement accounts setup. Take a day off work if you have to. It does not take a lot of time and is the highest ROI activity you will do all year.

    The content here is for informational purposes only, and should not be taken as investment advice. All views contained herein are my own and do not represent the views of any other organization.

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