Why a Roth and a taxable account are a young saver’s best friend

Wood chair on beach
KJ: We recently wrote about: Financial independence: a new concept in lifestyle retirement planning, but how do you know where to save and how to save to reach financial independence? Especially if you are a young saver, some of the retirement account types might restrict you too much on how and when you can ultimately use the funds.

Only saving to a pre-tax account can cause you to lose flexibility
If you save ONLY to traditional retirement vehicles like a regular pre-tax 401(k), traditional pre-tax IRA, Simplified Employee Pension (SEP), etc. then you might find that you have the savings and ability to be financially independent, but you may not have the ability to live off of the money and withdraw funds from these account types before age 59 1/2 without incurring significant taxes or penalties. So, how do you build flexibility into your lifestyle so you can more quickly reach – and realize – financial independence, whether that is at age 35, 40, 50, or 55?

Save to Roth accounts
Roth accounts currently have a very nifty feature for young accumulators. If you were to ever need to withdraw funds from the account(s) before turning age 59 1/2, then you CAN withdraw some funds without taxes OR penalties. In fact, any withdrawals are treated as first coming from whatever money you put in before dipping into any earnings on the account. To illustrate, if you collectively had put $50,000 into a Roth account, and the account is now worth $75,000, then the first $50,000 you withdraw would be tax-free return of your capital contributed (read no taxes or penalties). If you began to dip into the remaining $25,000 before age 59 1/2, then you would of course have to pay hefty taxes and penalties.

Overall, it still builds a lot of flexibility in your plans to reach financial independence because your first dollar withdrawals are tax-free and can further push you closer to the 59 1/2 age where you would then be able to take remaining funds out without taxes or penalties.

Contrast this with regular 401(k) accounts or Traditional IRAs where any funds withdrawn would trigger income taxes as well as penalties if removed before age 59 1/2. Even after age 59 1/2 you still have to pay income taxes on withdrawals from a Traditional IRA, but at least you avoid the penalty!

For a Roth account, as long as your income is below a certain level (approximately $180,000 for married couples in 2014 ), then you can save up to $5,500 per person for a Roth IRA (with an extra $1,000 if you’re over age 50). If that’s not an option, save to your employer’s Roth 401(k) feature if they have it since that could allow you to save up to $17,500 each year (and an extra $5,500 if you’re over age 50). If that’s still not an option, look at the regular investment account outlined below.

Save to a regular investment account
Lots of people think that once they save to their 401(k) or 403(b) and/or an IRA that they can no longer save for retirement. This is NOT TRUE! Sure, you may not have any more specifically tax-advantaged ways to save for retirement, but you can still be setting money aside for retirement in what is called a regular, investment/brokerage account. With an investment account, you pay income taxes in the current year on certain gains and income generated, but you still have the ability to focus on more long-term growth strategies to keep the investments and account with some tax-efficiency.

Contributions are limitless. Seriously. There are not any maximum contributions (or distributions for that matter!) on what you can save to a regular investment account. If you get to the point where you’re bankrolling $100,000 per year in extra income (would be nice wouldn’t it!), then you could be setting it all aside in a regular investment account. The more quickly you set aside money, the sooner you will be able to reach financial independence. Plus, you can use the funds whenever and however you would like. Save enough to reach financial independence at age 45? Not a problem! Money you withdraw does not have penalties. Sure, if you sold an investment to be able to make a withdrawal you could have some gains or tax implications but generally much less so than a regular pre-tax account, AND there aren’t any IRS penalties.

No age restriction. Yep, you read that right. There are no age restrictions to when you can access the money or time waiting periods. You don’t have to keep the money in the account for even a year, and you can withdraw at age 25, 30, 40, 50, etc. as needed to fund your goals.

Talk about ultimate flexibility! So, even though the funds don’t grow as tax efficiently as they would in a pre-tax IRA, 401(k), 403(b), or a Roth IRA, you ultimately have 100% control of when and how you use the funds without Uncle Sam getting involved.

Especially for the young accumulator that is really building their portfolio for long-term success, this type of account will ultimately help you build the flexibility you need to reach financial independence at an accelerated rate.

So, are you convinced yet? What’s stopping you from opening and saving to a Roth or regular investment account?

    Are you taking advantage of an employer 401(k) or 403(b) Roth?
    Do you have a taxable investment account for long-term growth?
    Share with us what is stopping you from building more flexibility into your savings goals.

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Financial independence: a new concept in lifestyle retirement planning

Sea Wave on Beach
KJ: One of the biggest topics in the media today is retirement. With thousands of baby boomers reaching the official retirement age each day, it’s all a lot of us think or talk about. How do you get there, how much do you need? What happens when you get there, and why is it called “retirement?” What’s so great about that point in time? Especially for us young savers, the normal retirement age could be DECADES (20, 30, 40 years) away, so what can you do now to really help you get on track and realize this flexibility sooner? Few people want to completely sacrifice today (and every year thereafter) until you get to retirement and can “live the good life.” It’s important to have periodic milestones along the way to celebrate life and youth.

Throw out the concept of retirement
I’m starting to get a little tired of the word retirement. It seems to imply that you’ll work all your life – tirelessly – to get to some point in the future where you can stay home, play computer games, and eat Cheetos until your heart is content. Or, maybe it means laying on a beach sipping piña coladas without a worry in the world. Sure, that sounds like fun for a period of time, but why wait until retirement to do any of that?

Many people who get to retirement realize it isn’t what they thought it would be. After all, what are you going to do to stay active (and not just turn into a vegetable on the couch!)? You may quickly realize you would like to spend time doing something meaningful by taking on a part-time job, another full-time job, or volunteering for a cause that is closest to your heart.

Instead, reach for financial independence
Financial independence is a very similar concept to retirement, and it’s my preferred term for what people are doing to try and accomplish this “lay on a beach and sip drinks” utopia.

What financial independence means is not so much not working at all, but rather the concept of working because you want to and not because you have to and need the income. Maybe your savings numbers are much the same as the traditional concept of retirement, but look to get to a point where you can live off of your savings and investments indefinitely. There are lots of studies designed to help you figure out what that number could be, so work with an advisor to help understand what it really means and what you need to save.

Even though 60 is the new 50, sacrificing it all today for that one point in time seems ludicrous. Set goals for you and your family and include some fun checkpoints along the way. Maybe it’s reaching a net worth of $100,000, $250,000, $333,000, $500,000, $1,000,000, etc. Even though these numbers can just be figures on a page, it can help you learn to celebrate what you’ve accomplished. Crack open the bottle of champagne, go to a fancy restaurant with your significant other, or take a nice trip.

How financial independence is different than retirement
It helps bring the concept of retirement into perspective for younger generations. By understanding where you are heading and what you need to do to get there, you can make the changes today to get you on the right track.

Financial independence helps bring the concept of retirement to what you can actually do today that can have an impact. Saving blindly to a 401(k) just *hoping* to get to retirement decades from now can often be very burdensome and unfulfilling. So, put it in terms of what you spend today. Looking at it from the perspective of working because you want to and not because you have to may mean to make a few different career or lifestyle choices to more quickly build flexibility in your life. The lower you keep your expenses, the lesser amount you need to sustain your lifestyle, and the quicker you can get to financial independence. If you get raises or bonuses, use it to sock more money away and get ahead – not use it for that expensive car or to subsidize the cost of a pricey home!

Cut your expenses for the next five years
Maybe this means cutting your expenses for the next five years, so you can take a year or two sabbatical to travel or spend more time with family. Stopping work on a whim would be ill-advised, so planning ahead to have this type of flexibility is important.

Think ahead for your five year future. Maybe you’re a two income household and are looking to start a family in the near term. What is life going to be like when you lose one income? Will it be temporarily for a few weeks, months, or years? Thinking about this ahead of time will allow you to plan ahead and save for those contingencies. Instead of a 3-6 month emergency fund, maybe it’s a 12-24 month fund you need!

Save more, spend less
To me, the concept of saving 5-10% of your income will take you forever to get to financial independence. If you have children and education goals and/or goals to get to financial independence quickly, saving 10-30% of your income isn’t unheard of.

If you found that saving an extra 5-10% of your income could shave off years of your goal for financial independence and allow you sooner flexibility to take a sabbatical, European trip, or Bahamian beach vacation for weeks, would you do it? We sure would!

    What does financial independence look like for you and your family?
    What are you doing to ensure your success in reaching financial independence?
    Share with us what your goals are to get to financial independence.

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How often do you look at your net worth?

Growing Dollar Tree Photo
KJ: How often do you look at your net worth? Weekly, monthly, quarterly, yearly, never? Why or why not?

I track our net worth on a monthly basis, and we review it together during our quarterly presentations. Yep, you read that right. For those of you who do not know us, we actually have a presentation that we review each quarter with information on investment performance, net worth changes, and other financial highlights for the quarter. We used to do a comprehensive cash flow each quarter, but since I’ve fallen behind on tracking it in Quicken, the numbers aren’t as reliable. Sure Mint.com has a lot (or mostly all) of the information, but since we stay on top of our net cash flow each month, the quarterly figures aren’t as useful. It’s fun (and shocking) to look at periodically even if you know what you spend each week or month. There’s something about seeing some of the figures on a quarterly or annual basis that makes you wonder, “we spent how much at [insert retailer or restaurant]!?”

AJ: I know we’ve talked about our quarterly presentations before but looking at our net worth on a quarterly basis helps me understand where we are without getting too caught up in the tiny details that occur month to month. Ensuring we’re on track monthly helps keep us from having to catch up later, but I leave the monthly net worth review to Kirby so I don’t go crazy :).

Why track monthly?
So, why do I track our net worth monthly? Short and simple: to see if we’re on trend with our goals. It helps keep front of mind when we have a lot of goals that are very long-term in nature. Otherwise, it’s easy to let them slip by the wayside and lose sight of what the end goals may be.

Tracking it on a daily or weekly basis would probably make you go insane, but tracking it on a monthly basis still gives you the regular updates you need in order to stay on track. Plus, if you start tracking it regularly when you are younger, you’ll begin to learn how much investment performance and the whims of markets can impact an account in the short-term – a valuable lesson to learn sooner rather than later!

What do we track?
Well, everything we can think of to track that represents an asset we own except household valuables and furnishings. We include our house, cars, cash value life insurance, investment and retirement accounts, savings, etc.

What don’t we track?
For administrative simplicity, we don’t track jewelry, silver, furniture, furnishings, etc. in our overall picture. One-off expensive jewelry, art, wine, etc. could be included if you felt it were meaningful, but in most instances, it’s not something you would look to sell to raise cash anyways.

We also don’t track checking accounts or credit cards on our net worth. Since we keep relatively minimal amounts in our checking account from time-to-time other than to meet cash flow obligations, it’s not useful to show in our net worth figures. Same goes for credit cards, since we pay them in full each month, it doesn’t do any good to show the value. Technically, we could show the difference of the checking accounts and credit cards to come up with the net figure each month, but for simplicity, we do not. However, if you do have any type of credit card or loan balance that is carried over from month to month, then you would want to make sure it is properly included (i.e. reducing your net worth).

How do we get values?
Some items are easy to value like your 401(k) or investment accounts that have regular daily values. These most often come from online account summaries or statements that are easy to access. Try to use the same date for valuations, otherwise you might be double-dipping! If you have a deposit or transfer in transit, you could be including it in the value of the receiving account, yet it still hasn’t been deducted from the sending account, so make sure you’re not overstating a value.

Other items like a home and cars are a little less easy to value.

I try not to make any adjustments to the value of the house unless a meaningful event has happened (mostly a significant decline in prices in the neighborhood like 2008 and 2009 showed most of us), but I seldom increase the value of our home. In fact, I even take off 6% of the estimated value to show the true, net estimated costs of selling with all the realtors fees and transaction costs involved if we were to sell it.

For the cars, probably about once or twice per year I’ll head on over to Kelly Blue Book.com to check out the current values of our cars. They don’t change a whole lot, but it’s good to be realistic (and conservative) about the values we’re showing them at, so I usually round down.

If we had business interests, we would include that, but we don’t at this point in time. That part of your net worth may be the most tricky to value, and it is likely to be infrequently valued (probably at most once per year).

Do we use after-tax figures in our net worth?
The short answer is no, but if you really think about it, shouldn’t you show the after-tax value of your retirement accounts? Seeing as how we’ve tried to put as much as we can in Roth accounts, they’re essentially after-tax funds anyways, so we don’t make any adjustments. However, Angela has a 401(k) that is pre-tax that we could consider reducing by our tax rate. Maybe this will be a change we make going forward, but this has just added one more step in complexity to tracking it, so I haven’t taken the plunge to make the adjustment to show our after-tax net worth specifically. It’s really not difficult to do, and I would highly encourage you to make the adjustment particularly if it’s a very significant part of your net worth.

Take the value of your account and multiply it by (1-Tax Rate). So, if you’re in the 25% tax rate, and your account is $10,000, then you would take $10,000 (1 – 0.25) to get a result of $7,500 to show on your balance sheet. A pretty meaningful adjustment though when you think of the impact on a large pre-tax account!

    How often do you look at your net worth?
    Do you exclude the value of anything from your net worth?
    Do you look at the after-tax figures?

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Smart 401k planning must knows

Heart monitor on piggy bankKJ: We recently came across a quick 401(k) article talking about 7 ways to avoid a 401(k) disaster. In my opinion, there’s never too much you can read or understand about your retirement plans, so we’ve created our own set of do’s and don’ts when it comes to common 401(k) mistakes to avoid. We’re not forgetting about those of you who have a 403(b), as this list applies the same to you! Read the full MSN Money 401(k) article here.

Take full advantage of your employer’s match
Mistake #1. Don’t leave money on the table. Even if you think you can’t possibly save money because your cash flow is too tight, chances are you actually can come up with a solution. Even if it’s an extra $50 or $100 per month, that can make a huge difference in getting you on track for your goals. You may not be able to make a change in one area to come up with the extra $50-100, but maybe you can adjust a few categories. Cut out that movie channel package, get a cheaper electricity provider, cut out dining out once per week (this alone could save most couples $120 per month), or shop around for some deals and coupons before you make a purchase. Stop making excuses, and do whatever it takes to at least get your full employer match!

Take advantage of the 401(k) Roth feature
Sure, not every firm has this, but more and more companies are offering it nowadays. If you’re young, in a low tax bracket, and have a LONG time until you retire, then not participating in the Roth feature of your account is a big no-no. You pay taxes on the money this year (i.e. you can’t deduct your contributions like you can for a traditional pre-tax 401(k)), but money withdrawn in retirement is tax-free! Huge win for us young savers.

Know your fees
All investing involves not only risk but also fees, so be aware of what you’re getting charged. New regulations enacted in 2012 require your 401(k) plan to provide detailed fee expense information. Not all fees may be paid by you, but it’s important to know what they are. In addition to administrative and record-keeping fees, there are also mutual fund fees (commonly known as an “expense ratio”). Each mutual fund is different, and various strategies have differing amounts of fees. However, just because a fee is higher than another fund, doesn’t mean it is not appropriate. Large company domestic stocks are usually lower in expenses compared to an international stock strategy, so know the differences and make sure you’re comparing apples to apples.

Know your investment options
Pay attention to the options you have to invest in. Much like you probably shop around for the best retailer when making a purchase, do your research to make sure you are picking the right funds for your goals and risk appetite. If you aren’t prepared to analyze all the factors in making an investment decision, then hire out proper counsel!

Diversify your investments
Just because yesterday’s top performer did well, doesn’t mean it will be tomorrow’s best performer. The purpose of diversification is to build a more stable portfolio over time, so some funds will underperform while others outperform in different market conditions. As we’ve seen twice over the last 13 years, stock markets (or real estate) don’t always go up! It’s part of the cyclicality of markets, and knowing that is half the battle.

An important component of this aspect is periodically watching how your investments are positioned. If you own a fund that is considered an “asset allocator” (meaning it could be invested in stocks, bonds, cash, etc.) or target date fund, then it’s important to watch what they do in conjunction with your other investments. Digging into the numbers may help you realize you’re either way LESS or way MORE positioned in one area – too much Europe, too much U.S. small cap?…

Know your retirement needs
Chances are you may not be equipped to know realistically what you need to have for retirement (is it $500,000, $1,000,000, or $5,000,000 – all entirely contingent upon what your expenses are). Work with a knowledgable advisor to help you navigate not only how to position your portfolio, but also what milestones you’re trying to reach for. If you don’t know where your “financial independence” ship is headed, how can you ever expect to know when you’re there?

Use your account for retirement purposes ONLY
While there are a few IRS tax provisions to allow you to avoid penalties for withdrawals prior to retirement (or at the earliest of age 59 1/2 as set by the IRS), using your retirement funds for non-retirement purposes can be disastrous. Don’t dip into the account before it’s time. You may not even realize the compounding effect of the $1,000 or $5,000 you “need” now and what that could do for your long-term retirement plan!

    Are you maximizing your 401(k) or 403(b) contributions?
    What would motivate you to take advantage of the employer match?
    Is there anything you would add to this list?

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Someecards.com I'd like to run something past you and stick with my decision regardless of your opinion.

AJ: Over the course of my life I have become increasingly aware of the amount of feedback people have about other people’s lives. We’re all guilty of inserting our opinions where they might not have been requested, but what happens when other people’s feedback begins to impact your financial decisions? Learning from the experiences of others can be incredibly helpful, but sometimes it’s important to take feedback with a grain of salt especially if it impacts your financial well-being.

We got married.
AJ: Kirby and I were an “us” for many years before becoming engaged and as soon as we became engaged we were bombarded with opinions of why we should/shouldn’t (mostly shouldn’t, honestly) get married at all – from other married people, no less! It seems that things always go south according to these feedback-givers: bills pile up, you begin to resent each other, you get tired of seeing the other person’s face. All very fair concerns (maybe). But in those pre-wedded months it became abundantly clear to us that we needed to remain a united force which is a great lesson for not just your marriage but for your financial success as a couple. The most positive piece of feedback we receive is one we hear often: Kirby and I make a great team. And we DO make a great team because when we receive feedback from the world, we already know where we stand financially and are able to make the best choices for us based on actual math, not wants and wishes.

We bought a house.
AJ: Buying your first home is an invitation for feedback. A little of my own feedback – if you decide to buy a home, don’t tell people, just do it! Everyone has a list of must-haves when looking for a home but before you let anyone else tell you what you absolutely must have in your first home know what you absolutely can afford based on the guidance of an advisor. That’s your end-all, be-all, thank-you-for-the-feedback resting place. It’s lovely that your best friend loves carrera marble and pendant lights, but your best friend isn’t financially responsible for your house, you are, so go on and be responsible.

KJ: Studies show that it’s best to not spend more than 2.5 times your annual household income on a home. So, if your family’s income is $50,000, then consider looking at the $100,000 – $125,000 range for a home. If you make $100,000, then stick to the $175,000 – $250,000 range. For those families that are really serious about keeping their expenses low, look instead to buy a house that’s 1.5 times your yearly income.

We bought a second house.
AJ: The problem with the second house we bought, based on feedback, is that it had incredible bones, but it needed updating. Person after person came through our new home with thoughts of ways they would personalize and update our new home and we suddenly found ourselves considering a myriad of changes (most of them costly, mind you) that we hadn’t previously considered. People have opinions, you have a budget. Stick to the budget at the expense of the door pulls, carpet on the stairs and lack of color on the walls!

KJ: Learn to separate the wants from the nice-to-haves. Sure, it may be nice to make every single update and completely personalize your house, but chances are that your budget isn’t limitless – and if it is, then it shouldn’t be! Figure out what it is that is most meaningful to you and your family for those personal touches and put pen to paper to see how realistic it is for you to accomplish them. For some, it may be immediate, but for others, it may take a couple years to really get there!

People have kids.
AJ: We don’t, but some of you do, so I hear. I’ve also heard that you’re not crazy about people telling you how to raise YOUR kids. That seems perfectly reasonable to me. However, when they start going to school and all your friends are trying to convince you that there’s only ONE school for your little dude/-ette that’s WAY out of your price range, remember where you came from. You’re a reasonable, financially-savvy person who can balance the necessity of education with the long-term goal of providing a well-rounded life for your entire family.

Focus on what is right for you and your family
KJ: In today’s world of instant access to everyone and lots of data on a limitless amount of goods and services, there’s definitely not a shortage of other’s feedback! Learn to sift through the noise to find what information you need to make sound decisions for you and your family. Be conservative in your estimates, and don’t just assume tomorrow’s income can subsidize today’s lifestyle!

AJ: Professionally group think suits me beautifully. It helps me achieve things much more quickly. Personally, however, group think is a recipe for financial disaster. Keep in mind that outsiders don’t necessarily have all of the information necessary to make appropriate recommendations for your financial well-being. Stay strong, people. Listen to the feedback, acknowledge the feedback, make your own choices outside of the feedback.

    What do you do to filter through the feedback?
    Have you been swayed into making financial decisions for your family that you wouldn’t have if you had the chance to do over?

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