401K vs. Roth IRA

[UpandComer]

Hi,

I've been re-evaluating my investment strategy based on what I've been reading in the book "Retirement Savings Bomb" and the investment strategies of succesful ER'ers.

I'm currently savings 10% of my pre-tax salary in my 401K and receiving a 5% match from my employer. My original goal was to eventually increase my contributions until I reached 20%. I am currently not contributing anything to my Roth IRA which contains only about $350 rolled over from an old 403b.

I am considering reducing my 401K contribution to 5% to take advantage of the 5% match and funding my Roth IRA with the after tax $$ (about $200/month) in an ETF.

Does this make sense?

If it does make sense where should I purchase my ETF? ShareBuilder or Vanguard?

Thanks!

[Whakamole]

That sounds reasonable. Common Wisdom about 401k versus Roth is: max out matching in 401k, fully fund Roth, fully fund 401k.

If you are going to be buying ETFs, I think Sharebuilder is a better bet. Commissions are lower (Vanguard brokerage is NOT cheap) and they have free dividend reinvestment. That being said: the cheapest commissions they have is $4 per purchase. If you are investing $200, that's 2%.

[Hyperborea]

I would suggest not using the ETF particularly with such a small amount monthly. *As Whakamole says the fees will be high as a percentage of the amount invested. *I use ETFs for my taxable account but only because of two reasons which don't seem to apply to you.

The first is that I'm a temporary US tax resident and Vanguard doesn't have a great policy of dealing with non-US residents. *My wife's IRA is with Vanguard but that's because they can't kick out her IRA once we stop being US tax residents (though we'll probably be draining it at the point anyways).

And second I'm making my purchases in sporadic lumps that are quite large (ESPP money, bonuses, topping out on FICA, build up savings, etc.) so that my cost for the purchase is *a very small fraction of a percent.

In general, ETFs make sense for individuals like me and those who want to trade in ETFs. *Most others would be best served by buying into a Vanguard index fund instead. *If the reason that you are planning to buy the ETF is for diversification it is likely that the benefit that you gain from that will be swamped by the higher purchase fees. *If it's because you won't have enough for the minimum purchase amount on a Vanguard fund then just collect the money up until you get to the threshold.

[Whakamole]

I would recommend that you just buy into a Vanguard index fund instead. If the reason that you are buying the ETF is for diversification it is likely that the benefit that you gain from that will be swamped by the higher purchase fees. If it's because you won't have enough for the minimum purchase amount on a Vanguard fund then just collect the money up until you get to the threshold.

May I make an alternate suggestion: TIAA-CREF. You can start with a $50/mo automatic investment plan, and no minimum. Low fees, and it looks like they have a better selection of funds now (including a REIT fund.)

You can then build up until you have enough to invest in ETFs or funds with higher minimums.

[UpandComer]

LOL - to me $200/month to a single investment *IS* a lot....but I guess it's all relative.

How much do people normally invest when they're buying ETFs?? On ShareBuilder, a comment on the site indicated that the common automatic purchase was $100/month.

Also, which are better, ETFs or index funds?

[Whakamole]

I really think you are better off with mutual funds for now.

Each time you buy and sell an ETF, you have to pay the brokerage fee which is fixed. So you are at a disadvantage to begin with. If you buy an ETF with $200 at Sharebuilder, you only get $196 worth of stock - you have to earn 2% just to break even!

There are mutual fund companies that are friendly to small investors (as long as you agree to a monthly investment plan.)

I started with American Century.

[UpandComer]

I really think you are better off with mutual funds for now.

Each time you buy and sell an ETF, you have to pay the brokerage fee which is fixed. *So you are at a disadvantage to begin with. *If you buy an ETF with $200 at Sharebuilder, you only get $196 worth of stock - you have to earn 2% just to break even!

There are mutual fund companies that are friendly to small investors (as long as you agree to a monthly investment plan.) *

I started with American Century.

Thanks. I already have a few mutual funds at T Rowe. I'm looking for a wider selection of funds than can usually be found at any 1 brokerage house. Are there any other low cost options for getting into ETFs?

[Nords]

Up&Comer, the expense ratios have to be converted to dollars.

So project out how much you'll save in a year and how much it would cost to hold it in a mutual fund (expense ratio). Compare that to how much it would cost to buy ETFs (commission) and hold the ETFs (expense ratio). As you make monthly donations, some of your money will be invested for the entire year and some of it for less than a year... so technically you'd have to pro-rate the annual expenses for the fraction of a year that each money donation is in the fund.

That can get pretty math-intensive, but that's my style. OTOH I've seen articles that suggest investing in a Vanguard index (ER of 0.2, for example) up to $25K and then withdrawing that $25K to buy an ETF with a lower ER. The idea is that you pay an up-front brokerage commission, but every year you hold the ETF will save you on Vanguard's expenses.

So at your current savings level you're much better off with index mutual funds. Take another look at it in three-five years.

Discount brokerages. Sharebuilder might work, Scottrade has a great rep too. It depends on how much you're bringing to the account...

BTW I also agree with Whak's priority-- get the 401(k) match, fund a Roth, then go back for the rest of the 401(k).

[UpandComer]

Thanks Nords!

[Skylark]

I started out with Scottrade but their online service is not the best. I just moved my Roth over to Vanguard, hopefully with improved service. I am maxing out both 457 (similar to 401k) and Roth this year for the first time. I think that I would put top priority on the Roth if I had to choose one or the other. I still have almost 20 years before I could start drawing down on the Roth.

I have a theory that early on in your life, Roth should be the primary investment. This is because the more income you can make in the Roth account, the more untaxed income you can cash out during your lifetime. I like the concept of money earned that will never be taxed.

As you start to get of an age closer to retirement and drawing down the funds, the pre-tax (401k, etc) plans start to look better because of the lower income tax rate on your lower retirement income. Sock it away pre-tax while you are earning big, then a few years later, start withdrawing it at a lower tax rate.

I wonder if you started putting money in a Roth for a newborn, how many years you would have to max it out to guarantee the child a good retirement without paying any income tax. Probably not too many years. The income you make in the Roth account is golden!

Thats how I would prioritize. But preferably I intend to max out both as long as possible.

[KB]

Skylark, you can't invest in a Roth IRA for a newborn. The money invested in a Roth must be earned income by the person named on the account. I opened one for each of my kids when they were 16 and working. I matched their incomes to open the account.

[Skylark]

OK, well, we don't have children so I usually tell friends, "don't take uncle Paul's advice on raising kids!"

Sounds like a wise move on your part.