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"You're Investing in What? Where?"

by Greg Mermel

Published in the "Money and Taxes" column in PerformInk on January 18, 2008

In my last column of 2007, I talked about the various flavors of retirement investment accounts to which you, as a worker, can contribute: traditional IRAs, Roth IRAs and 401k plans. The next question is which one to choose, if you have a choice.

“If” is an extremely important word in that sentence. Both types of IRAs have restrictions based on the amount of your income, and in the case of a traditional IRA, whether you are also covered by an employer-sponsored retirement plan. 401ks not only relate to a specific employer, but also you must have worked there for some specific period of time to be allowed to participate.

Whatever choices you do have, there will be tradeoffs. Aspects that may be important to you may be trivial for someone else, or vice versa, so weigh each plus and each minus carefully.

Say What?

These tax-advantaged accounts are not themselves investments; rather, they are legal entities (a type of trust, really) that allow you to hold investments with special tax treatment. You still have to decide what the actual investments will be.

If the idea of winnowing through the entire universe of investment possibilities seems overwhelming, take heart. Certain types of investment activity are not allowed in these accounts, narrowing the field.

Purchase of life insurance is flatly prohibited in these accounts. So is the acquisition of collectibles, such as art, antiques, jewelry or rare wines. Real estate is pretty much ruled out, as that normally requires a mortgage and you cannot incur debt inside these accounts. A variety of complex rules effectively prohibit investing in a business that you are actively involved in running.

What this leaves are financial assets. Stocks and bonds. Mutual funds. Bank certificates of deposit, for the very cautious. Commodities and options trading, for the wild-swinging and foolish. And a bunch of esoterica that I won’t describe because I do not really understand them despite an M.B.A. from the University of Chicago and many years’ experience as a financial professional.

Within those limitations, you still have a vast range of potential investments. There are tens of thousands of individual stocks, somewhere upwards of seven thousand mutual funds, and a near-infinite variety of bonds. Just about any of these can be bought and put into either type of IRA.

This can be exhilarating, or scary, or both.

If it is scary, you might be more comfortable putting your money into a 401k plan, where your options are likely to be more limited. How limited depends on how your employer set up the plan and with whom.

In the very early days of 401ks, plans might offer as few as five options: bank certificates of deposit; three generic sort-of mutual funds (tagged “stock,” “bond” and “blended” with absolutely no other information) and company stock. Bad investment results, followed by the inevitable lawsuits under a federal pension law called ERISA, meant that broader options and more detailed information were rapidly becoming the minimum acceptable practice even before Enron proved the stupidity of loading up on company stock.

Today, the least you will see is a dozen or so mutual funds with actual names attached to them. In this minimum scenario, the funds offered will typically be from one of the giant mutual fund companies (Vanguard, Fidelity, Putnam, etc.) – all from the same giant which, not coincidentally, will be collecting fees for managing the 401k. That’s unfortunate because any particular fund company will excel at running some types of funds, be a bit below average on most, and really suck at others.

At maximum, you could be given just as wide a latitude as in an IRA. “Call this guy at Charles Schwab” (or some other big investment house), “and you can invest in anything they sell.”

Eeny, Meeny, Miney, Mo

Unless the investment options in a 401k are too limited, or just plain crappy, I think your first retirement dollars each year should go there for one simple reason: free money.

You see, 401k plans cannot discriminate in favor of the highly-paid workers (“bosses”), and discrimination is measured by who participates at what percentage of their wages. Most 401k plans encourage participation by the lower-paid workers (“wage slaves”) by matching the first part of the slaves’ contributions. Often it is a dollar-for-dollar match, which means you have a 100 percent return on your money in the first year. Let’s see you beat that in the stock market.

Assuming still that the choice of available investments has not made the decision for you, I generally recommend that younger workers switch to funding a Roth IRA when they reach the maximum employer match. The more working years you have ahead of you, the more powerful the tax advantage of the investments’ earnings compounding tax-free. (If you want to review that idea, look at my December 21, 2007 column.)

For older workers, the Roth juju is not as powerful. With less time before retirement, the immediate tax deduction for a traditional IRA might be worth more.

Before you ask, no, I cannot say whether you count as a “younger worker,” and could not even if I knew your real age. There is no magic dividing line.

Maximizing the 401k match and fully funding a Roth IRA will generally exhaust most artists’ ability to save for retirement in any particular year. But if more money is available and you have a 401k plan, consider contributing more to that.

Note that I have softened the verb to “consider.” You can be a bit less picky about available investment choices when the employer match subsidizes the investment return. Not now.

The other option is to put the rest of your retirement savings into a non-tax-advantaged account. In fact, it’s the only remaining option for employees who have no 401k available and have fully-funded their Roth IRA.

Call me a heretic (please, no burning stakes!), but I think it can be a really good idea to invest some of your retirement money in a regular, taxable investment.

Come back in two weeks, to read about that.

Free Offer

Every year during the income tax season, I offer free copies of my “Checklist of Potential Deductions...” for those in the arts. Just call my office, or send an email to checklist@gregmermel.com.

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