roll your own target date fund, part 3: location, location, location

Welcome to part three of my series on rolling your own target date fund — taking charge of your own investments so as not to get blindsided, but without spending every waking moment reading the Wall Street Journal. Last week was all about the biggest factor in determining how volatile your portfolio is going to be: your asset allocation. This week, we talk about where best to place those assets. Yep, it’s all going to be about taxes and fees, fees and taxes. Since the vast majority of your investing is going to be for retirement, today I’m just going to talk about retirement vehicles; if you’d like to know about college savings, you might want to check this out.

Ready? Let’s go.

401(k)’s: For lots of you, this is where nearly all of your investments will be located. Many companies offer a 401(k) match (in lieu of a pension plan), which can make investing in a 401(k) a tasty treat. However, once that match has been met, a 401(k) becomes much less appetizing. For one thing, there are generally only a small handful of choices to invest in; this wouldn’t be terrible, were it not for the other thing, which is that either (a) most of the choices are expensive, or (b) there is a fee tacked on top of the funds’ normal expense ratios, or (c) both. 401(k) administrators have to make money somehow! So generally, once you’ve hit the match on your 401(k), it’s time to move on to a better home, like…

IRA’s: An Independent Retirement Account is generally a better alternative for retirement investing than a 401(k): your options are better, especially if your IRA is with Vanguard, where you have access to some extremely nice, low-cost, no-load funds (more on that next week). And there are no fees. However, there’s a couple caveats: for one, as of this writing you can only contribute $5,500 annually to your IRA ($6,500 if you’re 50 or older), while you can contribute $17,500 to your 401(k). (And yes, you can do both!) For another, IRA’s are subject to an income limit, so some people can’t contribute at all.*

Roth v. Traditional: Now, 401(k)’s and IRA’s come in two different flavors: Traditional and Roth. The main difference lies in how they’re taxed: Traditional IRA’s and 401(k)’s are tax-deferred, which means that you don’t have to pay taxes on the money you contribute, but you do have to pay normal income taxes on money that’s withdrawn in retirement. Meanwhile, Roth 401(k)’s and IRA’s grow tax-free, which means that while you are taxed as normal on your contributions, your withdrawals are completely tax-free. A couple related wrinkles to also consider:

• For any given amount of money contributed to a retirement account, you’ll get more out in retirement if you contribute to a Roth rather than a Traditional. The logic is simple: $5,000 in a Traditional will be taxed when you pull it out, while $5,000 in a Roth won’t be.**

• Contributions to a Roth IRA (not 401(k)) may be withdrawn at any time, tax-free. Note that this does not include capital gains, and that this is a withdrawal, not a loan, so you can’t just put the money back when you’re done if you’ve already contributed the maximum allowed amount for the year.

So…what to do? Everyone’s situation is unique, but a good strategy for most people when allocating your contributions is to contribute to your 401(k) up to your company match (the Roth option, if your company offers it), then max out your Roth IRA, then max out your 401(k).

Got it? Great! Next week, we’ll get down to brass tacks: exactly what funds to buy to implement that asset allocation you crafted from last time!

* You’re right, that’s not entirely true: there is a sneaky backdoor, where you can contribute to a nondeductible IRA at any income level, and roll that over to a Roth IRA. Good call, have a lollipop. ** The same smart kids who got a lollipop will note that because you’re not taxed on contributions to a Traditional 401(k)/IRA, you could in theory afford to contribute more to it. This is true…until you reach the max, which is the same dollar amount for a Roth as for a Traditional. So: the Roth wins. Nyaah nyaah.