What happens when you’ve paid off all of your debt and maxed out you’re 401(k)? That is the very question that my friend and reader Jennifer asked. She and her husband recently sold their home in Portland and realized a good increase in value. They moved to a lower cost condo, allowing them to pay off all of their debt, except for their new mortgage. With no debt payments, they’ve been able to maximize their retirement plan contributions, and Jennifer wondered how best to save beyond her 401(k). Thanks so much for the question Jennifer!
First, make sure that you have a good emergency fund. The minimum amount that you should have in an emergency fund is three months worth of normal living expenses. This bucket of money will help you get by if you lose your job for any reason, are unable to work due to injury or illness and if unforeseen expenses arise. Three months worth of living expenses is really the bare minimum, since it can take months to land a new job if you’ve lost your current one, and the average time those who become disabled spend out of work is more than two years.
Once you have a comfortable cushion for life’s unexpected disasters, start an individual retirement account (IRA). If you already have a 401(k)(or other employer sponsored retirement plan), your contributions to an IRA will not be tax deductible, however the investment earnings on your account will be tax free. If you meet the income requirements of less than $183,000 per year for a married couple and less than $117,000 per year for singles, I recommend a Roth IRA*. With a Roth IRA, your future withdrawals, after you reach age 59 1/2, will be entirely tax free. This is not the case with a traditional IRA where the earnings and any pretax contributions are taxed as current income when you withdraw money from your account. Other benefits of a Roth IRA are that there are no required minimum distributions as there are with a traditional IRA, and you can withdraw your contributions (but not your investment earnings) without penalty prior to turning 59 1/2. For both types of IRA, you can contribute up to $5,500 in 2016.
Where can you open an IRA account? You can open an IRA at just about any bank, brokerage firm or mutual fund company. However different institutions have different minimum investments and fees. Discount brokerage firms offer a wide array of investment options, and generally low fees. The minimum deposits are low, but for mutual fund investments, investors would still be subject to the individual mutual fund investment minimums. For example, Charles Schwab has a minimum deposit requirement of $1,000 which is waived if you set up a $100 monthly automatic deposit. Their stock and ETF transaction fees are $8.95, and their mutual fund purchase fee is $76. They do have a long list of no transaction fee mutual funds though, and if you purchase a Schwab ETF there is no transaction fee on those either. The Scottrade minimum deposit is $2,500, stock and ETF trades are $7.00 and mutual fund trades are $17, but they also have a long list of no transaction fee funds. When you open an account with a mutual fund company, if you purchase their mutual funds, there is no transaction fee, but there are varying minimum investment requirements depending on the fund company and the mutual fund.
Since your IRA is a retirement account, I recommend that you choose a target date retirement fund for your investment. Target date retirement funds are fully diversified mutual funds invested in a manner that is appropriate for the time you have remaining until retirement. The funds come in a series with the individual funds designated by the year of assumed retirement. If you plan to retire in twenty years, for example, you would select the 2035 target retirement fund from your favorite fund company. This is the only investment you will need until you get closer to retirement and begin planning your withdrawal strategy. For more information on target retirement funds, check out my previous post. Fidelity, T. Rowe Price and Vanguard are the dominant fund companies for these funds, holding three quarters of all target date investment assets. While you can buy their funds from brokerage firms, since this will be your only investment, why not just go directly to the source? All three companies waive their minimum balance fees if you choose electronic delivery of statements and confirmations, leaving your only expense the internal mutual fund expense.
One of the reasons that I recommend a target retirement fund if you are just starting out is that it is difficult to find an adviser to manage your money for you if you have a small balance. Some financial planners will help you with a savings plan and create an investment strategy for you for an hourly fee, but they won’t manage your money. Some brokerage firms, like Edward Jones, will provide some advice and select investments for you, but they are paid on commission, and therefore you may wind up in funds with higher than average expenses. A Target retirement fund is the perfect solution for the do-it-yourselfer with little investment expertise.
Congratulations to Jennifer for being able to pay off her debts and save more! If you are in a similar situation, your next step, after establishing your emergency fund, is to open an IRA. Just about any financial institution can help you, but don’t get overwhelmed by the number of options. Take the straight forward investment approach of buying a target retirement fund from your favorite mutual fund company or discount broker.
*You can actually open a Roth IRA if you earn more than these amounts, but your maximum contribution limit is reduced between $183,000 and $194,000 for married couples and $117,000 and $132,000 for singles.