Small Business Realities: What's the Difference Between a 401k and an IRA?

This is one of those questions that pops up routinely. The answer is most important for those of you who own your own business, but it crops up for those who work in small companies, too. So what is the difference between a 401k and an IRA? Well, it comes down to a matter of trust—trust accounts, to be exact.

IRA's are really cheap and flexible

An IRA or "Individual Retirement Arrangement" is just what it sounds like. The account is fully owned and controlled by you, the person who hopes to retire one day. The IRS Tax Code says that, as long as you follow their rules with your "arrangement," they won't ask you to pay income or capital taxes on the money you put in your account until you start taking it out (for more about tax deferral and why it's so great, check "Making Sense of Your Company's Retirement Plan"). The rules here are fairly simple: you need to put the money in a trust for your own benefit. Of course, there are some details, but the banks and brokerage houses have stepped in to cover you there. You can open an IRA account at any average bank or anywhere you would open an investment or stock trading account. And in many cases, it costs nothing to open one. Here is Investopedia's list of no or low-balance IRA account offerings for 2015.

Because the IRS doesn't put many limits on what can go into an IRA account, you can invest in all sorts of things with your retirement money. So, when you do go to choose the bank or broker for your account, check their offerings and ask about things like account management fees or trading fees. We often use different brokerage houses for someone who wants to "sit on" three or four standard index funds as opposed to someone who will be doing more trading.

Use the IRA for you business

Believe it or not, your business can open IRA accounts for your employees instead of a 401k plan. Called a SIMPLE (Savings Incentive Match Plan for Employees), these accounts let you, the employer, contribute money to your employee's IRA accounts without the hassle of a 401k. Cheap, easy and available to any business with less than 100 employees (and no other retirement plan), the SIMPLE only requires you to choose a fixed amount to contribute to your employee's plans—either 2% of her salary each year or a "match" of what she contributes between 1% and 3% of her salary.

The IRA compromise

There is a catch. If you are an ambitious saver, IRA contribution limits might mean that you can't put as much into your account as you like. For 2015 and 2016, your total contributions to both your IRA and Roth IRA can't be more than $5,500 for the year ($6,500 if you are over 55). BUT, if you are contributing to an IRA through your employer's SIMPLE plan, that limit goes up to $12,500 (or $15,500 if you're over 55) per year for 2015 and 2016—and that doesn't include your employer's contribution.

The Great 401k

There are a lot of smaller companies out there that would probably do better with a SIMPLE, but the fact is that 401k's, a type of qualified profit-sharing plan, dominate the U.S. workplace. And there are some good reasons for that. Like the IRA, the 401k is a form of trust account that follows rules laid out in the IRS code  in exchange for tax deferrals.

In this case, though, the rules are more complex and the employer retains a lot more control over what's offered in the plan. And that means some serious compromises for both the employer and the employee.

Employees can only invest their 401k money in what's offered in their employer's plan. If your employer has done a great job sourcing a plan, that should be fine for most people. Historically, though, we've seen a lot of 401k plans that offer expensive and/or limited investments and include high management fees. That leaves employees with a less effective account that can add up to tens of thousands of missing dollars over the course of a career.

Employers also often struggle with their 401k plans. As the employer, you have a fiduciary duty to ensure that the plan is fair and well-managed for your employees. And you have a more complex set of filing requirements so that the government can make sure you are taking that duty seriously. For this reason, it has often been difficult for smaller companies to get a good, reasonably priced 401k plan. Keep in mind that the fees will generally include someone to manage the investments and someone to manage the plan to keep you out of trouble.

Why We Love 401k's

Despite the complexity of 401k's, they remain a favorite even amongst smaller companies. Some of this is just down to the enthusiastic efforts of brokerage houses to sell these plans. But there is a real advantage to the 401k, as well. While the SIMPLE limits employees' contributions to $12,500 ($15,500 if she is over 55), employees can contribute a lot more to a 401k account—up to $18,000 per year for 2015 and 2016 ($24,000 if she is over 55). That extra can mean a lot to the right employee.

The Conclusion

So, which sort of plan works better? As you might expect, it all comes down to the size of the business and the savings ambitions of the employees. If you are an employer, it pays to look at your options. If you go with the 401k, be finicky about the brokerage house or investment advisor you choose—choosing the wrong one can cost you and your employees a lot. And if you are an employee in a small business, don't hesitate to approach your employer if you think there's room for improvement. Most employers don't know any more than you do about retirement plan options and are happy to get better information (especially as it might save her some money, as well!).

If you have more questions about small business retirement plans, send me an email.

High Stakes Learning: why figuring out your investments is so hard

Last week we kicked off the Women & Finance series with a "Stocks & Sushi" stock trading game night in Cambridge. As you might have guessed, the emphasis was on having a good time. Our 15th Floor event room above Kendall Square gave us panoramic views across to Boston, and trays of sushi, cakes and a case of wine meant no one was feeling particularly stressed out about learning anything. But the learning—along with a healthy dose of competition (and a little buttercream frosting)—happened all the same.

Since Thursday, I've had a slew of comments and emails from attendees about how much better they understand their own investments since participating in the game. The game itself is a version of something I used to do with an auditorium full of undergrads when I taught the origins of the modern stock exchange. You can't, in my opinion, really understand how and why stock prices fluctuate (and how bonds work at all!) until you are in the middle of the psychological cauldron that is a marketplace. When the dice send the market into a meteoric rise, you can actually feel the tempting pull of the next big bet or the cautionary tug of anxiety, even though those make-believe shares of "Doctor & Gamble" in your hand are, literally, not worth the paper they are printed on.

So why, if this all quickly becomes clear in the game, do the real investments in our 401k account remain so murky to us? I think the answer has something to do with the stakes of the game.

I once had a conversation with a client about why her teenage daughter seems to magically understand all the bizarre features on her smart phone while my client still struggles with turning the camera on and off. "Think about when you use the phone," I said, "you've got a grocery bag in one hand, your half-drunk coffee in the other and you realize you have to make a quick work call in the two minutes before a meeting starts." On the other hand, her teen is using her phone while waiting in the car with a bag of chips and her feet on the dash. While my adult client has precisely three seconds to get the phone to do exactly what she needs before everything starts to come unglued, her teen can play with every button, slide and touch without worrying about it. She's literally just playing around (and she's not paying for that phone). We don't say this often, but the teenager with the smart phone is in a much better state for learning.

If you really want to learn something, it has to be ok to try stuff out, to take risks, to push random buttons and see what happens. But unless someone's already covering retirement for you (wouldn't that be lovely), you aren't going to feel that relaxed about your actual investments. Which means we need to find ways to make learning about finances a more playful experience. It can be events like stock trading night (no one cried or lost their homes when American Textiles went bankrupt following an embezzlement scandal). Or we could be using all of those apps and game software to make the foundations of our financial system accessible to anyone who wants to understand them. And sometimes the answer is just in the way we present investment choices to people. Frankly, those of us in the financial industry—from actual financial advisors to the agents and brokers handling most of the country's retirement plans—have kept the tension high and the chance for learning pretty low. We are going to need to do better.

In the meantime, we will get going on another Stocks & Sushi night. I'm feeling like "Donut Barn" has some real earnings potential.

Should I keep putting money in this investment? Dollar-Cost Averaging and Time

I got a great question yesterday about the difference between saving and investing. Everyone knows that we are supposed to regularly save money. Most of us who follow a set savings plan have our banks set aside a little bit monthly or from each paycheck just to make sure this is happening. But putting money aside in a savings account is not the same as regularly investing it in a stock, bond or fund. We all know the difference matters. So here are a few things to think about when you are trying to decide where, exactly, the money goes.

Dollar-cost averaging.

This is the auto-pilot of investing, which makes it one of my favorite techniques to recommend to new investors. The old "buy low, sell high" investment advice suggests that you should be analyzing the market every time you buy more units of your favorite stock, bonds or fund—not so realistic if you are putting money aside monthly and don't plan to give up your job for day trading.

Fortunately, dollar cost averaging studies show that you actually do well over time by choosing your fund and buying into it at a regular interval, regardless of the price that day. Some months, you will pay more as the price goes up. Other months, though, you will hit those bargain moments when the price is temporarily down. And in between, you usually take advantage of the general growth in the market.

If you could predict the future, you could always get the lower prices, but since none of us (even the experts) are really good at those short-term predictions, statistics show you are better off to not even try. With this in mind, use the settings in your investment account to automatically invest your monthly savings in a good fund. And don't forget the automatic dividend reinvestment setting, too. We love studies that tell us to do less work.

Volatility and your investment account.

Let's say that you already have money in the investment account and want to keep adding but know that the college tuition bill or house down payment will be coming your way in a few years. This is when you start thinking about volatility.

Volatility is the measure of how often and how dramatically the value of a particular investment tends to change. A mutual fund with high volatility will drop and soar in price regularly. We don't have a crystal ball, but we know that the value of bonds tends not to move very fast while company stocks tend to be volatile. For this reason, financial planners recommend that you start putting more of your money in bonds as you get closer to the time when you need it. After all, you don't want one of those price drops to hit just when the tuition bill comes due.

If you don't have a financial planner to help you figure this out, try creating your own simple version of one—pair a cheap, blended stock fund with a government bond fund. As you get closer to when you need your money, put more into the bond fund. (For more on how to choose a fund, check out this earlier post). Or, you could use a "Target Date Fund."  Target date fund managers assign each fund a target year when the investor expects to start drawing out money. The fund manager gradually shifts the investments as it gets closer to that year. Target date funds and blended funds are only a rough approximation of your needs, but they can be a cheap and viable way to manage things yourself.

Bank Accounts verses Investment Accounts

Almost all of the investment advice you will see on the internet assumes you are going to leave that money in your investment account for a long period of time—preferably 10 years or more. Why? Because we are betting that the economy and its markets will continue to grow bigger over time. The majority of investment professionals have developed their strategies to take advantage of just that fact. On the other hand, we are all pretty much positive that the market's growth is not going to be smooth and easy. In other words, we expect a few dips and crashes along the way. That's where your time problem comes in. If you need that money out in 2 years, you may get hit with the crash but not had time to benefit from the growth. It's a good way to lose some of your hard-earned money.

There are cases in which you are better off to use an investment account than a bank account even if you only plan to put the money in something very safe. College savings accounts and retirement accounts offer tax advantages over regular bank accounts. But if you aren't looking for the tax deferral and you are just putting the money away for a few years, don't overlook your bank. I find that local banks and credit unions often offer you better interest rates on savings accounts and CD's (Certificates of Deposit), so you can squeeze just a little bit more out of that savings.

Follow the plan

The single most important factor in determining you success as an investor is making a plan and sticking to it. Choose your strategy and your investment allocation first. And then let all of those auto-deposit and auto-invest features work for you. I firmly believe that paying for a financial plan at this stage is a bargain for just about anyone. But if you are willing to put in some time and do a little research, you can do this yourself. Ready to start? Begin with this How To Start Investing: Basics for Doing It Yourself.

This post is not about life insurance. Okay, yes, it is.

I meant to get this post out on Thursday, when we were all feeling very focused about the work week. Or at least early this morning before you realized that it's now Friday. Because, really, I can't think of a more un-Friday-like topic than life insurance. But it's been a busy week, so here we are planning for death on Friday afternoon. You can leave work early and grab a drink or a tub of ice cream afterward. I promise.

Under the circumstances, let's just straight to the point. If you actually need life insurance, there are two basic categories to think about. About 98% of you will want the first type.

Term Life Is Where It's At

Term Life has been the choice of the masses since insurance salesmen started wearing gabardine suits. It's cheap, and it works. You pay your premiums (monthly or annually), and if you kick off before the term of the insurance contract is out your beneficiary gets the money. The biggest pitfall here is in not doing your shopping. Insurance companies come in various levels of financial stability (it doesn't work if the company dies before you do), and they choose their ratings differently. To get the best deal, find someone who works with an independent broker to shop for you, or look for an online service that does the same.

There is one more catch—you should know how much insurance you actually want and how long you need the policy to last before you choose your policy. That means you should always know what "gap" in your financial plan you are trying cover.

Permanent (Whole) Life For The Other 2%

I have never sold insurance (too lazy to fill out the paperwork), so before writing this post I asked my partner how often he has sold permanent life insurance policies to people over the past 15 years. He figures it's two or three times.  You can probably guess the big advantage of permanent policies from the name—you buy the policy and it lasts your entire life so long as you pay the premiums. The insurance company generally builds in a sort of mini-investment account to these policies to help pay for the premiums and to serve as an add-on benefit of the policy. Most insurance sales people put a lot of the focus on that component.

The catch here is that these policies are more expensive—usually a lot more expensive. And there have been cases where the returns from the attached investment account did not cover the premiums. Policy holders that are counting on that automatic premium payment need to be careful that policy does not lapse, undoing all of their investment.

So who should look at permanent life insurance? We see these used most often during estate tax planning, where it's not so much about covering a financial gap as making sure there is a lovely inheritance. So if you are working with an estate attorney, you might discuss it with her. And some people just kind of like the idea of having a policy that lasts their entire lives.

For the vast majority of us, though, the best financial choice is to get term insurance and in just the amount and term needed. You can use the money you saved from those permanent life premiums anyway you want—a strong investment account, a gift for you heirs while you are still around, or just a fund for ice cream purchases. Because no financial plan will stave off mortality, but at least you can enjoy your Fridays while you've got them.

Some Terms To Know

Participating: A “participating” plan pays dividends depending on the company’s returns; these can be used to pay premiums, taken in cash or left in the invested portion of the policy.

Premium payments: premium payments can be “level” (stay the same throughout the policy), “limited” (higher but for a limited period), “single” (just one, large payment), or “adjustable” (the company reserves the right to increase or decrease premium payments).

Variable: In a variable policy, both the value of your investments and the death benefit will vary according to the how well the investments in the account perform. Traditional variable policies will guarantee you a minimum death benefit as long as premiums are paid.

Universal: A universal policy allows you and the company to move money around amongst the premiums due, death benefit amount and investment account depending on investment returns and premium adjustments. Universal life is flexible but risky unless carefully managed—you can find your policy lapsed if not enough of your money is going to premiums.

Surrender Charges: the fee for cancelling your policy and withdrawing your cash balance.

How To Talk To A Teen About Money

One of my clients told me the other day about a conversation she had recently with her teen. The conversation began as a typical mother-daughter talk about a purchase and had every chance of devolving into an equally typical argument. But suddenly, my client decided to take the conversation in a different direction—into the sort of conversation she would normally have with me, her financial advisor. She was surprised at the results. Most of us don't talk to our older children about money because we don't want to share worries and anxieties or because we've been trained to keep the information "private." But very few of us live without financial limits. What we do within those limitations—the planning, the discipline and the constant adjusting for unexpected costs and opportunities that crop up in our lives—these are exactly what a young person in our society needs to understand. Next time you get a chance to mentor a young person about finances, resist the urge to hide the realities that you've been managing (whether skillfully or not), and try sharing your own experiences:

Don't be afraid to share how much you make

We train ourselves to hide how much we make, and most of us have suffered at one time or another from our resulting ignorance of how others in our community are faring. Besides, you might not be impressed by your modest income, but the teen who counts out spending cash one bag of chips at a time probably is. Enjoy the rare moment of respect when you tell them that you make more than a three-figure salary.

Show them the real costs of life

You build your choices around some pretty heft and inescapable costs—housing, health care, transportation, groceries and taxes just to get started. When you share these figures with a teen, you are often giving them their first real look at the baseline for getting by as an adult in our society. This is also a good moment to reflect on how much you ask of yourself as a breadwinner.

Have a dialogue about the choices

Our choices are where we become who we are. Every day we decide what is important to us: because that expense makes us healthier or saves us time we badly need elsewhere, because we are afraid of what might happen, because we believe in something outside ourselves. We make financial choices because we dream of changing our lives some day or just because that little expense makes us happier. None of these choices are things to be ashamed of, even when we aren't completely sure those choices are the right ones.

And this, I think, gets at the root of why we are so reluctant to talk to our teens about these things. As a society, we have been floundering along under the assumption that we should be better at managing our money than we are. Money has a way of squirming its way into every worry and challenge we face in life. And yet, the vast majority of us somehow find a way to get through. We probably all need to give ourselves a bit of break. We definitely all need to talk about it more—not just for our teens' sake, but as a reminder that every day, no matter how many unexpected obstacles crop up, we are there figuring out a way to make things work all over again.