You might not have noticed the seismic shift in your world last week, but something big happened that could make the last 40 years or so of your life a lot less stressful. After years of battling, arguing, and dithering, a new law went into effect that prohibits your financial advisor from trying to sell you on all sorts of expensive nonsense in your retirement account.Read More
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.
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.
September is always a busy month for financial advisors. Everyone has returned from those last vacations of the summer, kids are back in school and there is a general sense that it's time to get back to work. At this point in the year, we usually get a lot of interest from people who have steeled themselves to face the investment questions they have been putting off: should I own these bonds? Is this a good stock still? What about this mutual fund? Should I have bought this annuity? And over and over again, I find myself explaining that it isn't really about the investments. By which I mean that I can't answer any of your questions about whether an investment is "good" until you've answered some questions about what you are trying to do with it. And that's the really stuff part about buying, selling and managing investments. There are some truly crummy investments out there, but for the most part any given investment is "good" for somebody. It's just a question of whether that someone is you.
Let me give you an example. We invest most of our clients' money in a long list of stocks or index funds that are designed to move with different portions of the economy. A so-called U.S. "mid cap" index fund should reflect how well the stocks of our large (but not enormous) publicly traded companies are doing as a group. We like this type of index fund strategy because, historically, it has allowed investors to take advantage of the growth in U.S. markets over time (and it's relatively cheap to do!). But that growth in "mid cap" companies over time might require a long period of time—years, in fact. What if you might need that money three years from now? What if your investments are in a 401k that doesn't have a "mid cap" fund? Or, what if you know you are only going to look at your investments every couple of years? What if your job hinges on the health of these same "mid cap" companies? In all of these cases, I might recommend that you avoid one of my favorite investments. They can be just as bad for your strategy as they are great for someone else's.
I write this blog so that you can better understand the often intimidating world of investments and consumer finance. You need to financial understand the tools that are out there if you are going to make the most of what you have and what you earn. Never lose track, though, of the fact that these are tools. And just as the best drill in the world is a lousy tool for fixing your tv set, the best investment in the world could be exactly what your financial strategy doesn't need.
I came up with this post after meeting with a favorite client today. She's a charming and intelligent woman with a good career and a 401k who, until recently, had never thought of herself as an investor. Investments were complicated things designed for wealthy people. And then she realized that she wanted to buy a home. Part of our problem with the term "investor" is that too many of us picture this when we hear it:
There is some kind of vague understanding out there that "real" investors have special access to a supply of financial jargon, legal tricks and overpriced cuff links that somehow make sense of those relentless scrolling stock prices on CNN. And let's face it, throwing in tax references (tax-deferred, capital gains, tax efficiency) isn't helping. It's enough to make any reasonable person throw her hands up. And it's no surprise that so many of us, even when we actually have investments, don't think of ourselves as investors.
Watching the determination with which my client approached her goal of homeownership really brought home what we are doing wrong when it comes to investing. Buying a home is a form of investing, but where talk of 401k's and index funds makes people feel overwhelmed and anxious, talk of mortgage calculations and down payments has a completely different effect. People who feel empowered as they approach home ownership. And that's important. Because while I am the first to point out that homeownership isn't a good investment for everyone, the real estate industry has done something right by making clear that every buyer should feel like she belongs at that proverbial homeownership table just as much as any coiffed businessman in navy suit.
Since the great home building boom of the 1950's, Americans have understood that our economy depends on the willingness of "average" middle-class people to buy homes. But we seem to have forgotten that our economy depends on those same people to hold up everything else, as well,—grocery chains, cars, professional services, restaurants, charities, and yes, stock markets. Because no matter how wealthy our wealthy class gets, they are never going to make, hold or spend enough money to sustain a modern economy (feel free to ask me why "trickle down theory" was a clever illusion).
All of this leaves us with a dilemma. Most of us believe that we are cut out to be investors in housing, even if we aren't quite ready, yet. And we believe (even if we have temporarily forgotten) that we, in fact, are the U.S. economy when we work and when we spend. But we don't seem to realize that we are also the "public" behind publicly traded corporations and the only reason that stock markets are worth tracking. The hard truth is that we depend on these markets to ensure that we have funds to live on after 65 and that we have the money to buy homes (or to help our children buy them). So how do we convince one another to demand a little more clarity around the retirement plans and investment accounts on which we depend? How do we claim our places at this other table?