Saving for the Future

I recently set up a 529 Plan for my nephew Nathan and ended up writing up a long email explaining IRAs and 529 Plans to my sister Laura. I thought some of you might find it interesting.

Read on to learn about saving for the future, when you’re young.

Simple Retirement Strategy

  1. In your 401k, save the percentage of your salary that your employer meets.
  2. Open a Roth IRA (Individual Retirement Arrangement) account at Vanguard.
  3. Put the money into a target retirement fund, like the 2050 target retirement fund (assumes you’ll retire in 2050). Minimum investment is $1,000, and the fees (often called the “expense ratio”) are very low at 0.18% a year.
  4. Set up automatic contributions from your checking account. Maximum is $5,500 a year. You can set it to reach the max by the end of the year, or any amount you like.
  5. Don’t take money out for as long as possible. First exhaust all taxable sources, like a Traditional IRA or 401k. All money in a Roth IRA grows completely tax free, so let it grow.
  6. If you still have more money after meeting 401k match and maxing out your Roth IRA, then max out your 401k.


  1. You can withdraw the money you contributed anytime, but taxes and a 10% penalty may apply on the gains. H&R Block has a good overview of the withdrawal rules for Roth and Traditional IRAs.
  2. To avoid taxes and penalties, the account must be 5 years old and the money used for eligible expenses, such as higher education, first home ($10,000 lifetime limit), disability, death, or large medical expenses.
  3. If the account is over 5 years old and you are over 59.5 years old, you can take the money out without penalty for any reason.

Simple College Savings Strategy

  1. Open a 529 Plan in your state of residence if it offers tax incentives. Roll it over to your new state when you move, but only if it also offers tax incentives. Choose a target-date mutual fund that is cheap and balanced between stocks and bonds.
  2. If you get no tax incentives, open a Utah 529 Plan. It offers Vanguard funds with low fees. Put the money (no minimum) into the age-based growth option.
  3. Set up automatic contributions from your checking account.
  4. You can take out the money any time and for any reason. But only use it for qualified educational expenses (tuition, room, books) to avoid tax penalties. Otherwise the gains on principal are taxed and is docked a 10% penalty. You also would have to repay any state tax benefits you received.
  5. You can make the check payable to beneficiary, the school, or yourself. The first two are easier to deal with come tax time.
  6. Keep the documentation that proves that you spent that money for qualified educational expenses.

Your retirement savings come first before your child’s college savings. There are student loans, but no retirement loans.

Basic Questions Answered

Why Save for Retirement Now?

Because of compound interest. It is secret sauce and the closest thing to a free meal. Even Wells Fargo agrees.

The younger you start saving, the more interest will accrue on your interest. By saving in yours 20s, you can end up with more money at retirement than someone who started in his 40s–even if the latter saved much more.

Do not delay–regardless of your age.

Why a Roth IRA over Traditional IRA?

A traditional IRA charges you taxes when you take the money out, so you get a tax refund today. This is how many 401k’s are set up (though there’s Roth 401ks too). A Roth charges you taxes today, but it’s tax free when you make eligible withdrawals.

Roth IRAs are the best investment vehicle for young or low income individuals. Your current tax rate is almost certainly lower today than it will be at retirement age, so you want to be taxed today. As you get better jobs and make more money, your tax rate will jump to higher brackets.

(NOTE: Taxes are not levied at a flat rate, but at a marginal rate. You pay a tax rate only for the dollars that fall within the appropriate  income range. For example, if your income in 2013 is $60,000, the first $8,925 will be taxed at 10%, then from $8,926 to $36,250 at 15%, and finally from $36,251 to $60,000 at 25%.)

Furthermore, tax rates are historically low today. That won’t always be the case because we will need to raise taxes to pay off the national debt. The tax brackets of the future will most likely be higher than they are today.

Roth IRAs also have more flexible withdrawal and distributions rules. It’s easier to withdraw early, or not at all. And Traditional IRAs require minimum distributions starting at age 70.5; the money in a Roth IRA can stay there until you pass away.

When is a Traditional IRA Better?

When you expect your tax rate to be lower in retirement than today. Meaning, you’re making lots of money now and you don’t see it going anywhere but down.

Each IRA hedges against the other. A Roth IRA bets that your taxes will be lower today, while the Traditional IRA (and most 401ks, unless Roth 401k) bets that your taxes will be higher today. Use a Traditional 401k as a hedge to the Roth IRA,so you’ll be OK regardless of what happens to your tax rate.

Use a Traditional 401k as a hedge to the Roth IRA, so you’ll be OK regardless of what happens to your tax rate.

Use a Traditional 401k as a hedge to the Roth IRA, so you’ll be OK regardless of what happens to your tax rate.

When is a 401k Better?

Whenever there’s an employer match. That’s free money. Save at least what your employer will match.

Then top off your Roth IRA ($5,500 max). If you still have more money to save, top off your 401k ($17,500 max).

Note, however, that Roth and Traditional IRAs share the same contribution maximum, so always choose Roth. 401ks are entirely separate in the tax code.

Should I use an IRA to pay for college?

A 529 Plan is similar to an IRA, and both can fund your education.

IRAs don’t factor into financial aid calculations, whereas a 529 Plan owned by a parent or child does. IRAs are also cheaper. For example, Utah’s 529 Plan charges 0.22% a year for the same target-date fund that would cost 0.18% through a Vanguard IRA. Sounds insignificant, but in the long-term it amounts to thousands of dollars lost.

Nevertheless, you should avoid withdrawing from your IRA, especially a Roth IRA. Yes, you can use it to fund your first house or education without penalty, but at the expense of your retirement. Your retirement savings come first before your child’s college savings. There are student loans, but no retirement loans.

You can’t retroactively fund an IRA either, unless you’re over 50. Each year, you can save $5,500. Miss it, and it’s your loss. Take the money out, and you can’t replenish it later. Don’t touch that money!

Which State’s 529 Plan is Best?

529 Plans make it easy for anyone (family, friends, etc.) to contribute to it. The money can also be withdrawn right away–but the gains are taxed and docked a 10% penalty if the money is not used for higher education.

If your state’s 529 Plan offers a tax incentive, it’s probably a reasonable deal. 34 states and DC offer incentives, but usually only to residents who contribute to the state’s plan.

In DC, I can deduct up to $4,000 from my income for state taxes. But only contributions I make to DC’s 529 Plan while living in DC count. And it’s expensive! For example, Utah’s offerings are up to 3 times cheaper than comparable DC funds. I only started one in DC for the tax deduction, because otherwise it’s terrible.

Thankfully, you can roll over your 529 Plan to another state, whether you live there or not. I will do so when I move from DC.

If your state doesn’t offer an incentive, open a 529 in a state that offers low-cost, flexible funds. I recommend Utah’s. You can also read Morningstar’s 2012 recommendations here.

Avoid advisor-sold funds. Stick to cheap target-date funds that you can purchase directly.

Why Vanguard?

Vanguard is a non-profit mutual fund company. It is universally recommended.

Unlike the other large mutual fund companies, T. Rowe Price and Fidelity, any profits Vanguard makes go back to the stakeholders (you). Vanguard often uses these profits to lower their funds’ expense ratios. Consequently, their funds’ fees are usually among the lowest.

Choosing an Investment

When investing for the future, there are two important goals:

  1. Diversity in domestic and international stocks and bonds.
  2. The lowest fees possible.

The best way to achieve these goals is with index funds, which track a section of the market (e.g., S&P 500). Index funds are cheap because they are simple. But they also require more work on your part to re-balance every couple of months to maintain your preferred balance of stocks and bonds.

The rule of thumb is your age as the percentage of bonds in your portfolio. My current allocation is 28% bonds, 12% international stocks, and 60% domestic stocks. I’m hoping to increase my exposure to international stocks soon.

Choose a target-based mutual fund, or build one with individual index funds. Keep about your age as the percentage of bonds in your portfolio.

Choose a cheap target-date mutual fund, or build one with individual index funds. Keep about your age as the percentage of bonds in your portfolio.

The second best option is to choose a target-date mutual fund, which automatically balances the mix between stocks and bonds as you age. But, because it’s more complicated, a target-date fund will have a higher fee than a comparable mix of individual index funds.

Never choose an actively managed fund. They have much higher fees, and it has been proven time and again that no manager consistently beats the market.

And, since you can’t predict what the market will do any better than the average manager, the only certain way to increase the profitability of your investments is to choose a mutual fund with low fees or expenses.

For a complete guide on how to invest, read the Bogleheads Wiki. I left a lot of detail out.

3 Responses to “Saving for the Future”

  1. Ruth March 11, 2013 at 2:28 pm #

    Very interested view. I thought to invest in vanguard a while ago, i even when to the building where somebody told me i had to do it online. I had interest in a diversified portfolio, but i lost interest when I started thinking I was not in an economic position to do so. For those that can, is very good though. It is a forced saving because once you started you do not want to stop or you would be loosing paying on penalties. Besides, it represents interests on your portfolio, and is a credit on your taxes.

  2. Jenny August 18, 2013 at 8:12 pm #

    Are there limits on Roth contributions for high income earners?

    • Dennis August 19, 2013 at 10:31 am #

      Yes, there are limits. If you’re offered a Roth 401k at work, you can use that instead.

      High earners lose some of the advantages of a Roth plan (high income = high taxes), but tax rates are historically low today. A Traditional 401k (the industry standard) should be better for high earners once tax rates jump.

      I wrote an more in-depth article about retirement savings that should be more helpful. I’ll have to link it once it’s published.

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