Retirement Vs. Regular Investments: Where Should Your Money Go?

Investing for retirement is a long-term process that requires careful planning and consideration. It's essential to understand the different options available, such as retirement accounts and regular investments, to make informed decisions. While retirement accounts like 401(k)s and IRAs offer tax advantages and employer matching contributions, regular investments provide more flexibility and control over your investment choices. Here, we will discuss the benefits and drawbacks of both options to help you make an informed decision about your financial future.

Weigh up the pros and cons of a 401(k) plan vs stock-picking

A 401(k) plan is a popular retirement savings scheme in the US, where employees contribute pre-tax dollars to their retirement savings. It is a convenient way to save and invest for retirement, with some employers even matching employee contributions. However, 401(k) plans also have some drawbacks, such as limited investment options, high fees, and early withdrawal penalties.

On the other hand, stock-picking involves actively selecting individual stocks to buy or sell, often based on an analyst's strategy. While it can be fun and rewarding, it is also time-consuming and may not yield better returns than passive investing in index funds.

Pros of a 401(k) plan:

• Easy and consistent contributions with the option of employer matching.
• High contribution limits, allowing for greater tax-deferred growth.
• Loans are available in emergencies.
• Contributions reduce current taxable income.

Cons of a 401(k) plan:

• Limited investment options, with little advice or guidance from the plan provider.
• High fees, especially in smaller company plans.
• Early withdrawal penalties and difficulty accessing funds before retirement.
• Potential for higher taxes later when withdrawing funds.

Pros of stock-picking:

• Can be fun and rewarding if successful.
• Allows for active investing based on personal strategies and market interpretations.

Cons of stock-picking:

• Time-consuming, requiring significant research and market monitoring.
• Most investors do not beat the market, and passive investing in index funds often provides higher returns.
• May not be suitable for those who want a more hands-off approach to investing.

Understand the different types of retirement accounts

Retirement accounts are specialised investment accounts designed to help individuals fund their retirement. There are many different types of retirement accounts available, each with its own benefits and considerations. Here are some of the most common types of retirement accounts:

• 401(k) plans: These are tax-advantaged retirement accounts often sponsored by employers. Employees can contribute a portion of their paycheck to the account, and employers often match these contributions. 401(k) plans come in two main varieties: traditional and Roth. Traditional 401(k)s are funded by pre-tax income, allowing employees to defer taxes on contributions and interest until withdrawal, while Roth 401(k)s are funded by after-tax income, resulting in tax-free withdrawals during retirement.
• Individual Retirement Accounts (IRAs): IRAs are tax-advantaged retirement accounts that can be opened by anyone with earned income, making them a popular option for self-employed workers. IRAs offer more flexibility in investment choices compared to 401(k) plans. They also come in traditional and Roth varieties, each with different tax implications.
• 403(b) plans: These are similar to 401(k) plans but are offered to employees of public schools, certain charities, and other nonprofit organisations. 403(b) plans can also be either traditional or Roth, and employers may choose to provide a partial or full match to employees' contributions.
• 457(b) plans: These plans are similar to 401(k) and 403(b) plans but are available only to eligible employees of state and local governments. They also come in traditional and Roth varieties and may include a potential employer match. A key difference is that there is no early withdrawal fee for savers with a 457(b) account.
• SIMPLE IRA plans: These are retirement accounts designed for small businesses with fewer than 100 employees. Employers are required to contribute to these plans, either through a dollar-for-dollar match or a non-elective contribution. SIMPLE IRAs have lower contribution limits than regular 401(k) plans.
• SEP IRAs (Simplified Employee Pension plans): These are retirement accounts primarily for self-employed individuals and small-business owners. SEP IRAs have higher contribution limits compared to regular IRAs and are often described as a mix between an IRA and a 401(k).
• Solo 401(k) plans: These are retirement plans designed for self-employed individuals or sole proprietors. They share characteristics with regular 401(k) plans but with some differences, such as higher contribution limits.
• Spousal IRAs: These allow a working spouse to contribute to an IRA for a non-working spouse, offering the same benefits as traditional or Roth IRAs.
• Rollover IRAs: These are created when an individual moves their existing retirement account, such as a 401(k) or IRA, to a new IRA account, allowing them to retain the tax benefits of an IRA.

Learn how to calculate your net worth

When deciding whether to invest in retirement or regular investments, it is important to understand your net worth. Net worth is a snapshot of your current financial position and is calculated by subtracting your liabilities from your assets.

Identify Your Assets

Assets are the valuable possessions that you own. This includes cash, retirement and investment accounts, vehicles, and real estate. It's important to note that assets are not limited to liquid assets like cash and include any items of monetary value that you own.

Determine Your Liabilities

Liabilities are your financial debts and obligations. This includes credit card debt, student loans, mortgages, auto loans, bills, and taxes. Liabilities deplete your resources, so it is important to keep them in check.

Calculate the Difference

Once you have identified your assets and liabilities, subtract the total value of your liabilities from the total value of your assets. The resulting number is your net worth.

Track Your Net Worth Over Time

Calculating your net worth at a single point in time gives you a snapshot of your financial position. However, tracking your net worth over time allows you to see if you are making progress towards your financial goals. Consider calculating your net worth regularly, such as once a year, to ensure you are on the right track.

Take Action to Improve Your Net Worth

If you find that your net worth is not where you want it to be, there are steps you can take to improve it. Focus on either reducing your liabilities while maintaining or increasing your assets, or increasing your assets while keeping your liabilities constant or reducing them. This may involve creating a budget, implementing debt reduction strategies, or consulting a financial professional for personalized advice.

By understanding your net worth and taking steps to improve it, you can make more informed decisions about whether to invest in retirement or regular investments based on your financial position and goals.

Understand the risks of emotional investing

Emotional investing is a common pitfall, where investors let their feelings, rather than logic, dictate their investment choices. It can be tempting to bail out of the stock market at the first sign of a downturn, or to invest too conservatively for fear of losses. Conversely, past successes can lead to overconfidence, prompting risky investments that aren't fully understood.

• Keep a long-term perspective: While it's important to monitor your investments, fixating on daily ups and downs can lead to poor decisions. Bear in mind that, on average, bear markets last less than 10 months, and over the past 100 years, stocks have delivered average annual returns of about 10%.
• Diversify your portfolio: Many financial advisors suggest diversifying across asset classes, with a mix of stocks, bonds, mutual funds, exchange-traded funds (ETFs), and index funds. This helps to insulate you from dramatic market fluctuations and ensures that losses in some investments are offset by gains in others.
• Use Dollar-Cost Averaging: This strategy involves investing equal amounts of money at regular intervals, regardless of market conditions. In a downward trend, you buy shares at lower prices, and during an upward trend, you benefit from capital gains.
• Get professional advice: Financial advisors can provide an expert perspective on market fluctuations, helping you make rational decisions. Robo-advisors are a more affordable option, using algorithms to create a custom portfolio based on your goals, timeline, and risk tolerance.
• Check your emotions: Be mindful of your wins and losses, and take time to evaluate your choices and learn from them. This will help you make better decisions in the future.
• Maintain a balanced portfolio: Diversify your investments according to your age, risk tolerance, and goals. Younger investors can focus on higher-risk/higher-reward investments, while older investors typically opt for a higher proportion of lower-risk investments.

By implementing these strategies, you can avoid the pitfalls of emotional investing and improve your long-term investment returns.

Know the fees associated with retirement investing

When it comes to retirement investing, fees can significantly erode your funds. It is important to be aware of the fees associated with your investments and to understand how they can impact your returns.

There are various fees associated with retirement investing, and these can come from two sources: the plan provider and the individual funds within the plan. Plan provider fees are typically static and may be difficult for individual investors to negotiate. However, investors can minimise fees by choosing funds within the plan that have lower expense ratios.

It is worth noting that fees are not "hidden". The U.S. Department of Labor requires 401(k) providers to disclose all fees in a prospectus provided when enrolling in a plan, which must be updated annually. When reviewing these prospectuses or statements, look for line items such as Total Asset-Based Fees, Total Operating Expenses as a %, and Expense Ratios. These fees can add up over time and impact your overall returns, so it is important to pay attention to them.

Some common fees to look out for include:

• 12b-1 fees: These are filed under marketing and distribution expenses and are capped at 0.75% of assets. Some funds also charge a 0.25% shareholder services fee.
• Investment management fees: These are fees retained by the 401(k) provider for themselves.
• Transaction fees: Mutual funds also charge transaction fees that are not reflected in the expense ratio.

Additionally, fees vary depending on the size of the employer's 401(k) plan, the number of participants, and the plan provider. Smaller plans tend to have higher fees, and these can make a significant difference to your overall returns. For example, a 1% fee on a $1,000 monthly investment over 40 years would result in a portfolio of $4.3 million instead of $5.8 million, a difference of $1.5 million or 25% of the total wealth.

In summary, understanding the fees associated with retirement investing is crucial to making sound investment decisions. While some fees may be unavoidable, being aware of them can help you make more informed choices and potentially improve your overall returns.

Frequently asked questions