One of the best vehicles for accumulating a nest egg for ordinary investors is the 401 (k). For most employees of large companies, they get the ability to contribute as much as $18,000/year, and get a tax break in the process. The money is then invested in those 401 (k) plans, and grows tax-free for decades, until it has to be withdrawn at retirement. At that point, the withdrawals are taxed as ordinary income for pre-tax plans, and not taxed for after-tax ones. This is the best way to invest for someone who holds a demanding day job, and spends a lot of time on family affairs, and is not able or willing to dedicate even 10 hours/week on their goal of retirement or financial freedom. This is the best way for probably 80% of employees out there. Those include most investors that probably have no clue about investing, economics, business, the difference between preferred stock and livestock, and are not going to spend the time or effort to learn about it. A very close relative of mine invests entirely in index funds in their 401 (k) and Roth IRA every month, and have ok over the past decade.
I have been thinking about it, and think that this is also a very good way to invest for the average self-directed investor. Basically, what I am trying to say is that the ability to defer taxes in a 401 (k) today, enjoy tax-deferred compounding for decades, and earn an employee match on contributions is a more advantageous place for your money than a taxable portfolio. This is because by investing in a taxable portfolio, you are essentially able to place much less money to work for you. In addition, in a taxable account your capital gains and dividends are taxed during your accumulation phase, when your total income is usually at its the highest. Thus, even a portfolio of the best dividend paying stocks has to perform at least a couple percentage points better per year, in order to keep up with the tax-advantaged performance of investments in a 401 (k). In my case, I am getting a 25% effective discount from my purchase price by investing through a tax-deferred account.
If that 401 (k) plan allowed for selecting individual companies, I would select my own investments, rather than use the pre-defined portfolios available. This is because a diversified portfolio of dividend growth stocks would likely do equally as well as an index fund, while also providing the benefits of dividend investing to the saver. Those benefits include a stable and growing stream of dividend income, which is always positive and is an income source that is not dependent on a bull market increase in stock prices. Plus, the regular dividend payments soften the losses when stock prices fall during the next bear market. The other benefit includes lower costs, because there should be almost no turnover. The third benefit is that I am in control of the investments I select, and not some committee. I do not want to include a business selling at a stratospheric triple digit P/E ratio in my portfolio, merely because it has a market capitalization due to a stock market euphoria about the company. The fourth benefit is that a nest egg consisting of index funds is usually not a very good method for living off assets, as it is dependent on sequence of returns, bear markets, and extended periods of flat stock prices which are tough to predict. The fact is that my goal is to generate enough cash from my investments, in order to meet my annual expenses. Thus I buy dividend stocks, and do not expect to materially change my strategy. For example, in my 401 (k), I invest in index funds. However, in previous 401 (k) plans, I have rolled the money over into an IRA, and selected my own investments.
The only reason to not contribute to a 401 (k) include:
1) Poor selection of investing options such as loaded or high fee mutual funds
2) If you are not familiar with the rules behind 401 (k) plans and do not want to learn about them
3) A 401 (k) plan is not available to you
4) You cannot afford to contribute or you have high interest rate debt that needs to be paid off first
5) You are in a low tax bracket, and do not expect to be in a higher tax bracket again
You might be surprised to hear that sentence, uttered from a dividend growth investing website. The truth is, that my goal is to be a successful investor and remain objective in my pursuit of financial freedom. Dividend growth investing is a strategy I have chosen after a careful study of different methods of earning money, across asset classes. There are many other ways that someone can generate a fair return on their investments, thus earning a total returns in the 8-10% range per year over say a 30 year time period. My aptitude is leaning towards dividend stocks however.
I myself invest in index funds through my 401 (k), because of the tax deferral and employer match. In the accumulation phase, I do not want to have annual leakage in the form of taxes. This reduces amount of money I have to put towards building my financial freedom. It intuitively makes sense that the less money I spend on taxes and commission costs each year, the more money I would have to compound for me. This is all part of my unique approach to investing for retirement. When I finally do call it quits however, a large portion of this 401 (k) will be slowly converted to income producing investments. I also plan to convert 401 (k) and IRA balances into Roth slowly wnen I retire. You can recall that I get a 25% - 30% deduction for putting money in 401 (k) and IRA today. My goal is to convert that amount in 401 (k) and IRA slowly into a Roth IRA when I retire, and to pay no taxes in the process.
To summarize, when you invest through tax-deferred accounts you gain:
1) A tax break upfront, which allows you reduce taxes today, and invest more (exception is Roth IRA)
2) The ability to compound your money for decades, while deferring taxes ( in the case of Roth IRA - eliminating any taxes)
3) You get a greater level of asset protection than with taxable accounts
4) The ability to save and invest automatically
Full Disclosure: None
Relevant Articles:
- Taxable versus Tax-Deferred Accounts for Dividend Investing
- How early retirees can withdraw money from tax-deferred accounts such as 401 (k), IRA & HSA
- My Retirement Strategy for Tax-Free Income
- How to Grow Dividend Income Much Faster With Tax Advantaged Accounts
- How to Make Money in Your Sleep with Forever Dividend Investing
- How to buy dividend paying stocks at a 25% discount