Is it better to invest in a 401k or stocks and mutual funds?

Is it better to invest in a 401k or stocks and mutual funds

Like all good questions the answer is…it depends, but this one has a pretty clear winner most of the time. 

Largely this question revolves around the impact of taxes and the ability to compound money early and often. 

In a 401k plan, every dollar of your allocation is deductible on a federal and state basis. When you invest directly into equities (stocks) in a non-retirement account, you are investing after tax dollars.

A 401k plan is an employee sponsored plan that is tax sheltered. 

When you contribute money as part of your weekly/bi-montly/monthly pay cycle that money goes directly into an account and no taxes are withheld on the allocation. 

That is an incredibly impactful factor in that your money has an opportunity to compound without the negative effects of taxes. 

Compounding money early in life, and avoiding taxes have a significant impact on your final net worth.  More to come on this later.

Free Money

401k money invested well

The second benefit of a 401k is that often an employer will contribute above and beyond your allocation. 

This is considered an employment perk and is also an employer’s tactic to help encourage retirement savings.  

A specific example of this is that if you were to decide to invest 5% of your pay to a 401k, an employer will often match the first 3%. 

In essence, this is additional pay, and again will go into your account without tax withholding. 

This specifically started to become the practice once fixed income retirement plans (pensions) started to fall by the wayside. 

Out of guilt, out of obligation, or something else, it is commonplace to see employer’s contributing directly into 401k plans.

Time matters when making the 401k decision

Savings of Median Households in the US for retirment

The longer you can wait to withdraw invested funds will shift your preference to using a 401k account; at least, until the very end. 

If you are going to need your funds before the age of 59 ½, you will have to both pay taxes and an additional early withdraw penalty–that’s very hard to make up. 

However, if you will need the money earlier it will often make sense to take the tax hit, invest conservatively, and invest in an after-tax account. 

This can be modeled pretty simply but the high level take away is immediate and near-term needs should be invested in taxable accounts and beyond that go with the 401k.

Quality of the Plan Plays a Role

Dollar Worth With Age

Some of the plans that I have reviewed over the years are simply terrible. 

They contain only fixed income funds with low returns, or they have annuities with massive service fees. 

It will be very difficult to compound returns in these environments even with the benefits of pre-tax dollars and free money from your employer. 

In these extreme cases, it may make perfect sense to invest outside of a 401k. 

If you are going to go this route you will need to keep a long-term perspective and have a heavy lean to stocks vs. bonds to overcome the friction of tax. 

In fact, this is where it makes the most sense to invest in low-cost index funds with reduced tax exposure.  In our buyer’s guide we have recommendations that will provide specific fund and stock recommendations. 

What are the Right Stocks to Outperform a 401k

Top Tech Stocks 2009-2019

Depending on the time horizon described in our considerations above it will put us on a couple different paths. 

When the need for funds is near-term, we should leave the funds in the most conservative fixed return funds where our primary objective is capital preservation. 

When we have a longer time horizon (plus 5 years) but will need the funds prior to our 59 and ½ birthday, we’ll want to shift to low cost index funds but will want to shift the portfolio heavily towards stocks/equities. 

Going longer-term, we will want to push for more aggressive risk/return because we have a longer time period for the risk premium of stocks to be realized. 

However, as a default rule stick to low cost index funds and turn your focus to increasing contributions by reducing your living expenses.

What are the Right Stocks to Outperform Inside a 401k

Stok Screening Tools

Inside a retirement account, I’m always looking to maximize dividend yields while remaining cognizant of individual equity risk. 

The perfect candidate would distribute a high monthly yield but have a strong balance sheet and a conservative distribution coverage ratio (I’ll address this further in another post). 

I like to have a high monthly or quarterly yield inside my retirement account so I do not have to pay taxes on these distributions.  I’m also a big fan of having the cash now rather than trusting a company to return it when it benefits them. 

Inside my retirement accounts I’m trying to maximize monthly dividends without exposing my portfolio to unneeded risk. 

When mining for these stocks or funds I use a bottom-up approach where I’m selecting the 50 best candidates. 

Once I have the equities selected I will monitor exclusion criteria and will quickly kick a stock out of my preferred list. 

Next, I will monitor both the dividend yield, and will be looking up these candidates when their price takes a hit. 

There are several stock screening tools available and the principles listed above are critical to building a strong retirement account, and a secure future.

Conclusion

401 Retirment Plan

If you do not have an immediate or near-term need for your funds, it almost always makes sense to invest the funds inside a 401k fund. 

Only when the options inside that fund are very poor or too conservative would it make sense to avoid the tax and employee matching contribution. 

If you are going to invest outside of a 401k you should try to ensure the stock or fund is tax efficient (holds equities beyond 1 year and how low turn-over), and you should allocate funds heavily towards equities (versus bonds) so you can overcome the friction of taxes. 

There will be additional posts that provides the specifics on stocks but the above principles should serve as your foundation.

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