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Summary:

I read about the SPY ETF here on SE ( Where should my money go next: savings, investments, retirement, or my mortgage? ) and I am curious about JoeTaxpayer's comment specifically on the idea of using the SPY ETF as an investment vehicle for retirement, in the case of a young investor with a relatively high income, high marginal tax rate, and a company 401k which has a poor match. I would like more information about this use (or for someone to tell me that I have misunderstood the logic presented in the above post by JoeTaxpayer).

About Me: 28 years old, single Expected gross income (before any deductions, pre or post tax) for 2012 - $100k. $15k student loans, car loan ~$2k, no other debt including credit cards $11k in the Vanguard Windsor II fund Current 401k balance $5k

Note: this puts me in the 28% marginal tax bracket. I think with a $5k standard deduction I would need to contribute $10k to get me right on the edge of the 25% bracket, if I understand it correctly (do I?)

About my employer's 401k plan:

Plan profile (Fidelity Freedom 2050) http://quote.morningstar.com/fund/chart.aspx?t=FFFHX&region=USA&culture=en-US

Match details:

"The company matches 10% of an employee's contribution on the first 10% of income that an employee contributes, on a per payroll basis."

In practice this means the best I can get (I think), is to contribute 10% of my income (which is a little challenging for me to do right now, given other financial goals such as a down payment on a home in 3-5 years), and I only get 10% of that as a match.

This match is also on a vesting scale, I am fully vested in 10 years.

The company plan has an expense ratio of 0.8%. Morningstar rates it as three stars.

My "great" idea which I need you all to comment on: (note: when I say "great", I'm saying it tongue in cheek...)

Invest in SPY as a long term savings vehicle, contributing 10% of my income on a TBD (but at least every quarter) basis (for cost averaging), to be used only for the following circumstances:

  1. Down payment on a house in 3-5 years (potential... depending on the market, I may stay a renter :D)
  2. True emergencies that cannot be handled by a 6-12mo liquid expenses fund
  3. Retirement

I currently have $5k in my employer's 401k, I would only contribute to SPY in this scenario, not sure what to do with the current 401k balance.

Expense ratios: my 401k has 0.8%, SPY has an expense ratio of 0.1% (source https://www.spdrs.com/product/fund.seam?ticker=spy) but it could go up (which is ambiguous).

Questions:

  1. Is this a good idea? Is it really risky? What are the pros and cons?
  2. Is it a bad idea to hold both long term savings and retirement in the same investment vehicle, especially one pegged to the US stock market?
  3. Is buying SPY a "set it and forget it" sort of deal, or would I need to rebalance, selling some of SPY and reinvesting in a safer vehicle like bonds over time?
  4. I don't know ANYTHING about ETFs. Things to consider/know/read?
  5. My company plan is "retirement goal" focused, which, according to Fidelity, means that the asset allocation becomes more conservative over time and switches to an "income fund" after the retirement target date (2050). Would I need to rebalance over time if holding SPY?
  6. I'm pretty sure that contributing pretax to 401k is a good idea because I won't be in the 28% tax bracket when I retire. How are the benefits of investing in SPY outweigh paying taxes up front, or do they not?
  7. Please comment on anything else you think I am missing

Many thanks in advance, I will monitor this question closely so that I can provide updates and answer requests for further information in a timely manner.

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I'm not sure you understand what ETF means. Its just a stock. You can buy it from your 401K or any other investment account. I think you should first read about ETFs (Wikipedia for a start), and then may be revise your question for it to make any sense. –  littleadv Jan 2 '12 at 1:44
    
@littleadv, to clarify, I am referring to this: finance.yahoo.com/q?s=SPY, the product offered by State Street Global Advisors. If I am still missing something obvious, I apologize. –  Jeremy Jan 2 '12 at 1:49
1  
I know what SPY is. –  littleadv Jan 2 '12 at 1:50
1  
@Jeremy Perhaps the misunderstanding is that you can't "open a SPY ETF" .. that wording doesn't make sense. You don't open an ETF. You simply buy an ETF from within a brokerage account. The account, perhaps, is what would need opening ... if you don't have one already. –  Chris W. Rea Jan 2 '12 at 2:22
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SPY is just a stock, for that matters. You can't open it, you can't close it, you can only buy it and sell it from within a trading account. 401k is an example of a trading account (with special tax treatment). You can by SPY from within your 401k or any other brokerage account (regular, IRA, Roth 401K, Roth IRA - just a few possible). –  littleadv Jan 2 '12 at 2:48

2 Answers 2

up vote 6 down vote accepted

Answers:

1. Is this a good idea? Is it really risky? What are the pros and cons?

Yes, it is a bad idea. I think, with all the talk about employer matches and tax rates at retirement vs. now, that you miss the forest for the trees. It's the taxes on those retirement investments over the course of 40 years that really matter.
Example: Imagine $833 per month ($10k per year) invested in XYZ fund, for 40 years (when you retire). The fund happens to make 10% per year over that time, and you're taxed at 28%. How much would you have at retirement?

  • In a taxable account: $2,394,071 -- Not bad!
  • In a tax-free account: $5,311,857 -- Woah! More than twice as much!!!

2. Is it a bad idea to hold both long term savings and retirement in the same investment vehicle, especially one pegged to the US stock market?

Yes. Keep your retirement separate, and untouchable. It's supposed to be there for when you're old and unable to work. Co-mingling it with other funds will induce you to spend it ("I really need it for that house! I can always pay more into it later!"). It also can create a false sense of security ("look at how much I've got! I got that new car covered..."). So, send 10% into whatever retirement account you've got, and forget about it. Save for other goals separately.

3. Is buying SPY a "set it and forget it" sort of deal, or would I need to rebalance, selling some of SPY and reinvesting in a safer vehicle like bonds over time?

For a retirement account, yes, you would. That's the advantage of target date retirement funds like the one in your 401k. They handle that, and you don't have to worry about it. Think about it: do you know how to "age" your account, and what to age it into, and by how much every year? No offense, but your next question is what an ETF is!

4. I don't know ANYTHING about ETFs. Things to consider/know/read?

Start here: http://www.investopedia.com/terms/e/etf.asp

5. My company plan is "retirement goal" focused, which, according to Fidelity, means that the asset allocation becomes more conservative over time and switches to an "income fund" after the retirement target date (2050). Would I need to rebalance over time if holding SPY?

Answered in #3.

6. I'm pretty sure that contributing pretax to 401k is a good idea because I won't be in the 28% tax bracket when I retire. How are the benefits of investing in SPY outweigh paying taxes up front, or do they not?

Partially answered in #1. Note that it's that 4 decades of tax-free growth that's the big dog for winning your retirement. Company matches (if you get one) are just a bonus, and the fact that contributions are tax free is a cherry on top.

7. Please comment on anything else you think I am missing

I think what you're missing is that winning at personal finance is easy, and winning at personal finance is hard

  • Easy -- All it takes is spending (a good bit) less than you make, (sensibly) investing the difference, and giving it time. Those three things will have much greater impact on your net worth than any tweaking of tax rates, or shaving fund expense ratios, or juggling the finer points of asset allocations.
  • Hard -- the hard part is self-discipline. Putting that money in there every month, even when everything is crashing, sticking with an investment strategy when there's nothing but red ink, and not spending it when there's that nice shiny house or car or whatever that you think you need. Fortunately, you can set it up so that self-discipline is mechanically imposed, or at least some of it. And that is by having the money automatically deducted from your paycheck, sent into an account that's hard to touch (like 401k), and automatically invested in something that's strategically sound to invest in (like a target retirement mutual fund). After a little while, you forget about the money, and even forget about the part that's leaving your check. And one day you open your statement and there's a nice big chunk of money sitting there.
  • Bonus Extra Hard Part -- the extra hard part is also self-discipline. For those that want to personally invest in the markets (as you do with SPY), the biggest determiner of success or failure is how well you control your own psychology. Selling when everybody's excited to buy the thing you're getting rid, buying when no one wants it. It makes you unpopular with your friends when what you're doing is the opposite of what they're doing. It's really hard to go against conventional wisdom; to resist the excitement, or despair, of the crowd. If you do, if you force yourself against the tide, you're much more likely to become rich. But it's far, far harder than you think.
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Thank you for the detailed answer! –  Jeremy Jan 2 '12 at 14:02
    
This is a great answer. One question, though: When you computed the total for the taxable account, did you tax all the gains? Because with a stock, you only get taxed on the dividends until you sell, and then at a lower rate. Dividend yield on SPY is ~2%, IIRC. How much does that change the calculation? –  Rick Goldstein Jan 3 '12 at 17:31
    
@RickGoldstein I only did a basic calculation. You're right, that if you bought and held SPY over those 40 years you would only be paying taxes on the dividends, not the capital gains because of the way ETFs are structured. So, that figure would be better. That is, of course, assuming you didn't do any rebalancing. Plus, historically 40% of the s&p 500's return has been dividends, so reinvested dividends have a big impact. The crucial point is that taxes impart big drag on your return over 4 decades (as does inflation), so using any opportunity to shelter your retirement savings is key. –  Patches Jan 3 '12 at 21:51
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@Patches - I got similar numbers. While I still agree for the most part with your conclusion, one nitpick: 401k and pre-tax IRAs are not tax-free, only tax deferred. If, as true for most, your marginal rate is lower than during your working life, that's probably a net benefit, compounding being the most powerful force in the universe and all. Full analysis requires accounting for rate diffs and forced withdrawals after age 70. –  Rick Goldstein Jan 3 '12 at 23:52
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Have you considered maxing out a Roth IRA? That would be something I'd suggest considering here. –  JB King Apr 13 '13 at 8:03

I think you understood much of what I say, in general. Unfortunately, I didn't follow Patches math.

What I gleen from your summary is a 1% match to the 10% invested, but a .8% expense. The ETF VOO has a .05% annual fee, a bit better than SPY.

A quick few calculations show that the 10% bonus does offset a long run of the .75% excess expense compared to external investing. After decades, the 401(k) appears to still be a bit ahead. Not the dramatic delta suggested in the prior answer, but enough to stay with the 401(k) in this situation. The tiny match still makes the difference.

Edit - the question you linked to. The 401(k) had no match, and an awful 1.2% annual expense. This combination is deadly for the younger investor. Always an exception to offer - a 25% marginal rate earner close to retiring at 15%. The 401(k) deposit saves him 25, but can soon be withdrawn at 15, it's worth a a few years of that fee to make this happen. For the young person who is planning a quick exit from the company, same deal.

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