401k with paltry match or SPY ETF?

Question

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.

Answer 1

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.

Answer 2

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.

Answer 3

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

Switching to only 401k or only SPY? Both bad ideas. Read on.

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?

You need multiple savings vehicles. 401k, Roth IRA, emergency fund. You can/should add others for long term savings goals and wealth building. Though you could combine the non-tax-advantaged accounts and keep track of your minimum (representing the emergency fund).

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?

SPY is ETF version of SPDR index mutual fund tracking the S&P 500 index. Index funds buy weighted amounts of members of their index by an algorithm to ensure that the total holdings of the fund model the index that they track. They use market capitalization and share prices and other factors to automatically rebalance.

Individual investors do not directly affect the composition or makeup of the S&P500, at least not visibly. Technically, very large trades might have a visible effect on the index makeup, but I suspect the size of the trade would be in the billions.

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

An Electronically Traded Fund is sold by the share and represents one equal share of the underlying fund, as divided equally amongst all the shareholders. You put dollars into a fund, you buy shares of an ETF. In the case of an index ETF, it allows you to "buy" a fractional share of the underlying index such as the S&P 500. For SPY, 10 SPY shares represent one S&P basket.

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?

Targeted retirement plan funds combine asset allocation into one fund. They are a one stop shop for a diversified allocation. Beware the fees though. Always beware the fees.

Fidelity offers a huge assortment of plans. You should look into what is available for you after you decide how you will proceed. More later.

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?

SPY is a ETF, think of it as a share of stock. You can go to a bank, broker, or what have you and set up an account and buy shares of it. Then you have x shares of SPY which is the ETF version of SPDR which is an index mutual fund.

If the company is matching the first 10% of your income on a 1:1 basis, that would be the best I've heard of in the past two decades, even with the 10 year vesting requirement. If this is them matching 1 dollar in 10 that you contribute to 401k, it may be the worst I've ever heard of, especially with 10 year vesting. Typical is 3-5% match, 3-5 year vesting.

Bottom line, that match is free money. And the tax advantage should not be ignored, even if there is no match.

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

Research:

• https://www.reddit.com/r/personalfinance/wiki/commontopics
• Three fund lazy portfolio (bogleheads blog - named for Jack Bogle, inventor of the index fund)
• Financial independence, retire early
• frugal living

I applaud your interest. The investments you make now will have the greatest impact on your retirement.

Here's a scenario: If you can figure out how to live on 50% of your take home pay (100k * 0.90 * 0.60 * 0.5 / 12) (salary with first 10% in 401k at roughly 60% after taxes, social security, medicare, etc. halved and divided by 12 for a monthly amount), you'll have 2250 a month to live on. Since you're 28 and single, it's far easier for you to do than someone who is 50 and married with kids. That leaves you with 2250 a month to max out 401k and Roth and invest the rest in wealth building. After four or five years the amount your investments are earning will begin to be noticeable. After ten years or so, they will eclipse your contributions. At that point you could theoretically live of the income. This works with any percentage rate, and the higher your savings rate is, the lower your cost of living amount is, and the faster you'll hit an investment income rate that matches your cost of living amount. At least that's the early retirement concept.

The key, as far as I can tell, is living frugally, identifying and negating wasteful spending, and getting the savings rate high without forcing yourself into cheap behavior. Reading financial independence blog posts tells me that once they learn to live frugally, they enjoy it.

It's a lot of work, and planning, but if you want to be financially independent, you are definitely in a good position to consider it.

Other notes:

• Vanguard funds are highly regarded in personal finance and financial independence circles. Though typically the Total Market index fund or the S&P 500 index fund (Warren Buffet and Mark Cuban both recommend it). I'm not familiar with the Windsor II.
• A primary reason index funds can be good is they can have low fees. Fees are killer. Over the life of a 37 year investment like yours, a 1% fee, and the loss of return is significant.