Allocation between 401K/retirement accounts and taxable investments, as a young adult?

Question

I graduated college last year and began a career at a company with a 401K option.

I cannot pull any money out of the Roth 401K without tax consequences or a penalty.

I am interested in starting a business 5-20 years in the future.

I am interested in purchasing a home 10-20 years in the futre.

I currently invest 100% of my investment money into a Roth 401K, and 0% into any taxable assets.

Given my goals, would it be advisable to diversify my investments between taxable investments (meaning a no-load, low-fee index fund) and a Roth 401K?

If I invested in a taxable asset, I could sell it for use as capital in a business and/or home. A home would result in no rent payments except interest (but the expense of repairs would increase), with appreciation on the home. A business could either result in more revenues, or bankruptcy. In either situation, I am substantially decreasing the value of the 401K on retirement.

In other words, should a young adult who would like a home and business in the next two decades invest all of his investment money into a tax-sheltered 401K, or diversify it between the tax shelter and a taxable investment?

Answer 1

I'm afraid you're mistaking 401k as an investment vehicle. It's not. It is a vehicle for retirement.

Roth 401k/IRA has the benefit of tax free distributions at retirement, and as long as you're in the low tax bracket - it is for your benefit to take advantage of that. However, that is not the money you would be using to start a business or buy a home (except for maybe up to $10K you can withdraw without penalty for first time home buyers, but I wouldn't bother with $10k, if that's what will help you buying a house - maybe you shouldn't be buying at all).

In addition, you should make sure you take advantage of the employer 401k match in full. That is free money added to your Traditional 401k retirement savings (taxed at distribution).

Once you took the full advantage of the employer's match, and contributed as much as you consider necessary for your retirement above that (there are various retirement calculators on line that can help you in making that determination), everything else will probably go to taxable (regular) savings/investments.

Answer 2

I would say yes, it makes sense to keep some money in taxable accounts. Retirement accounts are for retirement, and the various early withdrawal penalties are designed to enforce that. If you're anticipating using the money before retirement (e.g., for home purchase), it makes sense to keep it out of retirement accounts.

On the other hand, be aware that, regardless of what kind of account it is in, you face the usual risk/return tradeoff. If you put your money in the S&P 500 and the S&P 500 tanks just before you were going to buy a house, your down payment evaporates and you will have to wait and buy a house later. You can manage this by shifting the allocation of this money and perhaps cashing it out if a certain amount is gained (i.e., it grows to the level of your target down payment) and you are close enough to the house purchase time that you don't want to risk it anymore.

Basically, if you invest money for a pre-retirement use, you may want to keep it in a taxable account, but you also need to take account of when you'll need it and manage the risk accordingly.

Answer 3

First off, great job on your finances so far. You are off on the right foot and have some sense of planning for the future. Also, it is a great question.

First, I agree with @littleadv. Take advantage of your employer match. Do not drop your 401(k) contributions below that. Also, good job on putting your contributions into the Roth account.

Second, I would ask: Are you out of debt? If not, put all your extra income towards paying off debt, and then you can work your plan.

Third, time to do some math. What will your business look like? How much capital would you need to get started? Are there things you can do now on a part-time basis to start this business or prepare you to start the business?

Come up with a figure, find some mutual funds that have a low beta, and back out how much money you need to save per month, so you have around that total. Then you have a figure. e.g. Assume you need $20,000, and you find a fund that has done 8% over the past 20 years. Then, you would need to save about $110/month to be ready to go in 10 years, or $273/month to go in about 5 years. (It's a time value of money calculation.)

The house is really a long way off, but you could do the same kind of calculation. I feel that you think your income, and possibly locale, will change dramatically over the next few years. It might not be bad to double what you are saving for the business, and designate one half for the house.