Advanced Personal Finance

The Thrift Savings Plan (TSP) has to be one of the best reasons going for working for the federal government. Well, that and some of the jobs have nice perks like:

• Instilling fear in your fellow citizen just by your presence (IRS auditor)

• Getting to blow stuff up (Military)

• Deciding how long people will spend locked up in jail (Federal judge)

The TSP is the gub’ment’s version of the 401(k) or 403(b). Only it’s way better. To wit,

• You can contribute any percentage of your pay, regardless of your income, up to the federal max ($15,500 in 2007).

• Depending on the situation, there is sometimes a match.

• The contributions are pre-tax, just as in a 401(k), so contributing reduces your tax bill.

• The investment selections are superior to just about any private plan I’ve seen.

Investment options

Where the TSP really shines is in its investment options. There are really two categories - Lifestyle and regular funds.

A lifestyle fund is one that changes the underlying investments gradually as you approach retirement. So as you age, your exposure to stocks decreases. The lifestyle funds are just like the better versions of the same in the private sector. For example, the 2040 fund investments are just about perfect, as far as I’m concerned. It has 60% in a total market stock index fund, 25% in an international index fund, 10% in a bond fund, and 5% in a cash equivalent.

The funds that underlie the lifestyle funds are the same ones you can invest in directly. That way, if you don’t like the lifestyle fund target mix, you can do it yourself.

There are two great things about the regular funds. First, they have the most awesome management fee around - 0.03%. That’s right, on a $10,000 investment you’d pay $3 in fees per year. That’s lower than even Vanguard’s ETFs. Unreal.

The second great thing about the funds is they’re simple. There are only five of them, so even novice investors aren’t going to be overwhelmed with options. They’re all also index funds. Since it’s been proven over and over that index funds beat actively managed funds over the long haul, that’s a good thing.

Other notes

Another thing to know about the TSP is that it’s portable. That is, you can roll it over when you leave government service. You can also roll over previous qualified plans into it. That keeps all your investments together, and since the funds are so great, I recommend that.

Normally, National Guard and Reserve members can’t contribute to the TSP. However, if you’re called to active duty, you can. That’s what I did when it happened to me right after 9/11. I knew about the program and enrolled. I was able to save, like, $3,000 in addition to my 401(k) that year (which is probably against the rules, but since I’m one of probably three people who’s ever done it, I’m not too concerned). Once I left active duty, I rolled it over into an IRA.

So what does all this boil down to? If you’re employed by the federal government, you owe it to yourself to invest in the TSP as much as you possibly can. If you’re unsure how to invest, pick the lifestyle fund closest to your target retirement date. Then, when you retire, you can sleep on piles of money, free from worry.

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For many people (me included), maxing out both a 401(k) (or 403b) and Roth IRA isn’t feasible. (Ok - for us, it’s feasible, we’ve just chosen to go a different way with our money.) Everyone must make the same decision with their money - how to allocate it. You could max out a Roth IRA, but maybe you’d rather eat out often. That’s a perfectly valid decision assuming you’ve actually made the decision consciously.

So if, like many people, you’ve decided maxing a 401(k) and Roth IRA is an either/or proposition, you have a big decision to make.

Is it better to save in a 401(k) or a Roth IRA?

Here is a head-to-head comparison of the 401(k) and Roth IRA. Assuming you’re eligible for both, this guide should help guide you to the right retirement savings account for you.

• Investment Options

Many 401(k) plans offer an inappropriate number and type of investment choices. Plans can have either too many or too few choices. Too many can cause investor paralysis or a ‘little bit of everything’ allocation. Too few choices can cause a dangerous overweighting in one asset class and other problems. Another problem with 401(k) plans can be the investment options themselves. Funds that are expensive in terms of load and/or management fees directly and dramatically affect your account balance at retirement.

On the other hand, a Roth IRA can be invested in almost anything. You can invest in Exchange Traded Funds (ETFs) with their low-fee advantage. You can choose mutual funds, fixed income assets (e.g. bonds), Real Estate Investment Trusts (a kind of real estate ‘mutual fund’), or most anything else. Being able to invest in whatever you want obviously is a great advantage because you’re not limited to your company’s investment choices.

Advantage: Roth IRA

• Access to Funds

You might need access to your savings prior to retirement for any number of reasons. While it’s almost never advisable to withdraw money you’ve saved for retirement before actually reaching retirement, circumstances sometimes dictate that course of action. For example, an extended job loss may require you to dip into retirement savings.

Most 401(k) plans offer an option to borrow some of what you’ve contributed. If you take this route, you pay the money back just like any other loan. Effectively, the loan payment comes right out of your paycheck and goes back into the 401(k) account.

The main thing to note about 401(k) loans is that, with most plans, you must pay any remaining balance in full immediately upon leaving your place of employment. If you can’t, the loan becomes a distribution with all the major disadvantages that come with those.

You can get money out of a Roth IRA in an emergency, too. There are two major differences with a Roth, though. First, the money you take out is not a loan. You can’t put the money back into your IRA once you take it out. That’s a major downer because you’re forgoing all the compounding that money would have had until retirement.

Second, you can always withdraw your initial contribution penalty-free. In other words, you can get at the money you put into the Roth IRA any time, but cannot get at the gain on that investment without penalty. So if you invested $1,000 and the account balance is now $1,500, at most you can withdraw the $1,000 without penalty.

Advantage: Depends. If you are confident you’ll be able to repay the money and will remain employed until you do, a loan from a 401(k) is the way to go. If the money won’t likely be repaid (e.g. a house down payment), use the Roth IRA.

• Creditor Shielding

The 401(k) is protected from creditors under federal law. You can be forced to surrender part in a divorce, but not in the event of a judgment or bankruptcy.

The Roth IRA, on the other hand, is at the whim of state law. As such, it’s possible a creditor could attach your Roth IRA depending on the state you live in.

Advantage: 401(k)

• Matching Contribution

Some 401(k) plans include a employer match. Typically, for some percentage, your employer will match your contributions. If your plan offers a match, not contributing up to this maximum is leaving free money on the table. There are times, however, when it may make sense to forgo an employer match and save outside the 401(k).

Naturally, the Roth IRA offers no matching contribution. You’re on your own with a Roth.

Advantage: 401(k)

When weighing whether to invest in a 401(k) or a Roth IRA, give these four points some thought. The answer won’t be the same for everyone, but thinking it through will help get you to a nice comfy retirement.

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One of the biggest reasons people shy away from investing is because, to the novice, it’s very confusing. There is a whole universe of choices when it comes to investment options. Even if you know a little bit and narrow it down to mutual funds, there are still thousands to choose from.

To help keep things simple, I often recommend what are called, variously, asset allocation funds, lifestyle funds, or target funds. In short, these are funds of funds that do the work of asset allocation for you. You simply pick a target date (usually it’s for retirement, but not always) and let the fund manager do all the work. It’s Ron Popeil at its best - set it and forget it.

I have been remiss, though, in doing some homework on these types of funds.

It turns out that the asset allocations between similar funds among different fund companies varies wildly.

For my analysis, I looked at three different target date funds for each of the ‘Big Three’ fund companies - Vanguard, Fidelity, and T. Rowe Price. All have very similar cost structures - management fees are below 1% in all cases. All three are reputable, consumer-friendly firms. There is a striking difference, however, in each firm’s apparent risk tolerance.

Vanguard

Vanguard offers target dates in increments of five years. It also has a target fund for those already in retirement. The longest time horizon it offers is a 2050 fund.

Here’s how Vanguard’s asset allocation looks for their 2025 fund:

As you can see, Vanguard has a roughly 80%/20% stock/bond mix. I’d say, for a target date about 20 years out, this mix is pretty decent. For my taste, maybe it’s not quite aggressive enough, but that’s a small point.

What I particularly like about Vanguard’s fund is it invests in indices. Specifically, for the 2025 fund, fully 63% of the fund’s assets are in the Total Stock Market Index Fund. I like that a lot - you’re getting the whole market. If there’s anything to complain about, it’s that emerging markets only get 3% of the fund’s money - to me, a little low.

T. Rowe Price

T. Rowe Price also offers funds in five year intervals. Their 2025 fund looks like this:

T. Rowe Price has the most aggressive stock/bond balance. Fully 85% of the fund’s assets are in stock funds. International funds are 13.5% of assets. Interestingly, only US bonds are represented. T. Rowe Price’s 2025 fund uses actively managed funds almost exclusively. Only one index (S&P 500) fund is listed.

Fidelity

Fidelity has greater ‘granularity’ in its fund offering. You can choose from funds at intervals of two years. As a result, for this analysis, I used the 2024 fund as a proxy. Here’s their asset allocation:

Fidelity is the only one of the three that has anything in cash equivalents, and it holds 14% there for this fund. That’s a shockingly high number. For someone 18 years from retirement, I’d say none of their money should be in cash. Even if you look at a target 2034 fund, they have almost 8% in cash. That’s just too much.

In addition to the cash position, this fund has a less than 40% stake in equities. Again, that number is just too small for someone with almost 20 years to invest. For this reason, I can’t recommend the Fidelity target date funds. Which ain’t so great, because my company’s 401(k) plan uses them.

I was surprised by this analysis. I figured all comparably-dated funds would have more or less the same asset allocation. As this post shows, that assumption couldn’t be more wrong.

This finding kind of sucks because the big appeal of target date funds is their easy application and selection. If a novice investor still has to understand asset allocation, I think these funds have largely failed to address one of the big obstacles to beginning investing, which is really too bad.

Here’s what some other PF writers have written about target date funds recently:

• Jim at Blueprint for Financial Prosperity recommends them after you’ve maxed your 401(k) and IRA.

• Jeremy at Generation X Finance addresses target date funds generally and brings up a good point about overlap in particular.

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Most people know it’s a good idea to save for retirement using a 401(k). But how do you know if your 401(k) plan is a good one? Sometimes it works out to be a better idea to save elsewhere if your 401(k) sucks. How do you know if yours sucks? What does a good 401(k) look like?

For the 53% of American workers who are even offered a defined-contribution plan (of which the 401(k) is but one), it’s not always easy to tell how good theirs is.

Here are the features of a good 401(k)

• Has an employer match - the higher the better. A common employer match is something like 50 percent on the first six or eight percent. Forty-five percent of 401(k)s with a match fell into this category in 2006 according to a study by Mercer Human Resource Consulting. Bonus points - your match is in cash, not company stock.

• Has immediate or very quick vesting. ‘Vesting’ refers to how long you have to wait for the employer match to truly be yours. If you leave the company before you’re fully vested, you forfeit some or all of the matching contributions. That truly sucks, so a good plan has immediate vesting.

• Allows you to participate right away. For the life of me, I cannot figure out why some companies offer a 401(k) but won’t let new employees participate right away. I’ve seen plans that make you wait six months or more. What jackass came up with that idea? As if it’s not hard enough getting people to participate in 401(k)s. Now you have interia working against you. Even if the employee remembers to sign up, some are bound to be deterred by the decrease in take-home pay. Good plans don’t make you wait.

• Allows loans. Look, I don’t recommend 401(k) loans. But the fact is, people are more likely to participate in the plan if they have the reassurance of being able to get at their money through a loan if necessary. Since only 42% of people contribute to a 401(k) plan, any way to increase that number is a good reason. Bonus points - the plan has generous repayment rules. Often, if you leave the company while a 401(k) loan is outstanding, you have some stupid short period of time to repay the loan or it becomes a distribution. That’s bad. A truly good plan will allow a good bit of time before you must repay any outstanding loan.

• Offers a handful of high quality funds. The best 401(k)s will offer inexpensive funds, several different index funds and/or lifecycle funds, and all the major asset categories (stocks, bonds, real estate, cash). I really like lifecycle funds which allow you to choose the date closest to your target retirement date and invest in just that one fund. I think the Ron Popeil ’set it and forget it’ style is appealing. Bonus points - the plan doesn’t offer 40 different funds. Sometimes more choice is not better. This is one of those times.

• Offers a Roth 401(k) option. I think the Roth 401(k) is awesome. These are just like a Roth IRA in most respects. Roths are awesome because you fund them with after-tax dollars, but when you withdraw the money, it’s tax-free.

Probably no 401(k) plan has all of these features. But the more closely your 401(k) matches this list, the better. Saving for retirement can be hard, but having a good way to do it helps a lot.

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One of the best 401(k) developments in recent years is the rule allowing companies to automatically enroll new employees in a 401(k). Unless the employee takes positive action and opts out, they’re automatically saving for retirement. But there’s a down side to automatic enrollment. Low contributions, no increases in contributions, and poor automatic investment choices all work to diminish the positive effect of this program. Make sure if you’re enrolled in your 401(k), you know what that means.

• Low contributions

Typically, when a company institutes an automatic enrollment policy, it makes the 401(k) contribution level something anemic like 1% or 2%. Often, it’s not even high enough to get the full company match. Ugh. Sometimes you can’t save people from themselves. Always, always, always contribute in your 401(k) at least enough to get the employer match.

• No increases in contributions

Automatic enrollment plans only enroll people; they don’t periodically increase contribution levels. There is a change to that in 2008 that allows companies to annually increase contributions unless employees opt out. However, I don’t see this being widely implemented. Increase your contribution by 1% per year and I guarantee you won’t even notice. That is, until you look at your 401(k) statement.

• Poor investment choices

Even if companies overcome the barrier to enrollment, they face the sensitive subject of where to put those contributions. A company can’t foresee each employee’s individual financial situation, and what’s appropriate for one person isn’t for another. As a result, often the default investment in automatic enrollment plans is something stupid like a money market fund. Worse yet is company stock as the default investment. You should always check your investment choices to make sure they make sense for you and your situation.

What all this boils down to is that automatic enrollment in 401(k)s is a good idea, it just doesn’t go far enough. So if your company offers it, do yourself a favor and actively look into the program. Don’t just assume you’re all set because you’re “enrolled in your 401(k).”

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