Helping parents invest

[brkuhn1]

Is there anything wrong with the plan of investing extra cash ($1,250) into VTI at the end of every month. The money wouldn’t need to be accessed for about 15 years. They would like to invest it using ameritrade and not putting into a 401k or IRA. Unless I can explain the benefit to them better.

I am having a hard time explaining it to them the benefit of tax advantaged accounts because I don’t fully understand it myself.

Any help would be appreciated.

[Villanelle]

So they want to put it in a regular, taxable account when they have access to a IRA of some kind?

Basically, for a taxable account you use money on which you've already paid taxes, and invest it, and then you pay taxes on any money your investment makes.  So you work to earn $1700, and get paid $1250 for that after taxes are paid, and then you invest it.  It grows to $2400 and you take it out, paying $200 in taxes on the $1150 in growth, walking away with $2200.  So it cost you $1700 in income/working to put $2000 in your pocket.

In a Roth, you also work for $1700, pay taxes on that and have $1250 left to invest, just as in that first example.  But now pay not taxes on the increase, so you keep all $2400 when you pull it out, paying no taxes on the $1150 in growth.  So your $1700 in work has bought you $2400 instead of $2000. 

With a traditional IRA, the money you invest is taken out of your pay *before* income taxes are collected.  So your $1700 in work puts $1700 in your investment, instead of the $1250 in the above examples.  You pay taxes on the growth/increase, however. So your $1700 grows to $3300 when you take it out.  You pay taxes on that entire $3300, paying about $500 in taxes, walking away with $2800.  So your $1700 in work gets your $2800.

As you can see, either kind of IRA (Roth or traditional) gets you more than a regular taxable account because you don't pay taxes on either the growth or on the income you invest, as opposed to paying income taxes on all of it.

My examples show the traditional being better, but that's just based on easy to do in my head math as far as tax rates.  It all depends on whether you think your tax rate will be higher now, or later, and that's something that's very difficult to know.  There are ways to make an educated guess, including current income/rates, and your plans for the future.  But either one is going to be a better choice than not using a tax advantaged account at all. 

If you are looking for an easy way to explain it, it's in that "as you can see" paragraph.  Tax advantaged accounts allow you to not pay income taxes either on the money you invest, or the growth in your invested money.  Taxable accounts force you to pay taxes on both of those things.

[MDM]

I am having a hard time explaining it to them the benefit of tax advantaged accounts because I don’t fully understand it myself.

The algebraic equations are available if one wants the quantitative math answer.

Staying in the qualitative realm, does "because you pay less tax and that means you keep more for yourself" suffice?

[Wintergreen78]

Here is the list of tax brackets: https://www.debt.org/tax/brackets/

If they are in the 22% bracket, they can put $1,250 per month into a taxable account or they can put $1,602 per month into a 401k and have the same amount of money left over each month. So, the 401k would save them $350/month in taxes.

Here’s the math: 401k contribution (pre tax) = $1,250/(1-tax bracket) = $1,250/(1-0.22) = $1,602

[brkuhn1]

Thank you! I was having a hard time explaining it but those are great examples. The other pushback I am getting now is "what happens if we need  to access the money before retirement."

My other question, is there anything wrong with just buying VTI every month?

Sorry for the newbie questions, I feel like the boss in this clip with most of this stuff.

[MDM]

Thank you! I was having a hard time explaining it but those are great examples. The other pushback I am getting now is "what happens if we need  to access the money before retirement."

See How to withdraw funds from your IRA and 401k without penalty before age 59.5 and links therein.

My other question, is there anything wrong with just buying VTI every month?

It's better than not investing at all, so if those are the choices then buy VTI. 

[Villanelle]

Thank you! I was having a hard time explaining it but those are great examples. The other pushback I am getting now is "what happens if we need  to access the money before retirement."

My other question, is there anything wrong with just buying VTI every month?

Sorry for the newbie questions, I feel like the boss in this clip with most of this stuff.

It may not be perfectly ideal, but it is better than nothing, and if simple is what gets this done, then it's the right solution. 

Do you know if their 401k has that option?  Does it have a company match?  If there's no match, most likely they can do better setting up their own IRA because there's a strong likelihood that the 401k has a higher expense ratio (more of the $ invested goes to pay a salary and admin costs than actually into the stocks). If there's a match, they should invest what they need to to get that.  If adding something else complicates it beyond their tolerance, then put all $ there, but if they can stand to set up a separate account, an IRA is probably best after they have gotten the full employer match. 

All of these are simplifications, but probably accurate enough for their simple purposes.  The most important thing is to get it done, and the second most important thing is probably not to stress over getting it perfect and 100% optimizing every decision.  That can prevent one from doing anything at all.  So if VTI is what gets it done, that's wonderful!  And if putting it all in their 401k is easiest because an HR person will help and it's just one time setting up one account and everything is kept in one place, then it's a fantastic move. 

 

[Rob_bob]

Roth contributions can be withdrawn penalty and tax free before 59.5 years old.  Only gains would be subject to a penalty.  As long as you don't pull out more than you put in there isn't a problem taking money out.