Your 401(k) is not an investment

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Your 401(k) is not an investment. Neither is your IRA. Those are legal compartments for holding investments. Your investments are the mutual funds, stocks, bonds, and so on that you've bought. The compartments are where you keep your investments.

The distinction makes a difference. When you decide where to invest your money--what investments to buy--you should ignore the compartments. Deciding what compartment to use for each individual investment should come later.

Asset allocation

Investment advisors use the term "asset allocation" to mean where your money goes. You can get a lot of advice on asset allocation from advisors, books, web pages, and so on. There's a general consensus nowadays that most people should invest heavily in stocks, especially early in their career, and then shift very gradually into bonds--probably keeping a good percentage in stocks even after retirement. There are people who disagree, though--see my review of Your Money or Your Life , for a view on putting your money into long-term treasury bonds.

Compartments

The compartments change how your ownership of the investment is treated legally. The most important distinction among the compartments (but not the only one) is the tax treatment. Both 401(k)s and IRAs let you invest money that you earn without paying taxes on it--that lets you put more of your money to work, and gives you a huge edge in getting started investing. Roth IRAs take after-tax money, but you don't need to pay any taxes on the gains you make inside the Roth. (All that is only true if you follow certain rules, mostly having to do with leaving the money in the compartment until you reach retirement.)

Putting them together

There's an inclination to match investments to compartments based on the goal of the compartment: People think of their 401(k) as being for retirement, so they want to put investments in it that are suitable for retirement--long-term, but reasonably safe. At the same time, they might have a brokerage account that's not a retirement asset, where they feel free to make short-term trades with the hope of a big killing. That's not the right way to look at compartments.

You only have one asset allocation, and it covers all the compartments. Let's say (purely as an example, and not recommended for anyone in particular) that you decide that you should have 60% stocks, 30% bonds, and 10% cash. That's one decision. Having decided that, you then need to decide which compartments should hold those investments. That's a separate decision.

The compartment decision

The main reason to pick one compartment over another is for tax efficiency. As rules-of-thumb:

• Investments that produce interest income should go into a tax-deferred account such as a 401(k) or an IRA. Otherwise, you need to pay taxes on the income every year.
• Investments with frequent turnover should go into a tax deferred account. If you make trades in your ordinary brokerage account, you need to pay taxes on any profits you make every year. In a 401(k) or IRA, you can postpone all those taxes until you take the money out.
• Investments that produces long-term capital gains or dividend income should probably not be in a tax-deferred account. Capital gains and most dividends are taxed at a reduced rate. If they're earned in a tax-deferred account, though, all the money that you withdraw will be taxed as ordinary income when it is withdrawn, losing the investment's tax advantage.

Of course, you're limited to the investments available in your 401(k). Fortunately, most 401(k)s offer a pretty good range of choices nowadays. Even if your 401(k) has only one or two good choices, though, you're still okay. Buy the best investments your 401(k) offers, then buy other investments outside your 401(k) to achieve your desired overall asset allocation.

No individual compartment needs diversification--only your overall portfolio does.

Company match

Probably the most important factor for your medium-term investment success has nothing to do with your asset allocation or the tax issues of your compartment selection. It's your company match.

If your employer offers a match on the money you put into your 401(k), you should almost certainly take it. Whether the match is 100 cents on the dollar or 50 cents on the dollar, it is still much more than you're likely to earn on any investment and much more than you're likely to be paying on your debts. As long as funding your 401(k) to the extent of getting the full employer match doesn't make you miss payments on your debts, you're probably better off funding the 401(k) even if it delays paying off credit cards. The match is that big. (If getting a 50% match meant delaying paying off a debt for, say, 3 years, you'll still come out ahead if the debt is at less than 16%.)

Protected compartments

One other advantage that most of these special compartments such as IRAs and 401(k)s have is that your funds within them are largely protected against being taken in a lawsuit or bankruptcy. No one is without risk of a lawsuit, so that's all the more reason to fully fund your 401(k) or IRA.

Retirement accounts are not protected against all risks. A divorce court will likely take retirement assets into account when making a property settlement. The government may also be able invade them for things like tax debts and student loan debts. Against most other debts, though, your retirement accounts are safe. The rules for each different compartment are slightly different, which means it makes good sense to divide your money up a bit, just in case one particular compartment is vulnerable to one particular hazard.

Recap

Wise use of compartments can protect you from taxes and many other things. Just don't confuse the compartments with the investments they contain.