If you read that and say, “huh?” Don’t feel bad. Despite hundreds of articles I’ve read on the topic, I have yet to find one that explains the differences between Roth and traditional accounts in a way that non financial nerds can understand it.

Today I’ll do my best.

Note: Not everybody has the option to do a Roth 401k. Only some employers offer this, although it’s becoming more common. In this series we’re discussing 401ks, but the differences between Roth and traditional accounts we discuss today apply to individual retirement accounts (IRAs) as well.

Traditional vs. Roth

Very quickly, retirement accounts come in two flavors—traditional and Roth.

• With traditional accounts, you don’t have to pay taxes on the money you put in now, but you have to pay taxes on the money when you withdraw it later.
• With Roth accounts, you can only put money in after you’ve paid taxes on it, but when you withdraw it in retirement, you don’t have to pay taxes on the money.

For quick trivia: the Roth accounts are named for this guy, the Delaware Senator who created the Roth IRA in 1997.

Roth 401ks vs Roth IRAs

We’re focusing on comparing Roth 401ks and traditional 401ks, but how does the Roth 401k differ from the Roth IRA, every blogger’s favorite retirement account? The big points are highlighted on the chart below—contribution limits, income limits, and mandatory retirement age.

But if you have a Roth 401k at work, is there any reason to still contribute to a Roth IRA?

Yes.

The main reason is Roth IRAs can double as emergency funds. With a Roth IRA, you can withdraw your deposits tax- and penalty-free at any time. (You just can’t touch the gains.) Not that you should do this, but if you ever had a big emergency and needed money, tapping a Roth IRA is better than tapping a 401k or traditional IRA and paying a 10% penalty. It’s probably better than taking a 401k loan, too.

*Penalty applies to earnings withdrawn before age 59 1/2 or within five years of contribution. You may withdraw deposits at any time penalty-free.
**Investors over 59 1/2 may make additional catch-up contributions.
***Anybody may contribute to a traditional IRA and earnings will not be taxed until retirement. Depending on how much you earn and whether you have a retiremetn plan at work, you may not be able to deduct all of your contributions, however.

Other Differences

As you can see, there are a lot of subtle differences between these account types, and all the acronyms and contingencies start to make your head ache like a bad hangover. Just a couple more things to mention:

Rollovers: When you leave a job, you can rollover your 401k into an IRA at the broker of your choosing. If you have a traditional 401k it becomes a traditional IRA; a Roth 401k becomes a Roth IRA.

Roth Conversions: You can convert a traditional IRA into a Roth IRA by doing a Roth conversion. You pay taxes this year on the balance of the IRA so you won’t have to pay them in retirement. This can be a way to diversify the tax basis of your retirement savings or for high earners to get around the income limits on Roth IRA contributions.

Choosing Between a Roth 401k and a Traditional 401k

Here’s the thing about this decision: If the tax rate you pay stays exactly the same between now and when you retire, there will be NO DIFFERENCE in your returns between a Roth and Traditional account invested in the same stocks. So:

• Roth 401ks are better if you believe you will be paying a higher tax rate in retirement than you pay now.
• Traditional 401ks are better if you believe you will pay a lower tax rate in retirement than you pay now.

Here’s how this looks. The table on top compares a traditional 401k with a Roth 401k if tax rates stay the same; the bottom table compares the accounts if the investor’s tax rate goes up 50%.

Of course, no one knows for sure what taxes will be in the future, but most people assume taxes won’t go down.

If you’re young and professionally ambitious, it’s a good assumption that you’ll be in a higher tax bracket as a successful retiree than you are now on an entry-level salary.

This is why most advice geared towards young investors heavily favors Roth accounts.

That said, some people hedge by using both traditional and Roth accounts so they get some benefits whether taxes go up or down. Before Roth 401ks became available, many investors had a traditional 401k at work and a Roth IRA too. If you can’t do a Roth 401k at work, this is what I recommend.

Here Are The Takeaways:

• Roth 401ks are good because if your tax rate goes up, your savings will be worth more in retirement.
• But because nobody knows what tax rates will do, it’s not a bad thing to have both Roth and traditional accounts.
• The less you earn now, the better it is to contribute to a Roth.
• The more you earn, the more you want to transition to traditional accounts.

If you make a lot of money, you cannot contribute to a Roth IRA because of income limits. You can still do a Roth 401k if you have one at work, but that doesn’t mean you should. Unfortunately, there’s no clear dividing line because nobody knows how their tax rate in retirement will compare to their tax rate now. If you want to make sure you get it right, regular visits with a financial planner or tax expert are a must.

To make it simple as possible, however, know that saving for retirement is more important than whether you use a Roth or traditional account. But as a rule, follow this automatic investing flowchart: Start with your 401k—traditional or Roth—and contribute enough to get your employer’s match (if there is one). Then contribute up to $5,000 a year to a Roth IRA. Then go back an max out your 401k.

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A few weeks ago, I sent my focus group a quick survey on 401k plans. I knew 401ks are confusing—even to someone who’s been writing about them for years—but I was interested in what, specifically, you want to understand better about 401ks.

Over the next few weeks I’ll publish several posts that answer your top questions about at-work retirement plans. Starting with: Should I contribute to a 401k or an IRA?

Note: We’ll be talking about 401ks—the most popular at-work retirement plan. Non-profits and other institutions may offer 403b plans. Although there are some differences, if you have a 403b plan, most of what we cover will apply.

Today we’ll look at the pros and cons of a 401k or other retirement account at work versus an IRA that is a self-directed retirement account.

Save Something. Anything!

At work or on your own, everybody should save something for retirement. According to a recent survey, 55% of Gen Y have not started saving for retirement. No surprise. But we need to start.

Look at the reasons people give for not contributing to their 401k:

(Are you eligible for a 401k or 403b but don’t contribute? Let us know why in a comment. If it’s because of something you don’t understand, maybe we can help.)

Of course, lots of young people simply don’t have the scratch. It’s hard to set aside $50 a month when Two-Buck Chuck is your go-to drink and your iPhone is still on your parent’s family plan.

Others are confused or intimidated by investing. Still more get paralyzed by questions like: “Should I use a 401k or IRA?” or “What mutual funds should I invest in?”

What’s important is to:

• Automatically save something—even a tiny bit— in a retirement account.
• Invest that money in stocks or bonds (in other words—don’t create an IRA comprised of cash in certificates of deposit.)

Are there exceptions? Only one: When you’re in credit card debt and paying interest over 10%. Even then, I wouldn’t fault someone for contributing a small amount to a 401k.

Now that we have that out of the way, let’s look at the differences between 401ks and IRAs.

401ks vs. IRAs At-a-Glance

*For 2012; savers over age 59 ½ are eligible to make additional catch-up contributions.

What a 401k Is (And Isn’t)

Before we dive in, there’s some confusion surrounding what a 401k plan actually is. One respondent asked:

“Wouldn’t it be better to do your own fund, such as a Roth IRA? I ask because with the current economy, many people I know lost up to half of their 401k.”

A lot of people think like this, in part due to the media commonly using people’s depleted 401ks as a sign of how the recession hurt everybody.

During the down economy, not everybody lost a job, but anybody with a 401k lost money. Only not everybody lost 50%. Investors with who were properly diversified fared better.

Both 401ks and IRAs are types of investment account. The IRS gives investors in both 401ks and IRAs certain tax advantages over a regular investment account, and also sets rules for how they can be used.

It’s helpful to think of both a 401k and IRA as buckets with which you fill will rocks (investments like stocks and mutual funds). Because everybody fills their buckets with different types and quantities of rocks, no two are the same. But this is where the similarities between 401ks and IRAs end. Let’s take a look at what makes a 401k different from an IRA, for better or worse.

401ks Have Limited Investment Options

With an IRA, you can invest in virtually anything. You can have an IRA that simply holds a savings account or an IRA with 100 different stocks, bonds, ETFs, and mutual funds. You can even have an IRA that makes loans to other people through a peer-to-peer lending network.

With a 401k, this usually isn’t the case. Your employer partners with a financial services company to administer your plan. That company then gives you a limited number of investment options (usually, but not always, these are mutual funds). If you work at a large company you may have a lot of investment choices. If you work for a very small company, however, you may only have 10.

For most people, having fewer investment choices is actually a good thing. Most people aren’t stock pickers and shouldn’t try to be architects of the perfect portfolio with hundreds of mutual funds. The problem, arises, however, when 401k plans only offer mutual funds that have unnecessarily high expense ratios.

If you work for a larger employer, you can research how your 401k stacks up in terms of investment choices and fees at Brightscope.

401ks Have Higher Contribution Limits

The whole point of 401ks and IRAs is that Uncle Sam is giving you a break on your taxes to encourage you to save for your retirement. Unfortunately, there’s a limit to this particular Uncle’s generosity: contribution limits.

And this is a big differentiator.

In 2012, savers under 59^1/2 can contribute up to $17,000 to a 401k and up to $5,000 to an IRA. (For IRAs, this is an oversimplification, but bear with me.)

When you’re starting out, contribution limits are hilarious. There’s no way you’re going to come close to them. But as you earn more money, pay off debt, and get serious about saving for retirement, it’s another story. Especially if you’re saving in an IRA alone, $5,000 may not be enough to fund the kind of retirement you’re dreaming about. Advantage 401k.

401ks Let You Contribute Pre-Tax Dollars

Normally, if you earn $500 and want to invest it in McDonald’s stock, you first have to pay income taxes on it. So you pay $100 of taxes and invest $400 in a stock. Assuming you hold this stock for many years, when you sell it, you’ll need to pay taxes on the amount the stock has appreciated…called capital gains tax, currently 15%. So if the stock goes from $400 to $600, you’ll pay $30 in tax. The $500 you earned (before taxes) has become $570 for a 14% post-tax return.

Now let’s say you invest the same $500 amount in a 401k. Now, with a traditional 401k, you don’t have to pay income taxes on money you put in. So you earn $500 and can invest $500. When it appreciates the same amount, you’ll have $750. But now, you have to pay income tax on the entire amount…not just the gains…$150. You’re left with $600…a 20% post-tax return. Okay, so the extra $30 in this example isn’t impressive. But these are small numbers over a brief period of time. If that $500 were $500,000, that’s an extra $30,000 you get to keep.

Here’s another example:

*In our next post we’ll take a closer look at how Roth accounts—both IRAs and 401ks—compare to their traditional counterparts.

401ks and IRAs Have Early Withdrawal Penalties

Here’s the thing about retirement accounts: They’re meant for retirement.

The tax breaks Uncle Sam provides us on money saved in a 401k or IRA are incentives to save for retirement. So he also provides an incentive not to touch that money. This is the early withdrawal penalty.

If you withdraw cash from a traditional 401k or IRA before you turn 59^1/2, you will owe a 10% penalty to the IRS on top of ordinary income taxes.

IRAs provide a bit more flexibility in this arena, and there are a number of exceptions to the IRA early withdrawal penalty. You can, for example, use funds to cover higher education expenses and up to $10,000 towards the purchase of your first home.

With a 401k, you must prove severe financial hardship to obtain an exemption from the early withdrawal penalty. Some employers, however, allow you to take out a 401k loan. Essentially, you borrow money from yourself. Although this sounds like a great idea, it’s a slippery slope. Any money you borrow ceases to earn returns for you and, if you lose your job, you must repay the entire loan or pay income taxes and the 10% penalty on the outstanding balance.

The Bottom Line

The decision to invest in a 401k, IRA, or both is different for everybody and depends on another set of circumstances: Whether you are eligible for either a Roth 401k or Roth IRA. We’ll talk about that next time.

In the meantime, I will say this: for those eligible, 401ks are the easiest way to save for retirement. The limited investment choices can be a good thing because it simplifies your investment decisions, and the money is automatically taken out of your paycheck. So if your employer offers a 401k plan and you’re eligible, you should contribute to it. If you don’t have access to a 401k—or maxed one out—-and still want to save for retirement, you should open an IRA.

In a few days, we’ll take a look at another common and confounding question: When given the choice among a Roth 401k, Traditional 401k, a Roth IRA and a traditional IRA, which one(s) should you choose? We’ll also cover how much you should be contributing and how to select investments to obtain the right asset allocation.

What about you? Do you participate in your company’s 401k or 403b? If not, why? Let us know in a comment.

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Earth Day is an annual reminder of things we can do as individuals to help preserve our habitat and the resources that sustain us.

When we think about living green, recycling, buying locally, or trading in the SUV for a Prius usually come to mind. Not coincidentally, these green practices may result in having more green of another kind…the money saved by reusing products and reducing consumption.

But there’s another way to influence your environmental footprint that gets less press: how you invest.

Green Investing

According to the Forum for Sustainable and Responsible Investing, one out of every 10 dollars are invested in socially responsible funds, a sum totaling over $25.1 trillion.

Socially responsible investing is a wide umbrella, but it usually means avoiding the stocks of companies in vice industries like gambling, tobacco, or firearms, or companies with dubious business practices like poor factory conditions or a spotty environmental record.

A variant of socially responsible investing, green investing strives to limit investments in environmentally irresponsible companies and seek out companies that take proactive environmental measures or are involved in ecofriendly businesses like renewable energy.

Getting Started With Green Investing

I don’t recommend average investors pour money into individual stocks. But without stock picking, it can be difficult to avoid stocks that don’t meet socially responsible criteria. Major mutual funds (like those in your 401k) invest in dozens of companies and are frequently trading. And one of my favorite types of investments, index funds, follow entire markets comprised of hundreds or thousands of stocks, including plenty that are not socially responsible.

What’s an eco-conscious investor to do?

Some mutual fund companies offer socially responsible and green funds. At least two fund companies, Calvert Funds and Pax Wolrd Investments, specialize in sustainable investing strategies.

The Catch

Choosing investments is tricky business. Among thousands of investment choices, many can help you reach your goals, but choosing the wrong investments can be devastating. High fees and investing objectives misaligned with your goals will cause your money to go nowhere fast.

When you incorporate values into your criteria for choosing investments, the field of eligible investments shrinks but picking the right investments gets harder. Many socially responsible investments, for example, have higher expenses than average; something I caution investors to avoid. Many green investments also have loads (sales charges, or commissions, of four or five percent)—a no-no for most investors.

Five Green Mutual Funds

As an example, here are five socially responsible mutual funds with no sales charges and minimum investments under $5,000. I like the Vanguard Social Index as a low-cost index fund and the TIAA-Cref Social Choice Equity fund for its low expenses and low minimum investment.

Natural Investing, an investment advisory company focusing on green investing, provides a 5-heart rating system for the social responsibility of the funds’ investments. Note that the rating considers only how socially responsible the investments are, not the fund’s financial performance.

Fund	Symbol	Heart Rating	Expenses	Minimum
Vanguard Social Index Fund	VFTSX		0.29%	$3,000
TIAA-Cref Social Choice Equity Fund	TICRX		0.41%	$250
Green Century Equity	GCEQX		0.95%	$2,500
PAX World Global Green	PGRNX		1.40%	$250
Domini Social Bond	DSBFX		0.95%	$2,500

Here’s a list of more socially responsibly mutual funds.

Learning More

If you’re interested in green investing, there are plenty of communities and publications to help you learn more. The Forum for Sustainable and Responsible Investing offers lots of information, and the Green Money Journal is a quarterly publication providing well-written features articles and lists of mutual funds and green investing events. Annual subscriptions are $25 and many articles are available online for free.

What about you? Do you incorporate green values into your investing strategies? How do you do it?

Photo credit: Ironrodart.

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***

You can invest in anything:

• Other people’s debt.
• Barrels of whiskey.
• Your cousin’s nightclub. (Warning: This is how many pro athletes go broke.)

Of course most of us hear “investing” and think 401(k)s and mutual funds. But maybe that doesn’t excite you. Maybe you want something more tangible than shares of stock. Maybe you want an investment that can provide cash flow now and a promising return over time. Maybe you’re thinking about investing in a rental property.

As a Realtor, I’ve chosen to investment mostly in real estate. But it’s not for everybody.

Why Invest in Real Estate?

Why do I feel real estate is the best investment? Because once I have a tenant, I like getting paid without work!

Each month my husband and I collect $600 cash flow on a rental property we own without having to do anything. (Cash flow is money in our pocket after we’ve paid the mortgage nad expenses on the property). We’re leverging the bank’s money to make money for ourselves.

Of course there are risks involved (like any investment) and from time to time we have to make a repair. But if I want $600 otherwise, I have to go work for it. This idea of creating passive income is what drives many investors toward real estate invest (including my husband and I).

There are also tax benefits to investing in real estate. When it comes tax time, IRS publication 527 states that you can deduct that interest from your taxes. You can also depreciate rental properties and, when you decide to sell, you can do a 1031 exchange to defer taxes even longer.

What’s The Risk?

In investing, risk and return are inversely related. The higher an investment’s risk, the greater potential for return. Safe investments yield paltry returns (think about that FDIC-insured savings account earning you mere pennies each month!)

Some people prefer to stick to investments with guaranteed, despite low, rates of return. Others are huge risk-takers. My personal opinion is that it’s good to take some risk as long as you know what you’re doing or have an expert to guide you.

In real estate, your risk can vary widely depending on how much due diligence you perform. Some investors buy properties site unseen at auction. They get a great deal, but don’t know what problems await them inside. Your risk is lower if you buy a property after getting a title report, home inspection, and an appraisal, but you’ll pay closer to market value with less chance of wild appreciation.

Is Real Estate Investing For You?

Now here’s the downside to owning rental properties: you either have to manage them yourself or pay a property management company (often around 10%) to do so for you. Managing your properties yourself takes time. You’ll have to advertise the property, screen prospective tenants, collect rent and fix common complaints like clogged toilets and appliance issues. If your tenant doesn’t pay rent, you’ll have to evict as well.

Also, real estate is not considered a liquid investment. You can’t quickly convert a house to cash when you need to sell, at least not as fast as you can with stocks or bonds. If you look at the Case-Shiller Index, you’ll see that house prices have dropped significantly in the past few years, which makes it difficult to sell a property quickly if you need to.

That said, rental properties could be a good investment if you:

• Are comfortable with the risks (including taking multiple mortgages).
• Can qualify for the loan and stomach the potential additional unexpected expenses.
• Are knowledgeable about real estate or have help.
• Want an investment that is more “hands on”.
• Don’t mind the work involved (renovations and repairs, screening tenants, collecting rent, etc.)

If You Want to Get Started

Before you dive into investing in a real estate property, it’s important to take time to learn. Here’s a post to get you started, about how one guy in his twenties got started buying income properties.

You may also want to check out some books like Rich Dad, Poor Dad by Robert Kiyosaki and Buy It, Rent It, Profit!: Make Money as a Landlord in ANY Real Estate Market by Brian Chavis. Some community colleges even offer basic courses in real estate investing.

Finally, if you like the idea of diversifying your investments with real estate but don’t want to manage rental properties hands on, there are other ways. Real Estate Investment Trusts (REITS) are one example. REITs are securities that trade just like stocks but invest in real estate instead of companies.

Do you own rental properties? Why did you get into real estate? Are you happy with your investments?

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Q: I’ve been employed for six months. I’m 30 (school took a long time) so this is my first time investing. I am maxing out my 401(k) at work but want to save more because I started late. I was looking at a Roth IRA but I earn too much ($105,000 plus a bonus). What kind of saving options do I have and what is the best way to save the annual bonus I expect to receive? —Carly

A: As long as you have a 401(k) at work, maxing it out is your best bet at your current income level because, as you discovered, you’ll be excluded from making a full Roth IRA contribution. 

Do you have a cash emergency fund? Although a savings account isn’t an investment per se (interest rates won’t even cover inflation), I recommend everybody have at least $5,000 (or the equivalent of six months’ expenses) in cash that’s quickly accessible. Don’t have this yet? Simply stash your bonus away in an online savings account for a rainy day.

Got the emergency fund covered? Then to continue investing, it’s time to look at a taxable investment account.

The good news is you can invest however you want and you can access your money whenever penalty-free. (With a 401(k) or IRA you typically need to wait until retirement to withdraw the money or face paying a 10% early-withdrawal penalty to Uncle Sam.)

The downside is that when you sell these investments you’ll pay capital gains taxes on any returns (although you can deduct losses sometimes, too). To minimize your tax bill, hold onto investments for at least one year.

A simple mutual fund account at a place like Vanguard or Fidelity is a fine start. Look for mutual funds with low expenses.

Betterment is another option: it’s a pretty cool new investing platform that makes investing in the stock market about as simple as opening a savings account.

If you continue to max out your 401(k) and invest more on top, you should build a nice portfolio quickly.

If you ever decide you want help choosing the right investments in your taxable account, you may consider hiring a financial advisor, especially once you have $150-$200k invested. My advice: Look for a fee-only financial planner who will serve as a fiduciary (meaning he or she must put your financial interests first). You can find a list at the National Association of Personal Finance Advisors.

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1. How to manage your spending without a traditional budget.
2. How to create a bank account buffer to eliminate the risk of overdrafts.
3. How to put your bills and savings on autopilot.

What I’ve written is incomplete, however, without one piece of the puzzle: an automatic investment plan.

Arguably, putting your investments on autopilot is the most important thing you can do for your finances.

If you don’t want to automate the rest of your finances—if you prefer to set aside a few hours a month to pay bills, transfer money to savings, and balance your checkbook, that’s fine. Some people will sacrifice time for that kind of control. But you should still consider setting up automated investments.

Investor and financial author Robert G. Allen sums up the biggest reason:

How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.

Many of us delay investing (or fail to start at all) because we’re either intimidated by choosing investments or we’re afraid of the risk. An automatic investment plan can help. One of the techniques I outline here requires zero investing knowledge to get started—it’s as easy as opening a bank account. And, when you put your investments on autopilot, you take your emotions out of investing, which can temper your fear—or at least limit fear’s ability to cost you money. Let’s look at how an automatic investment plan does this.

Dollar Cost Averaging

The technique of buying a fixed amount of an investment at regular intervals is known as dollar cost averaging (as opposed to investing a big chunk of money at irregular times).

If you were to buy $1,000 of a mutual fund when it’s per-share price is $100, you would own 10 shares.

If, however, you invest $100 a month for ten months and the fund’s price varies from $80 to $120, you may end up slightly more or less than 10 shares depending on the stocks prices. As the market climbs, the notion is you will end up buying more shares at a lower price than if you invested in a lump sum. Advocates of dollar cost averaging say this reduces risk, but critics disagree. The market goes up in the long run, so you want to get money in as soon as possible.

If you have a lump sum sitting around that you want to invest, then do it. Get it into the market and don’t worry about spreading it around and definitely don’t try to time the market or wait for the right time.

For the rest of us, an automatic investment plan makes sense for two reasons:

1. It lets you invest on a regular schedule.
2. It prevents self-sabotage.

INVEST AS YOU’RE PAID

Ask people who are successful at saving and building wealth and you’ll find that many of them have two things in common:

1. They invest, rather than leaving all of their cash in a bank account.
2. They pay themselves first.

I’ve recommend paying yourself first as a strategy for building cash savings for emergencies, and you can do the same thing with your investments.

Your employer may make this easy by offering a 401(k) or similar retirement plan to which you can contribute through automatic payroll deductions.

Otherwise, you can start a Roth IRA and begin making regular contributions on paydays in addition to cash you transfer to a savings account.

Are you already saving enough for emergencies and retirement? Then it’s time to open a nonretirement investing account and put money away for “life”. Use this flowchart to help you decide how to allocate your investing dollars:

PREVENT SELF-SABOTAGE

You can’t rely on willpower to reach your financial goals.

You may be able to hunker down and fight the urge to splurge at the mall or bet on a hot stock tip…for a while. But eventually your emotions will get the best of you. You’ll calm your nerves after a tough week with a spending spree. Or give into fear and postpone an investment during a volatile month in the market.

Carl Richards, author of The Behavior Gap, knows this, and in a recent New York Times blog post offers the same advice I’m giving now: Use automation prevent your emotions from influencing your financial decisions.

HOW TO SET UP AUTOMATIC INVESTMENTS

Nearly every mutual fund company and online stock brokerage makes it easy to set up automatic investing in mutual funds, whether it’s in an IRA or nonretirement account. Most will waive minimum investment requirements when you enroll in an automatic investment plan.

This is how it works:

1. You set up an automatic transfer from your bank account to your investment account (for example, on pay day).
2. You specify which mutual fund(s) to invest in and your money is automatically invested at the current price.

The key to keeping automatic investing affordable is to invest directly with a mutual fund company (for example, buy Vanugard funds through Vanguard or Fidelity funds through Fidelity) to avoid paying a trade commission each month. Alternatively, some online brokers (TD Ameritrade*, for one) offer hundreds of no-transaction-fee mutual funds in which you can automatically invest with no extra fees.

WHAT ABOUT INDIVIDUAL STOCKS?

Mutual funds make automated investing easy because you can invest any amount in a mutual fund regardless of the current price. (You can buy fractions of a share.)

In most cases, however, with individual stocks and exchange-traded-funds, you must purchase whole shares. So if you want to automatically invest $100 in ABC stock with a current price of $11, you can only buy nine shares and will have a $1 left over.

One way around this is with ShareBuilder, an alternative broker owned ING Direct. ShareBuilder’s entire model is built around automatic investing plans, and for $4 a month you can invest a fixed amount in individual stocks as well as mutual funds (you can hold fractional shares).

A final alternative to both direct mutual fund investing and ShareBuilder is Betterment, the new radically simple investing account that lets you make autopilot investments in entire stock and bond markets. Investing with Betterment is about as simple as opening a bank account, and I think it’s a perfectly acceptable strategy for hands-off investors.

What about you? Do you have an automatic investment plan? How do you structure it? Where do you invest? Let me know in a comment.

Note: MoneyUnder30 has financial relationships with the following companies mentioned in this post: TDAmeritrade, ShareBuilder, and Betterment. We may earn a referral commission if you visit one of these companies and ultimately open an account. If you choose to support our free content in this way, thanks!

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I’m a fan of simple investing.

And that’s why this company intrigued me so much that I opened an account.

The company is Betterment, a new online investing platform that automatically invests and balances your money in a portfolio of exchange-traded funds (ETFs) based upon your risk tolerance. In this review of Betterment, I’ll show you how Betterment works, what it costs, and how to open an account.

How Betterment Works

Betterment bills itself as the “simplest, smartest way to invest.”

Rather than creating an online brokerage account and facing thousands of investment choices, Betterment asks just one question: How much risk do you want in your portfolio?

Betterment then automatically invests your money in ETFs, dividing your money between baskets of stocks and bonds based upon your risk tolerance. (When you create an account, Betterment also asks about your investment goals and recommends a risk profile).

Here’s what my Betterment account dashboard looks just minutes after opening an account:

Note that my initial deposit hasn’t cleared yet, but I did get a $25 account-opening bonus (see below). The dashboard is showing the aggressive 90% stocks/10% bonds portfolio I selected.

WHAT IT COSTS

Unlike brokerages which charge commissions every time you buy or sell a stock, Betterment assesses an annual fee—a percentage of your total portfolio. For example, Betterment’s fee is 0.35% for portfolios less than $10,000 (a full schedule is below). This is in line with what low-cost mutual funds charge.

The catch is that you either need to set up an automatic investment of at least $100 a month or maintain a combined $10,000 account balance to avoid a $3 a month fee. (But of course, you should be automatically investing at least $100 a month anyway.)

Betterment’s fees seem fair, especially for new investors. Consider the fact that Betterment’s fee on a $5,000 portfolio is just $17.50 annually, and the percentage rate drops the more you have invested.

WHY I LIKE IT

Studies show over and over again how miserable humans are at beating market average returns over the really long run. (A lot of people can beat the markets for a couple of years, a few lucky ones do it for five or ten years). Most investors have no business monkeying around with individual stocks and frequent trades. The vast majority of investors should be focusing on finding money to invest and investing it, not worrying about individual investments.

Secondly, Betterment may be an answer to this common question I receive:

Savings account interest rates suck, how can I earn a better return on my mid-term savings?

Although I think you should always have some cash for emergencies that is completely liquid in an FDIC insured savings account (no matter how paltry the interest rate), if you’re really hung up on returns, you might create a conservative Betterment portfolio and see if you can do better than your bank account.

OPEN A BETTERMENT ACCOUNT, GET $25

Betterment’s offering $25 to any new investor who opens an account with at least $250. There’s no minimum to start an account but you need $250 to get the bonus. I just did this and it took maybe four minutes (you will need your bank account and routing number handy), and the $25 was credited immediately, as you can see above.

Open a Betterment account now

I should note that as an affiliate of Betterment, I get a small fee if you create an account, so thank you if you do…consider it the virtual tip jar that keeps this site ticking!

What do you think? Do you like what Betterment’s offering? Would you try it? Do you think it’s too simple? Share your thoughts in a comment.

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Although I’ve done it once or twice before, I try to avoid recommending individual stocks or funds. Such “picks” are a dime a dozen on other blogs, in major financial magazines or on Jim Cramer’s TV shows.

At best, investing in stocks and funds featured in the media won’t hurt you. The problem is, it could.

This is why I recommend beginning investors invest solely in one or two index funds that track the entire stock and bond markets. Often times, the entire market will beat most mutual funds anyway. But most importantly, when you invest this way, it’s a lot harder to make mistakes.

If you get to the point in your investing that you feel you need more specific investment recommendations, it’s time to hire a fee-only financial advisor who can evaluate your situation and provide some unbiased recommendations. In my opinion, you probably need at least $100k invested before you consider this, and you’d probably be OK waiting until you have $200k or so in play.

For the rest of us, simple index funds do the trick.

If you are investing in your employer’s 401(k) or similar plan, you will have to choose your investments from among a limited list of investments. That’s why these general guidelines on how to pick a mutual fund—choose an index fund with less than 1.0%—are more useful than individual picks.

If you must know, however, here are a couple of example mutual funds that meet these criteria.

STOCK MARKET MUTUAL FUNDS

Vanguard Total Stock Market Index Fund (VTSMX)
Expenses: 0.18%
Turnover: 5%
Min. Investment: $3,000*

If I were going to pick only two funds in which to invest, it would be a mix of this one and the Vanguard Total Bond Market Fund (below). Providing total exposure to the stock market and extremely low fees, this fund is the perfect incarnation of low-cost index investing.

TIAA-Cref Equity Index (TINRX)
Expenses: 0.29%
Turnover: 11%
Min. Investment: $2,500

Although Vanguard’s mutual funds are synonymous with simple, low-cost investing, this TIAA-Cref fund is proof that good, low-cost index mutual funds exist elsewhere. This fund holds a portfolio that closely tracks the U.S. equities market.

Vanguard Total International Stock Index Fund (VGTSX)
Expenses: 0.29%
Turnover: 11%
Min. Investment: $3,000*

This fund invests in both developed and emerging markets around the globe, excluding the United States. That makes it an ideal compliment to a US Stock index fund. Investing in foreign stocks is thought of as riskier in the short run but provides the possibility of bigger long-term returns, making it a good option for young investors with a long time to stay invested.

Dodge & Cox Stock Fund (DODGX)
Expenses: 0.52%
Turnover: 12%
Min. Investment: $2,500

Unlike the other funds listed here, DODGX is actively-managed; it’s not an index. But with low turnover and modest expenses, the Dodge & Cox Stock Fund is a solid bet for someone looking to keep things simple with one fund providing exposure to both domestic and international markets.

BOND MARKET MUTUAL FUNDS

Vanguard Total Bond Market Index (VBMFX)
Expenses: 0.26%
Turnover: 75%
Min. Investment: $3,000*

Every portfolio should have some bonds in it for diversification and stability. (Bonds are less volatile than stocks, but also don’t provide the growth potential that stocks offer). For many investors, you don’t have to look further than this Vanguard fund to grab some exposure to bonds.

*You can avoid the minimum investment by purchasing these funds as ETFs. Also, if you have $10,000 to invest, the Admiral’s Shares versions have even lower expenses.

Do you have other favorite low-cost index funds you would recommend to new investors? Share them in a comment.

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That is, if you have zero interest in immersing yourself in fund performance data and anlayst research, you will do best with a simple investing strategy: invest in an index fund that tracks the entire stock market.

Why? Because in the long run, actively-managed mutual funds rarely outperform the market.

CHOOSE INDEX FUNDS FOR SELF-GUIDED INVESTMENT

If you are investing on your own for more than 10 years (in an individual retirement account, for example), I recommend investing in a stock market index fund and a bond market index fund with low expense ratios. (Last week, I explained mutual funds costs and their importance to your investment returns here.)

If you plan to invest small amounts over time—monthly, for example—invest directly with the fund company using their automatic investment plan. Find examples from Vanguard, TIAA-CREF, or T. Rowe Price.

If you are investing a lump sum, you may consider an exchange traded fund (ETF) as an alternative.

Later this week I’ll provide some examples of each.

WHEN YOU MUST PICK A MUTUAL FUND…

Sometimes, you won’t be able to choose an index fund in which to invest. For example, your 401(k) or other retirement plan at work will likely ask you to choose from a number of mutual funds. If an index fund in not among them, how do you know which fund is best for you?

There are two areas to consider: 

• The fund’s suitability to your investing goals.
• The fund’s management style.

THE RIGHT FUND FOR YOUR GOALS

Long Term
If you’re under 35 and investing for retirement, you’ll want to seek out funds that have the following caracteristics:

• Invest mostly in stocks (domestic or foreign)
• Use terms like “aggressive”, “high risk/high return”, or “capital appreciation”

For investing periods of less than 30 years but more than 10 years, look for funds with more moderate risk/reward profiles. These funds will:

• Invest in a mix of bonds and (mostly domestic) stocks
• Use terms like “balanced” or “moderate risk”

Short Term
Investing for short-term goals requires a lower risk fund. Look for funds that:

• Invest mostly in bonds
• Use terms like “conservative” and “capital preservation”

A note about target-date funds

Target date funds are increasingly popular in 401(k) plans and other plans that provide you, the participant, with limited investment choices.

Target date funds are designed to provide the ideal risk level for a given withdrawal year (most commonly, the year in which you plan to retire). These funds are popular because they make choosing the fund easy and eliminate the need to move money into more conservative funds as you get holder.

To find the right target date fund for you, simply subtract your current age from 65 (or your desired retirement age). Add that number to the current year, and choose the nearest target date fund. Example: I’m 30. 65 – 30 = 35. 2011 + 35 = 2046. I’d pick a 2045 target date fund.

For most investors, target date funds are fine and allow you to “set it and forget it”. Some are better than others. So if you want simplicity, go with a target date fund. If you’re willing to do a bit more work to make sure you’re putting your money in the best place possible, compare facts about the target date fund to other available funds before picking your fund.

DECIPHERING A FUND’S MANAGEMENT STYLE

Found a fund candidate based on your investing objective? Next, review data on the fund on a site like Moringinstar or directly in the fund’s prospectus. Make sure it has:

• NO load, a sales charge that you should never pay
• A low expense ratio (under 1%)
• Low turnover (less than 50%)

To better understand a fund’s load and expense ratio, read last week’s post.

Turnover is the length of time a mutual fund holds stocks. The goal is to find mutual funds that hang onto stocks for a long time, resulting in a lower turnover. This results in lower trading expenses and capital gains taxes.

MUTUAL FUND RETURNS

Obviously, you’re not going to invest in a mutual fund without taking a peek at its historical returns. When you do, remember two things:

• Consistency is more important than a single blockbuster year.
• Past performance is no guarantee of future results.

Look for a fund that has done as well, better, or at least almost as well as the overall market year after year. If that fund meets your investing goals and has low expenses, you’ve found a winner.

Check back later this week for a few specific fund suggestions to get you started.

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Before you invest, do you know how much that mutual fund costs?

Last week, I wrote a beginner’s guide to mutual funds. As I said, mutual funds are ideal investments for new investors and anybody who wants to take advantage of the stock market’s upside but has no interest in trading stocks or worrying about the markets daily ups and downs. Mutual funds offer set it and forget it investing. That’s a good thing.

When you invest in a mutual fund, you want:

• the right mutual fund for your investing goals (we’ll cover this soon)
• a low-cost mutual fund

WHY MUTUAL FUNDS COST MONEY

When you buy stock in a single company, you must pay a stock broker a commission to execute the transaction. Then, you own the stock, and there are no more expenses to hold that stock until you sell it, at which time you pay another commission.

Mutual funds, however, have other fees.

Remember that mutual funds are collections of stocks, bonds, and other securities. Often times, they are actively managed, meaning a team of people are doing research and making trades daily to ensure the fund performs according to its investment objectives. Even in a fund that’s not actively managed, trades are executed to keep the fund’s portfolio balanced as money flows in and out of the fund.

These trades—and the management and research in an actively managed fund—cost money. And these costs are passed along to the mutual fund investor. That’s OK, but a key to smart mutual fund investing is to identify the funds with the lowest cost for your investing objective.

MUTUAL FUND COSTS

What you need to know about any mutual fund are its expense ratio and sales load.

Expense Ratios

A mutual fund’s expense ratio is the percentage of a fund’s assets that go purely to running the fund. It encompasses many things, including:

• investment advisory fee or management fee
• administrative costs
• 12b-1 distribution fee (advertising)

Basically, all the funds costs are rolled up into the expense ratio, which is expressed as a percentage like 0.20% (on the low end) or 1.60% (on the higher end).

Why do these fees matter?

Mutual fund fees are sneaky, because you never feel them come directly out of your wallet. When you invest $2,000 in a mutual fund, for example, you pay $2,000, not $2,000 plus $20 for expenses. But over time, the mutual fund company takes its expenses out of the fund’s total assets, and any investment returns you earned are reduced by the amount of the fund’s expenses.

For example, if you invested $10,000 in a mutual fund that gets an 8% average annual return for 30 years, here’s how mutual fund expenses can impact your return:

In a fund with a 1% expense ratio, you’ll have $76,122 in 30 years. Invest that same money in a fund with the same return but a 2% ratio, and you’ll only have $57,435 after 30 years. That’s a difference of $18,687 on just a $10,000 investment. The more you invest, the more fees eat away at returns. (And if you found a mutual fund with just a 0.20% expense ratio, you’d have $95,184 after 30 years. Take that to the bank!)

Sales Loads

Mutual fund expenses are a necessary evil—mutual funds cost money to administer. If you want the convenience of investing in these funds, you have to pay the expenses. But there’s another far more sinister fee that some funds charge known as a load.

A load is simply a fancy name for a sales charge or commission.

Fortunately, mutual funds are grouped into load funds and no-load funds, so it’s often easy to search only funds that don’t have this added cost. Note, however, that if a broker or financial advisor is recommending funds for you to invest in, these may be load funds. That person will likely get the load as a commission for helping you pick a fund. (That’s why I recommend using a fee-only financial advisor to avoid this.)

You can read more from the SEC here or from The Motley Fool about fund costs here and mutual fund loads here.

HOW TO IDENTIFY WHAT A MUTUAL FUND COSTS

Mutual fund costs must be clearly disclosed in the mutual fund’s prospectus, which you can download directly from the fund company’s Website or from a mutual fund research Website like Morningstar.

Morningstar and other sites make it easy to research fund sand identify their fees. As an example, the following screenshot of a Morningstar free fund information page clearly shows both the fund’s load and expense ratio, which I’ve highlighted.

TAKEAWAYS

What a mutual fund costs is one of the most important factors in deciding on a fund to buy.

• A mutual fund’s expense ratio eats away at your returns. Avoid funds with expense ratios of more than 1.0%.
• If you’re comfortable learning about and choosing a mutual fund yourself, you should never buy a fund with a load.
• You can find a mutual fund’s costs listed in its prospectus or on Websites like Morningstar.

Stay tuned for more articles in this series including how to pick a mutual fund and some fund recommendations for new investors.

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