Saving for retirement can be difficult. You have rent to pay, groceries, utilities, insurance, and the list goes on and on. So when you exercise the discipline to put money aside for retirement, you want to know that you’re getting the most of out of your investments. That’s why knowing how to cut the cost of your investments is so important.
In this guide, we’ll look at the two best ways to cut down on investment expenses so that you can keep more of your future retirement money.
1. Keep a close eye on the cost of your investments.
Many people don’t realize that every time you invest in a stock or a mutual fund, there are costs involved. You must be aware of these costs because when are too high, they dramatically change how much your money can grow over time.
What are three key costs associated with investments?
Brokerage firm cost
Vanguard is the most popular, but there are many other great choices, such as Charles Schwab, Fidelity, T. Rowe Price, TIIA-CREF, and many more. With each of these choices, you can buy and sell mutual funds with no trade charge.
Mutual fund purchase cost
Where does this money go? To the brokerage firm or the broker that you are working with. It is given to them as an incentive for selling you the fund. That’s why Bill Barker from The Motley Fool explains that when a broker recommends a fund to a client, the fund will in all probability be a load fund.
Adam Bold, from USNews, had the following to say in his article Why Investors Should Avoid Load Funds:
“If a fund carries a 5.75% front-end load, the broker will get $575 for every $10,000 you invest in the fund. That leaves you just $9,425 to start with. This means you have to earn back the $575 that was paid to the broker to just break even. You also lose the compounding of the load amount as the market rises.”
He goes on to say this:
“Loads can also cause investors to feel trapped in an investment. If you buy a load fund and want to sell it, the broker may want to sell you another load fund, which means you’ll have to pay another commission. Instead of selling it, you might stick with the fund longer than you should.”
Another thing that you should know about load funds is is that when you look at fund performance data on U.S. News’s site or Morningstar, those returns are net of fees and expenses that the mutual fund company charges, but they’re not net of the load.
In other words, returns that investors get from a load fund will actually be less than the returns commonly published.
Mutual fund management cost
This is a biggie that most don’t know to look at. Mutual funds have ongoing expenses that are known as the expense ratio of the fund.
The expense ratio includes the cost of hiring the fund manager and the administrative costs of the fund. These expense ratios typically range from 0.5 percent to 2% of your investment. This might not sound like much, but it makes a huge difference to your retirement.
- Walter Updegrave from the Wall Street Journal found that investing in low-cost mutual funds versus even moderate-cost mutual funds could yield you an extra 12 years of retirement!
- He also found that holding annual expenses to 0.5% instead of 1.5% could potentially boost annual retirement income by an extra 40%.
The Magic of Index Funds
One of the best ways to minimize the expense ratio of your mutual fund portfolio is to invest in index funds. Instead of hiring a fund manager who decides what stocks should and should not be in the fund, index funds simply follow certain common market indexes, like the S&P 500 for example.
- So, an S&P 500 index fund, for example, would include the stocks of every company that is in the S&P 500. There is no thought involved. It’s automatic.
- As the companies in the S&P 500 change, the index fund changes as well. When the S&P 500 goes up, your index fund goes up. When the S&P 500 goes down, your fund goes down. It’s very simple, clean, and requires very little management, which results in much, much lower operating costs.
While the average mutual fund will have a cost between 1% and 2%, the average index fund cost will be under 0.5%. I personally own shares of an index fund with an expense ratio of 0.09 percent.
But you get what you pay for, right? Wrong.
Year after year, Standard & Poor’s releases their annual report showing how many mutual funds outperformed the S&P 500. Here are the percentages of fund managers that underperformed the S&P 500 during the last year, 3 years, and 5 years:
- 1 Year: 64.49%
- 3 Years: 78.98%
- 5 Years: 82.14%
Does that kind of performance sound like it’s worth paying extra for? Not to me.
The bottom line: if you are going to choose anything other than index funds for your portfolio, you’d better make sure that have found one of the rare funds that have outperformed the S&P 500 on a long-term basis.
2. Take advantage of tax-saving opportunities
Another important factor that many investors fail to take into account is the amount of taxes that they pay on their investment. This can make a huge difference in your overall return.
In order to encourage Americans to save money for retirement, the government has created tax-saving opportunities. To not take advantage of these is foolish.
The three most common tax-advantaged retirement accounts used today are:
- Traditional IRA
- Roth IRA.
Traditional IRAs and 401(k)s offer nearly identical tax advantages, but they do have other things that make them different.
|Anyone with earned income can create one.||Must be employed a particular company to get access to their 401k|
|Usually able to invest in nearly any investment of your choice||Typically offer a limited number of funds/stocks for you to invest in (many of which are expensive choices)|
|As long as you have earned income, you can contribute up to $5,500 annually.||The employer decides who can and cannot contribute, and also decides how much employees can contribute annually.|
|You can pick any discount broker of your choosing.||Often have high expenses and fees dedicated to account management.|
Due to all the reasons explained above, an IRA is typically a better choice for your retirement money, but there is a key exception to this rule. If you are offered an employer match for your contributions, then this definitely makes your 401(k) the best choice for you.
What about a Traditional IRA versus a Roth IRA? We answer this question in depth in our Roth vs Tradition IRA guide and the 3 Secret Perks of the Roth. But for now, let’s suffice it to say that typically, for those in their 20s and 30s, a Roth IRA is their best choice, while a Traditional IRA can often be a better choice for those in their 40s and 50s.
But no matter which tax-advantaged account you use, the key is to make sure that you pick one! Unnecessary tax cost can put a big dent in your overall investment return.
Not paying attention to the costs of your investment could cost you a lot of money.
You work hard for your every dollar that you invest and you deserve to get the most bang for your buck. By paying attention to your investment cost and your tax cost, you’ll be well on your way to squeezing every possible dollar out of your investments.