When 401(k)s and IRAs are not enough

NEW YORK (Money) -- Question: I'm 32 years old and maxing out my 401(k) and my Roth IRA. I have another $1,200 a month that I'm putting into a savings account that already has about four months worth of emergency money and that pays only 4.5 percent. I'm not familiar with stocks and have limited knowledge of funds, but I'm wondering whether I can do better than the savings account for that extra $1,200 a month. Any suggestions? -Norm, Dumfries, Virginia

Answer: Sure, I've got a few suggestions for you, but before we get to them I just want to tell you what a pleasure it is to hear from someone in his early 30s who is maxing out on a 401(k) and a Roth and wants to do more-namely invest money in accounts outside employer and government tax-favored accounts. That's going above and beyond above and beyond.

I implore all you thirtysomethings out there (and you twenty-, forty- and fifty-somethings too) to take a look at what my man, Norm, is doing here and consider following a similar course. If Normie keeps this up, in 30 years or so he'll probably be able to create whatever kind of post-career or retirement life he wants. Indeed, he may achieve financial independence-or something close-even sooner.

But enough with the kudos. Let's get to those suggestions about what to do with that extra $1,200 a month you're saving.

First, I'm going to eliminate individual stocks from the discussion. I'm not convinced they're worth the extra return you might (note I said might, not will) earn. And besides, to the extent you want to put a lot of extra effort into improving your financial situation, you're probably better off putting it into your career so you can earn more and maintain or even bolster your savings regimen.

Which means I'm going to suggest you invest in mutual funds. Now, that alone doesn't eliminate complexity. There are more than enough fund companies, fund categories and funds out there to confuse the bejeezus out of even veteran investors. So to help you cut through the mind-numbing multiplicity of fund choices, I'm going to recommend three relatively simple routes you can choose from. I've dubbed these options The Easy Way, The Easier Way and The Easiest Way.

All three can get you a decent long-term return on your money and help you achieve financial security both during and after your career. The main difference between the three is how much work you want to put into your investments - a moderate amount, a small amount or a tiny amount. Let's start with The Easy Way.

The Easy Way involves investing in a breed of mutual funds known as tax-managed funds. The managers of regular mutual funds frequently trade the securities in their funds in an attempt to boost returns. Even if this trading is successful, it has the side effect of creating "realized gains" that the manager must distribute to fund shareholders and which are taxed by the IRS. The result is that even if you have all gains reinvested in the fund (as you should if you want to maximize your savings), you still must pay taxes on those taxable distributions.

Managers of tax-managed funds, however, use a variety of techniques to minimize those taxable distributions. They may sell some securities at a loss in order to offset realized gains in others. Or when they sell securities, they may sell shares with the highest cost to minimize realized gains.

Of course, there's a limit to what they can do. They can't, for example, use losses to offset dividends from stocks or, for that matter, interest from bonds (although they can use tax-exempt municipal bonds). By and large, though, these funds do a pretty good job of keeping taxable distributions to a minimum.

So while investing in tax-managed funds doesn't get you a tax deduction or tax-free return like in a 401(k) or Roth, you do get a tax break of sorts in that you're reducing the amount of money you have to shell out in tax payments for your taxable investment gains year after year.

Several fund companies offer a menu of tax-managed or tax-efficient funds. But, again, to keep things simple, I think it pays to stick to companies that have a good record of keeping investment expenses low and posting competitive gains. Both T. Rowe Price and Vanguard fit the bill on those counts, so you could start your search for tax-managed funds there. If you'd like to what other fund companies are offering, go to the Morningstar site and type Tax Managed into the Quotes box at the top of the page. You'll immediately get a list of tax-managed funds. Click on any of the entries and you'll get loads of information on the fund's investing style, its holdings and its pre- and after-tax returns.

Too much work for you? Okay, let's go to The Easier Way - investing in index funds. What makes index funds such simple - and, to my mind, excellent - investments is that you're taking the fund manager out of the equation. Not that I have anything against fund managers. Love them. But on occasion they will get swept up in fads and end up investing in securities that are very popular but perhaps overpriced and thus prone to setbacks. And, let's face it, everyone's gotta eat, so fund managers gotta get paid. And the higher the fees that go to the managers and their investment firms, the less of the fund's gross return shareholders like you get.

Index funds don't have a manager, however, at least not in the conventional sense of someone who's constantly buying and selling stocks and always on the lookout for companies that are going to grow faster than their peers or that are selling at bargain prices. An index fund simply buys and holds all the stocks in a standard market benchmark like the Standard & Poor's 500, which is an index of large-company stocks, or the Russell 3000 index, which is essentially a proxy for the entire U.S. stock market. There are also index funds that follow bond-market benchmarks.

So when buying an index fund you don't have to agonize over whether or not the manager is making good or lousy picks. The fund is going to slavishly follow its index no matter which fund company is running the fund. And because the fund isn't trading securities all the time, it's less likely to rack up realized taxable gains that must be distributed to shareholders. So index funds also tend to be tax-efficient.

That said, you don't want to just throw darts at a listing of index funds and buy on that basis. One reason is expenses. Different companies charge different annual fees for managing their index funds. And if two index funds both follow the same benchmark, then over the long run any difference in performance is going to come down to the size of the fees, with the edge going to the fund that charges less.

Which is why it pays to stick to fund companies that charge low fees for their index funds, such as Vanguard and Fidelity, both of which manage index funds that are listed in the MONEY 70, MONEY Magazine's elite list of recommended funds.

Another reason you want to pay at least a little attention to choosing an index fund is that there are dozens of different indexes and benchmarks out there that follow different segments of the market. My advice is to stick to very broad indexes rather than try to put your money into a particular market niche. So, for example, by buying a total stock market index fund and a total bond market index fund, you would own virtually the entire U.S. stock and bond market with two funds. Throw in an international index and you would have a diversified portfolio of domestic and international securities with just three funds.

So what could be easier than doing that? Why, The Easiest Way, of course.

Imagine if instead of creating your own portfolio by buying a domestic stock index fund, a bond index fund and an international index fund, you could buy one fund that did the work for you-in other words, gave you a pre-mixed diversified portfolio of U.S. and foreign stocks and a broad swath of bonds. And imagine if the mix of stocks and bonds in your fund was not only appropriate for your age - that is, mostly stocks for a young person like yourself - but also changed that mix as you aged, that is, gradually shifted more assets to bonds.

Well, you don't have to imagine it. Such funds exist and they're called target-date retirement funds. You simply pick a fund that has a target date that corresponds to the year you want to retire (2020, 2030, 2040, 2050 or whatever) and you get a ready-made diversified portfolio of stocks and bonds that makes sense for you someone your age today and that changes over time so it remains appropriate for you age. In other words, aside from buying the fund, you don't have to do a thing. The fund does all the work for you. I don't think investing gets much easier than that.

Of course, you do have to choose which target date fund to buy. As with index funds, I think the main factor you should consider is cost. And on that score, I think you would do well going with the low-cost target funds that made the cut for the MONEY 70 - namely, the ones offered by Vanguard and T. Rowe Price. Or you can type Target into the Quote box at Morningstar.com and check out all the target-fund offerings to see if there's one you like better.

I should add that target funds aren't going to be as tax-efficient as tax-managed funds or index funds. But losing some tax efficiency in the name of convenience isn't such a terrible thing. And let's be realistic. It's not as if putting your extra savings into a target-date fund rather than a tax-managed or index fund means you'll have to settle for a much lower standard of living in retirement. In the grand scheme of things, it's just not something I would worry about. The fact that you're saving and investing those extra bucks at all is the most important thing.

So check out the three easy routes I've outlined above. I know there are no sure things in the investing world. But I'm pretty confident that whichever of these three options you choose, your extra $1,200 a month will do a lot better in the long run there than in that savings account.

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