Investing Outside of a Tax-Sheltered Account
November 25, 2009 10:46 PM   Subscribe

Is it worth it for a student who makes less than $10,000/year to invest outside of a tax-sheltered account?

I recently opened a Roth IRA (with a target date retirement fund). I am a student and make less than $10,000/year so my contributions to the Roth are rather modest. Although I recognize the value of slowly investing towards retirement, I cannot help but feel an itch. The prospect of using my savings to make more money for short-term use is tempting.

I understand the risks involved in investing. However, I've recently been thinking about investing in the Vanguard STAR fund (low minimum amount, no annual fees, moderate risk) outside of a tax-sheltered account. I'm not expecting a high rate of return, just a something that is above the current 1.xx% rate I receive from a high-yield online savings account. I envision myself being a lazy investor who will settle for a lower rate of return and spend valuable time doing the things I love. But, what are the ramifications of doing so?

For example, would it be worth it to invest the minimum amount for the Vanguard STAR fund? What would be the tax ramifications (e.g. capital gains tax...)? Am I being naive in thinking that I can simply invest some money in January, subsequently contribute a small amount over the months, and take out a couple hundred bucks in December?

I am aware that there are other funds out there with higher rates of return than the Vanguard STAR, but I can only afford this particular fund's minimum at the moment. I will definitely reallocate once I've contributed past the minimum of other funds. My question, however, is what can I reasonably expect as a small-fish investor in his early 20's who is still in college?
posted by mahoganyslide to Work & Money (7 answers total)
If you are going to invest, you want to hold those investments as long as you can. The tax rates get better if you hold them for longer than a year, and risks tend to smooth more over longer periods of time.

But I wouldn't do it. The stock market is unstable right now, and there are actually far better things you can invest in at the moment. Which is to say... do you have any debt at all? Car loans, credit cards? Pay those first. Are there any things you can do right now that will improve your long-term earning prospects--unpaid internships over the summer, additional classes, studying overseas, any number of things that will improve your resume when you graduate. Those things will help you a lot more in the long run than the meager amount you'll be able to put towards retirement on this income.

I tried this, when I was in college. I ended up having to cash everything out before I'd actually made my original investment back thanks to the volatility of the market over the past few years and the difficulty I had finding work post-graduation. Unless there is absolutely nothing else for that money to do besides sitting in a savings account, I wouldn't put it in the market right now.
posted by larkspur at 11:16 PM on November 25, 2009

If you don't already have a lot of savings, it probably makes more sense to just continue building up your savings account, as an emergency fund. You probably won't make "a couple hundred bucks" in a year with a small investment unless you gamble and are lucky.

The strategy that made the most sense to me, when I was starting out, was to first get an adequate emergency fund, and then branch out into riskier investments. Though, like you, the first thing I started with was a Roth IRA that my Dad encouraged me to get.

However, if you want to invest, Vanguard is a good company to do it with, since they specialize in charging their customers (aka their sockholders, since they are a mutual company) the lowest fees possible.
posted by cosmic.osmo at 11:21 PM on November 25, 2009

Am I being naive in thinking that I can simply invest some money in January, subsequently contribute a small amount over the months, and take out a couple hundred bucks in December?

Yes, because there is a good chance the money will not be there in December. It is not a good idea to plan for an 11-month investment in a fund marketed for "medium- to long-term goals."

Do you have an emergency fund that will cover six months of expenses in an FDIC-insured account? Are you debt-free? If the answer to either of these questions is no, you should not consider this.

Vanguard is a good company to do it with, since they specialize in charging their customers (aka their sockholders, since they are a mutual company) the lowest fees possible.

The fund mentioned here is actively managed and therefore has particularly high fees as Vanguard fees go (0.32% versus, say, 0.18% for the Total Stock Market Index fee). Still lower than many other mutual funds though.
posted by grouse at 11:25 PM on November 25, 2009

You can withdraw any amount, up to the original investment, from a Roth IRA without (IRS) penalty. It's only gains above the original investment amount that are restricted.

Since it sounds like you aren't making the $5000 allowed contribution anyway, I would recommend you just put everything you want to invest into the Roth IRA. Try to leave it in, but take back what you need to if you need to.

This will ensure you get the maximum allowed contribution if things go rosy in your life, and avoids the probable additional fees and added complexity of maintaining a separate small investment account.

It's worth noting that whoever handles your IRA will possibly charge a fee of their own for withdrawals, so check to see if they do and if so plan accordingly.
posted by Bokononist at 2:49 AM on November 26, 2009

I endorse the Bokononist philosophy. You won't be paying taxes now either in taxable or tax deferred because of your low income. But presumably you will have higher taxes in the future when you get a real job and you can only contribute to an IRA a certain maximum each year. If you pass up this year's opportunity to contribute to a Roth, it is gone forever. Taxes make a substantial difference in your real return so it is best to use tax advantaged investing.

As Bokononist points out, you can have the best of both worlds. You can contribute to your Roth IRA now. In the best case you will leave it there for retirement. But in an emergency you can take out your contribution tax free and without penalty at any time.

Vanguard STAR is a great diversified starter fund, but consider putting it in a Roth IRA.
posted by JackFlash at 1:26 PM on November 26, 2009

Thank you all for your comments so far! It seems as if putting as much as I can in my Roth is the best idea. My follow-up question then is: should I stick with my aggressive Target Date fund (2055 from T. Rowe Price), or transfer my Roth to Vanguard for its STAR fund?
posted by mahoganyslide at 4:02 PM on November 26, 2009

T. Rowe Price has a higher expense ratio, 0.79% compared to STAR at 0.39% but with your small investment it isn't going to make a lot of difference one way or the other. Over time as your investments grow it would be a good idea to migrate to the less expensive Vanguard family of funds but no compelling need to do it now. T. Rowe Price also has a little more flexibility for small investments of less than $3000. Do whichever is easier for you.
posted by JackFlash at 4:43 PM on November 26, 2009

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