Planning for retirement part 1 - the basics
This post is part 1 of a series on retirement accounts, and a continuation of the financial basics series. The idea of becoming free from money is based on having enough passive income that you never have to worry about working for money again. For most people that is retirement. And one of the most powerful financial tools available for investors is the retirement account.
Why a retirement account?
In the past a company provided for their employees with a pension. You worked for the company for x number of years, and they would provide a fixed payment for you to live off of for the rest of your days. These are called defined benefit plans, since you will receive a predefined amount of money when you retire.
Then somewhere along the line employers made the switch to defined contribution plans. With this type of plan (typically a 401(k)) a company could shift the burden of funding a retirement to the employee. This is obviously a huge benefit to the company, but not so much for the employee, who now needs to plan to save enough, invest it wisely, and plan how long they will be living after they retirement (obviously not an easy thing to know!)
The big benefit of having an individually owned retirement account versus a company funded one is that you can take it with you between jobs. The old days of being chained to a job for a certain number of years so that you can collect your retirement are over if you are not receiving a pension. So now you can actively pursue jobs you want, and roll your accounts when you leave.
What types of accounts are available?
There are many different types of retirement accounts available, but the most common are the 401(k), the IRA, and the Roth IRA. There are a few other types of accounts available as well, but they generally all have a few things in common. First is that they are considered long-term accounts, and will impose steep penalties if you take money out of the account before you reach retirement age (typically 59 1/2 or older). Second is that they will allow your money to grow tax free every year. This is different from regular accounts that require you to pay annual taxes on interest, dividends, and capital gains.
The 401(k) is generally offered by a company to its employees, oftentimes with a match of some sort, either as a percentage of pay or a flat dollar amount. The money that goes in is pretax, but you will have to pay taxes upon withdraw of the money. As of 2008, the annual cap is $15,500, not including the match from your employer. So if your annual income is $50,000, you could contribute 31% of your income a year, regardless of what your company matches you.
The IRA is very similar to the 401(k) in function. The money you contribute goes in tax free, reducing your taxable income, and is taxed when you take the money out at retirement. The amount you can contribute is capped at $4,000 a year ($5,000 if you are 50 or older). IRAs can be opened with many different financial institutions depending on where you would like to invest. Stock market investors can open IRA accounts with brokerage firms and buy individual stocks and bonds. Mutual fund investors can choose a company like Vanguard or Fidelity. Even banks usually offer retirement accounts, although sometimes the selection of investment choices can be slim.
Similar to the IRA is the Roth IRA. The major difference between the two is that money that goes into a Roth IRA is after-tax, but the money you withdraw during your retirement years are tax free (since the money was already taxed before it went in). This annual limit is the same for each, and generally the same financial institutions offer both IRAs and Roth IRAs.
Which one should I pick?
If the company you work for offers any matching amount for contributing to a 401(k), then investing at least that amount should be a no brainer. Not putting money in is saying no to free money, and no matter how strapped for cash you might be there’s no reason to say no to free money, right? Add to that the tax savings and this is an easy place to start.
If your company doesn’t offer a match, or you’ve contributed enough to max out your company’s matching amount, an IRA (either a traditional or a Roth) might make more sense than investing in the 401(k). When a company sets up a 401(k) it generally has to choose a small number of funds for you to invest in. These may not always be the best funds, either due to poor management, lousy expense ratios, or they might just not be the types of funds you want to invest in. As I mentioned earlier, many financial institutions offer IRA or Roth IRA accounts. I personally invest with Vanguard and have been happy with them.
The decision to use a traditional IRA or Roth IRA is based on whether you think you will fall into a lower tax bracket when you retire or not. You could have both, but the $4,000 annual limit is cumulative between accounts - you cannot put $4k in an IRA and another $4k in a Roth IRA. If you are making a ton of money now, and could use a tax break, a regular IRA might be a good idea. Otherwise a Roth IRA may be a good idea.
Until next time . . .
So that wraps up part 1 of retirement basics. Hopefully this was helpful, and if you have any questions please leave a comment. Next week I will cover the basics of asset allocation and how to pick funds for your retirement accounts. See you then!
