Retirement Accounts 101
For most of us, investing starts with setting up an investment account. This is where you’ll hold your investments, like stocks, bonds, and mutual funds. And while there are a few different types of accounts to consider, they generally fall into one of two broad categories;
• Dedicated retirement accounts, like 401(k)s, 403(b)s, and IRAs
• Taxable accounts, like brokerage accounts and robo-advisors
Here we’ll be focusing on the first group, dedicated retirement accounts, starting with 401(k)s.
401(k)s and other workplace plans
You’ve just started a new job, and you’re excited to get after it, when someone from HR hands you a massive packet of information, covering everything from company policies to health insurance.
Mixed in there somewhere may be information on your 401(k) retirement plan (or 403(b) if you work for a non-profit). It can be tempting to set this pile of anxiety aside, letting it collect dust for the next six months. But try to fight the urge.
Because a 401(k) can be a great way to start investing.
“Why?” you ask.
Well, for starters, a 401(k) offers a tax advantage that your standard taxable investment account doesn’t.
With a traditional 401(k), your taxes are deferred, or in in other words, put off until later.
This means you can contribute money directly from your paycheck without it being taxed. Then that money can grow tax-free, meaning you won’t owe any taxes on your investment income along the way – normally you would have to pay taxes on your dividends, interest, and investment gains. However, you can’t avoid taxes forever. And once you do start taking the money out in retirement, you will have to pay income taxes on your distributions.
So your taxes are deferred until you take the money out.
This offers two potential key benefits;
1) Your investments will have more opportunity to grow since you delay paying taxes.
2) When you take your money out in retirement, you may be in a lower tax bracket.
And while you might actually end up in a higher tax bracket when you retire – if you’re wealthier and you’re earning a lot on your investments – it’s generally a good problem to have. And it probably means you’re in great shape financially.
Even beyond the tax benefit, contributing money directly from your paycheck has the added benefit of pushing you to save more automatically.
Matching and vesting
The other main benefit of a 401(k) is that some employers offer a match. This means they’ll contribute money in addition to what you contribute, up to a certain amount.
The exact matching formula can vary from one employer to the next. But a fairly common structure is for your employer to contribute a set percentage up to a maximum contribution.
For example – Let’s say your employer contributes a 50% match up to 5% of your annual pay. So if your annual pay is $50,000, and you contribute $3,000 to your 401(k), your employer would contribute $1,500 (50% of $3,000).
If you contributed $5,000, your employer would contribute $2,500, which is also the maximum they would contribute for the year, since $2,500 represents 5% of your annual pay. That’s an extra $2,500 to you just for investing in your 401(k). What a deal!
An employer match is about as close to free money as you can get. So even if you feel like you can’t contribute much to your 401(k), it might be worth trying to contribute enough to take full advantage of the match.
But there is a catch – you may not immediately own the money contributed by your employer. So you’ll need to look at the vesting schedule. This will spell out how much you’ll own based on the number of years you’ve worked for your employer.
The portion of the match that has vested at any given time is the portion that you own. That’s the amount you would keep if you left your employer today. Typically, it takes a few years to be fully vested. But you’ll want to check with your employer to see how your vesting schedule works.
Setting up your 401(k)
To get started, you’ll typically have two main decisions to make;
1) How much of your paycheck you want to contribute
2) What investments you want to own (typically from a pre-selected offering of funds)
While these two decisions are certainly important, you should keep in mind they aren’t set in stone. You can always change them later by increasing or decreasing your contribution amount or changing your investment selection.
We have a separate guide explaining how to set up your 401(k).
And if you want to learn more about investing in general, like how to choose investments, we cover that in our Core Content, starting with the basics.
Traditional Pension Plans
While 401(k) plans have become quite popular since they were introduced in the 1970s, some employers still offer traditional pension plans. These are sometimes referred to as defined benefit plans (versus 401(k)s, which are considered defined contribution plans).
With a pension plan, your employer will be responsible for making contributions and managing the money on your behalf. So the future benefit will be more clearly defined – hence the name.
But it’s important to note that these types of plans have become less common in recent years. And even if you do have a pension plan, it may not pay as much as you’ll want or need in retirement. So you may still want to open an IRA or taxable investment account to supplement your savings.
If you aren’t sure what your employer offers, check with someone in human resources.
“Opt-out” plans
Some employers have gotten wise to the fact that people tend to put off signing up for a 401(k). So they’ve started to automatically enroll employees in retirement plans, leaving it up to the employee to change their contributions if they want to.
This is referred to as an opt-out plan (by default you are in the plan and it’s up to you to “opt-out”). And research does show this strategy can be an effective way to encourage people to save more for retirement.
However, even if your employer does this, you should still review your contribution amount and investment choices. Opt-out plans tend to set fairly low contribution amounts, and they also tend to select conservative investments that may not be great for long-term investing.
Cashing out early
401(k)s are specifically designed to encourage long-term investing, and they offer attractive benefits for doing so, but they’re also designed to discourage you from taking your money out early.
For the most part, if you start taking money out before you’re fifty-nine and a half (set by U.S. law), you’ll have to pay taxes on it and will be charged an additional 10% penalty. Not something you want to do.
There are some allowable exceptions that don’t trigger the 10% penalty however, like taking money out to cover college tuition or medical expenses, or taking $10,000 out for a first time home purchase, but in general, you’ll want to leave the money alone.
There are also some other important rules and restrictions regarding 401(k) investing that we don’t cover here, but you can read more on the IRS website.
Borrowing against a 401(k)
Some 401(k) plans allow you to borrow against your account without triggering any penalties as long as you pay the money back within five years. And this money can be used for anything.
While this might seem like a tempting option, you need to be careful.
If you don’t pay it back on time, you can be hit with the income tax and 10% penalty, and if you leave your job, you’ll probably have to pay it back within 90 days.
You’ll also be forgoing your chance to earn a return on your investments, which can add up to a lot of lost money over time and defeats the purpose of saving for retirement.
And while borrowing against your 401(k) might be a better option than borrowing with your credit card and paying 20% interest, you should really be thinking of this as (almost) a last resort. It’s usually best to leave your retirement savings alone to grow.
Individual Retirement Accounts (IRAs)
If your employer doesn’t offer a retirement plan, you can still get in on the fun with an Individual Retirement Account, or IRA, which offers similar tax benefits. There are a few different types to be aware of.
With a traditional IRA, you can contribute pre-tax money (like you do with a 401(k)) and then you won’t pay any taxes on your investments until you begin to take your money out in retirement, at which point it will be taxed as if it was ordinary income.
With a Roth IRA, you contribute after-tax money, but then your investments are allowed to grow tax-free and you won’t be taxed when you take the money out in retirement. (There’s also a Roth 401(k) that works in a similar way. The 401(k)s we have been discussing up until now are considered traditional 401(k)s.)
There are certain rules for investing in IRAs which are covered in more detail on the covered in more detail on the IRS website.
For example, you can currently contribute up to an annual max of $6,000 for a traditional IRA if you’re under 50 years old and $7,000 if you’re 50 or older (as of 2019). Also, your eligible contributions may be reduced or eliminated entirely based on your income (i.e. high earners can’t contribute as much or at all), so you’ll want to review the rules.
If you’re interested, we can help you set up an IRA, and we also cover more details on Roth IRA vs Traditional IRA if you want to learn more.
Making regular contributions
One of the benefits of setting up a retirement account is that you can make automatic contributions from your paycheck throughout the year. This will help remove the temptation to spend your money on non-essentials when you earn it. Even if you’re investing in an IRA rather than a 401(k) at work, you should still try to do this.
You might discover that you simply aren’t left with enough money to cover necessary expenses, in which case you can reduce your retirement contributions, but you might also be surprised at how much you are able to save if you prioritize retirement savings.
What if I’ll need the money before retirement?
This is where taxable investment accounts come in, like brokerage accounts and robo-advisors. If you want to learn more about how these work, we have you covered.
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