So far, this year I have shared the importance of getting started on the road to financial freedom. We’ve gone over a variety of topics from living within means without feeling too restricted to budgeting our way to financial freedom. This month I’ll be introducing retirement savings plans. A retirement savings plan is a plan for setting aside money to be spent after retirement. We will cover retirement in two parts. First, we’ll get an understanding of the different options for retirement accounts.
Understanding Your Investment Account Options
Now that you’ve made the right choice in deciding to save for retirement, make sure you are investing that money wisely. The lineup of retirement accounts is a giant bowl of alphabet soup; 401(k)’s, 403(b)’s, 457s, I.R.A.s, Roth I.R.A.s, Solo 401(k)’s and all the rest. They came into existence over the decades for specific reasons, designed to help people who couldn’t get all the benefits of the other accounts. But the result is a system that leaves many confused. The first thing you need to know is that your account options will depend in large part on where and how you work.
IF YOU WORK AT A FOR-PROFIT EMPLOYER
Available account: 401(k) plan.
If your for-profit employer offers any workplace retirement savings plan, it’s probably a 401(k). (Many smaller employers do not.) You can generally sign up for this any time (not just during your first week on the job or during specific periods each year). All you have to do is fill out a form saying what percentage of your paycheck you want to save, and your employer will deposit that amount with a company (like Fidelity or Vanguard) that will hold it for you. Here, automation is your friend. Some employers will automatically raise your savings rate each year, if you let them. And you should.
Things to Know About a 401(k):
- Matching: If you’re really lucky, your employer will match some of your savings. It may match everything you save, up to 3 percent of your salary. Or it may put in 50 cents for every dollar you save, up to 6 percent of your salary. Whatever the offer is, do whatever you can to get all of that free money. It’s like getting an instant raise, one that will pay you even more over time thanks to the compound interest we were talking about before.
- Caps: How much can you put aside in a 401(k)? The federal government makes the call on this, and it often goes up a bit each year.
- Taxes: As with most other employer-based plans, when you save in a 401(k) you don’t pay income taxes on the money you set aside, though you’ll have to pay taxes when you eventually take out the money.
IF YOU WORK AT A NON-PROFIT EMPLOYER
Available accounts: 401(k), 403(b) and 457 plans.
If you work for the government or for a nonprofit institution like a school, religious organization or a charity, you likely have different options.
What to Know About a 457 plan:
- These are a lot like 401(k)’s, so read the section above to understand them better.
What to Know About a 403(b) plan:
- These frequently show up at nonprofits – 401(k)’s are more rare here – and often get complicated and expensive. You may be encouraged (or forced) to put your money into an annuity instead of a mutual fund, which is what 401(k) plans invest in. (More on mutual funds later.) Annuities technically are insurance products, and they are very difficult even for professionals to decipher. Which brings us to the expensive part: they often have very high fees.
- In some instances, especially if your employer is not matching your contribution, you may want to skip using 403(b)’s altogether and instead use an I.R.A.
IF YOUR EMPLOYER OFFERS NO PLAN OR YOU’RE SELF-EMPLOYED
Available accounts: I.R.A., Roth I.R.A., S.E.P. and Solo 401(k) plans.
People who are setting up their own retirement accounts will usually be dealing with I.R.A.s, available at financial-services firms like big banks and brokerages.
What to Know About I.R.A.s:
- Choosing where to start an I.R.A.: Ask the financial institution for a complete table of fees to see how they compare. How high are the fees to buy and sell your investments? Are there monthly account maintenance fees if your balance is too low?
- In general, what you invest in tends to have Taxes: Perhaps the biggest difference between I.R.A.s has to do with taxes. Depending on your income, you may be able to get a tax deduction for your contributions to a basic I.R.A. up to a certain dollar amount each year. Again, check the up-to-date government information on income and deposit limits and ask the firm where you’ve opened the I.R.A. for help. After you hit the tax-deductible limit, you may be able to put money into an I.R.A. but you won’t get any tax deduction. As with 401(k)’s, you’ll pay taxes on the money once you withdraw it in retirement.
- Far more impact on your long-term earnings than where you store the money, since most of these firms have pretty competitive account fees nowadays.
- Caps: As with 401(k)’s, there may be limits to the amount you can deposit in an I.R.A. each year, and the annual cap may depend on your income and other circumstances. The federal government will adjust the limits every year or two.
What to Know About Roth I.R.A.s:
The Roth I.R.A. is a breed of I.R.A. that behaves a little differently. With the Roth, you pay taxes on the money before you deposit it, so there’s no tax deduction involved upfront. But once you do that, you never pay taxes again as long as you follow the normal withdrawal rules. Roth I.R.A.s are an especially good deal for younger people with lower incomes, who don’t pay a lot of income taxes now. The federal government has strict income limits on these kinds of everyday contributions to a Roth. You can find those limits on the IRS website mentioned in the retirement plan topics section.
WHAT HAPPENS IF YOU CHANGE JOBS?
When you leave an employer, you may choose to move your money out of your old 401(k) or 403(b) and combine it with other savings from other previous jobs. If that’s the case, you’ll generally do something called “rolling the money over” into an I.R.A. Brokerage firms offer a variety of tools to help you do that.
That said, some employers will try to talk you into leaving your old account under their care, while new employers may try to get you to roll your old account into their plan. Why do they do this? Because the more money they have in their accounts, the less they have to pay in fees to run the program for all employees.
But leaving your money behind or rolling it into your new employer’s plan may have disadvantages. Most employer plans may have only a limited menu of investments, but your I.R.A. provider will generally let you invest in whatever cheap index funds you want.
Also, it’s generally best to keep all of your retirement money in one place; it’s easier to keep track of it that way. So, roll all your retirement accounts into an I.R.A. once you leave a company to simplify things, especially as you near retirement. You can’t count on former employers to keep in touch as your home or email addresses change. Nor will every entity that has an account in your name necessarily track you down when you near retirement.
This is just an introduction to getting an understanding of the different retirement accounts you are able to choose from. The next article will focus on the following retirement topics:
- When to start saving for retirement?
- How much money do you need for retirement?
- How much monthly income do you need to retire?
- What percent of salary should be saved for retirement?
- What is the average retirement income?