Now that you are convinced to start funding your retirement as soon as you start earning, there are a few other common terms and concepts you’ll hear that you’ll want to understand in order to be a “retirement pro.” Today’s post is just an overview and leaves the deep dives for another day and different bytes…
401(k)’s – You may have heard of a 401(k), but probably not sure what it is. Don’t be confused by the odd name. It’s just a retirement account plan which your employer offers, enabling you to set aside a portion of your pay for retirement savings. Contributing to a 401(k) plan account is voluntary, meaning you must choose to have money deducted from your pay to invest in the account. When you choose to participate, your employer will put the money into the 401(k) fund, however, the money is yours and you are in control of how it is invested – to an extent. Your investment options are limited to those that are offered in the employer’s plan, and some plans have broader choices than others. Most plans will offer just a handful of mutual funds to select from.
Now, whether you should contribute to the company 401(k) plan is another question and the answer is, “it depends” – ugh! – but that decision is a topic for a more in-depth post. For now, let’s assume you plan to contribute the company 401(k) so you just need to understand some of the big ideas around such a plan:
- There are 2 types of 401(k) plans -“traditional” and a “Roth” – and not all employers offer both. Most offer only the traditional, but the number offering the Roth too is growing. The most important difference between the 2 types is when you have to pay taxes on the money in them.
- Contributions to a traditional 401(k) are made pre-tax, meaning they come out of your gross income before federal and state taxes are deducted from your take home pay. While this reduces the amount you have to pay in taxes now, you will eventually have to pay taxes on the withdrawals you make from the 401(k) in retirement. Eventually, Uncle Sam always gets his piece of the pie…
- Roth 401(k) contributions are made post-tax, meaning they come from the dollars that would otherwise be in you paycheck after your employer has already deducted the taxes from your gross pay. However, when you retire, Roth withdrawals are made tax free. Nice…but you still paid taxes.
- Which is better? It depends – ugh – mostly on whether or not you expect to be subjected to higher or lower tax rates in retirement, but that’s hard to determine this early in you Money Marathon. Rather than worry about it now, I suggest that if a Roth 401(k) is available to you, it’s probably the better option for someone smart like you who will build a solid nest egg for retirement. If the traditional is the only available option to you – like its been for me – that’s OK too.
- Some companies “nudge” their employees to participate in their 401(k) plan by offering matching contributions, meaning they will match a portion of your personal contribution to the plan. If an employer offers this, take advantage of it – it’s free money! – by putting at least the minimum amount into the plan that your employer requires to get their matching funds.
- Not all companies offer a 401(k) plan to their employees. Most large and medium-sized companies do, but many small companies do not. Have no fear…If you decide to go into business for yourself or to work for a small company that doesn’t offer a 401(k) plan, there are other options for you to contribute to a pre-tax retirement account yourself.
- If you go to work in the public sector (e.g. government, school district), a non-profit, or in higher education (e.g. a university or research center) your employer may offer a 457 or 403(b) plan. They are similar to the 401(k), but have slightly different rules for contribution and withdrawals.
- There are bunch of rules in place to strongly encourage you to ultimately use the money in your 401(k) as it was intended: For retirement. The rules include maximum annual contributions, age limits on withdrawals, penalties for early withdrawals, etc. We won’t go into the details now, but here’s a solid reference to learn more.
Last note on 401(k) plans for now…If you’ve been paying attention, you may be confused with my earlier guidance about contributing 10% of your pre-tax income to your retirement fund and this “Roth 401(k) thingy,” since contributions to it are post-tax. Luckily, we can keep it simple for now. If you go with a Roth 401(k), tweak the rule to be “10% of your post-tax income to your Roth, and 20% to your other post tax investment account.” If you do the math, you’ll realize that the Roth contribution is actually a smaller dollar amount than the pre-tax 10%, (10% of your take home pay is less than 10% of your gross pay) but since you won’t have to pay taxes on the Roth withdrawals many years in the future, it’s probably OK that you are saving a bit less now.
Individual Retirement Accounts (“IRAs”) – IRAs are just what their name implies. They are, obviously, retirement accounts but you contribute to them and administrate them yourself, unlike your employer’s 401(k). Like a 401(k), IRAs have rules about contribution limits and withdrawals, and yes….there are both traditional IRAs and Roth IRAs with the same tax payment timing differences like the 401(k).
People open an IRA for several reasons:
- 401(k) “Rollovers” – When people leave a company where they have a 401(k) account they get to take their money in the 401(k) with them, but that money must be moved into another retirement account or there will be taxes and penalties to pay. While it sometimes possible to roll your account from your old to your new employer’s 401(k) plan – or even leave it in your previous employer’s plan – many people choose to open an IRA and roll their 401(k) funds into it instead. Not only does rolling your old 401(k) over into an IRA give you more direct control over the funds, it likely give you a wider variety of investment options with lower fees associated with the account.
- Investment Diversification – As I mentioned above, most 401(k) plans have fairly limited investment options. Usually, they consist of a short list of mutual funds that may or may not be great performers. Not only do IRAs allow you to invest in a much broader set of mutual funds, but they usually offer the ability to purchase individual stocks and bonds too. Many folks will choose to put a portion of their 10% into their 401(k) plan – especially if their employer offers matching funds – but will divert the remainder to their own IRA to seek better investment returns with lower fees.
- No 401(k) – Also mentioned above, if you are self employed or your employer doesn’t offer a 401(k), you can open one of several versions of an IRA to invest for retirement like an employer plan. Here’s a few you might hear about: Solo 401(k), SEP IRA, Simple IRA.
Social Security – You’ve heard of it. You know you have a Social Security number, and sometimes businesses or organizations ask you for it as a form of identification (hint: don’t give it to most who ask for it), but its primary purpose is for tracking your entitlement to receive regular payments from the Social Security Administration (SSA) when you become eligible for them. In return for all the money you paid into the fund during your working years (recall from the budget posts that some of your gross income will be deducted from your pay to fund SSA and Medicare), you will be entitled to receive a monthly check from the SSA once you reach the age of 67 (typically) for the rest of your life. The amount you receive is based on a average calculation of what you paid into SSA during your working years.
Here’s what is important to know now about Social Security: It’s an imperfect system, and while it will likely still be around for you to get back some of the money you paid into it over your working years, you should not count on it as the primary means to fund your living expenses in retirement. In Money Marathoner parlance, treat your eventual Social Security income as just a “boost,” and expect that the other investments you make and directly control over your career will be the primary means of funding your retirement.
Pension – Until the broad adoption in the 1980’s of 401(k)s as the primary means to save for retirement, pensions were the common employer-managed method. Some employers still have pension funds (usually large, long standing corporations or government/public service jobs like police, fire, etc), but most have eliminated them, replaced by 401(k)s. Pension funds vary significantly from one plan to another, but they all have a few characteristics in common:
- Employer Funded – Instead of you paying into the fund directly, a pension is funded by your employer
- Payout – The amount you are entitled to receive from a pension fund is always based on a formula tied in some way to how long you work for the organization, your age and the salary you were paid by your employer.
- Timing – most pensions allow you to begin to receive monthly payments from the fund at age 65, though some do allow for earlier withdrawals at a reduced rate. Like Social Security, once you begin taking pension payments, you will receive them for the rest of your life.
There’s plenty more to learn about retirement though I realize that reading this post probably hasn’t been the most exciting use of 5 minutes of your time. Trust me – you’ll be glad that you have a basic understanding of the retirement mumbo-jumbo as you move along your Money Marathon. Hopefully with the next post I can add a little more excitement, as we start to get into the nuts and bolts of investing…
The Money Marathon 