The 411 on the 401(k)
Starting out, let’s take a look at what a 401(k) is. This is what the Wall Street Journal has to say on the subject: “A 401(k) is a retirement savings plan sponsored by an employer (that) lets workers save and invest a piece of their paycheck before taxes are taken out.”
As with all numerically named retirement plans, the 401(k) plan is named after the section of the tax code where it can be found. In the old days, employers provided a pension to their employees after a set tenure of work. Some professions, including military and union jobs, still receive them. But with the ever-increasing costs associated with providing a stipend over the remaining years of an employee’s life, companies struggled to keep pensions in place. An alternative was needed, and the 401(k) came about.
With the 401(k), your employer may or may not put in matching funds, and you might have to meet a tenure requirement to become fully vested into the program.
Penalties like early withdrawal before retirement age and limitations on when you withdrawal are designed to encourage long-term investment. You choose a percentage of your income to contribute, and you work with your company’s administrator (a financial institution that manages the portfolio) to help reach your goal.
Go it Alone with an IRA
Another option is the IRA, which stands for Individual Retirement Account. Like the name implies, an IRA isn’t related to your employer – it’s a retirement product you enroll in on your own. You manage your portfolio using every investment available, rather than the limited portfolio your employer offers.
There are two kinds of IRAs: a traditional IRA and a Roth IRA. The difference in each boils down to contribution limits, income limits, taxes, withdrawals and other benefits. To qualify for a Roth IRA, you have to meet adjusted gross income requirements. A traditional IRA, however, has no income requirement, but you have to be younger than 70.5 years of age to contribute due to mandatory distribution rules. The government rewards you for long-term investing by allowing generous tax breaks for IRAs. But the difference between a Roth and traditional IRA comes down to how you claim them.
When you contribute to a traditional IRA, you avoid taxes when you put your money into the account. For a Roth IRA, you avoid taxes when you take them out. IRAs handle the withdrawal and disbursement differently, as well. With the Roth, contributions can be taken out at any time, without taxes or penalties. For a traditional IRA, however, withdrawals are tax and penalty free beginning at age 59.5. There’s a full breakdown of the difference and benefits of both the traditional and Roth IRA at the Motley Fool, which is a great resource for all things financial.
Have you ever heard anchors on the news talk about the Dow or the S&P 500? Most savvy investors know that these indices are a broader measurement of the health of the stock market. Each index has a select group of companies, such as GE or Microsoft, that act as market bellwethers, or indicators. What some might not know is that you can invest in these indices just like any stock.
Over time, these indices have grown with the economy. Even if there’s a down day – or even a down year – the stock indices have remained on a long-term growth pattern. That’s not to say it will always be that way, but historically speaking, stock indices grow.
So when you invest in an index fund, you become a partial owner of the companies within the index, and your money will grow (or shrink) depending on the index’s performance. You assume the same risk as you would if you bought individual stock in a company, but since the American stock market is generally healthy, index investing could be considered as a long-term alternative to a 401(k).
Financially speaking, bonds are about the most stable investment money can buy.
According to AARP.org, buying a bond is like lending money to a borrower that promises to pay interest over the life of the bond, and repay the face value when it matures.
A bond is like a savings account that pays an interest rate set at the time of bond purchase. It’s considered safe because it’s stable, but it typically offers a lower yield than other investment options. You pay for that security by forgoing the variable risk of the stock market.
So Now What?
I’ve just grazed the surface of your retirement options, but with a little hard work and plenty of research you’ll at least have options. The part where you actually put the money aside is still up to you.
Here are a couple parting words of wisdom:
- Make your contribution as high as you can as early as possible.
- If your company doesn’t match your contribution, speak with your administrator and ask for improvements. If not, there’s nothing keeping you from making investments on your own.
- Speak with a certified financial planner for help navigating your retirement options. It’s what they do!
- Don’t cash out before you need the money. There are options to take loans against your 401(k) that won’t tax you at such a high rate.
- Don’t be afraid to get started! The more you learn, the better educated you’ll be, and the better your retirement fund will be.
- Whatever you do, do NOT put cash in a mattress! If you come into an inheritance or win the lottery, put your money to work for you. Money in the bank is accessible, but invested money makes more money for you.
Good luck! And if you have any other 401(k) suggestions or retirement options that I managed to overlook, by all means, let me hear them in the comments below.
If so, subscribe now for tips on home, money, and life delivered straight to your inbox.