Florida? California? I could even see myself living in somewhere like Idaho with some cold, open air. Also never been to Europe so that would be on the bucket list. When I retire I want to be able to have the financial security and backing to do what I want for myself and those that I care for. How do I achieve that? What are the first steps? For starters, we will go over the two most well known platforms to save for retirement - the 401k and IRA. Ready to start saving? Here we go:
Brother From Another Mother:
Both a 401k and an IRA are investment plans that specifically focus around sustainable growth over a long-term horizon, with the end goal being a healthy base of savings to be used in retirement. The difference between the two is the party that sponsors the investment plan - your company or yourself. IRA stands for Individual Retirement Account and is held and established by an individual and opened through a broker or bank. A 401k is a profit-sharing retirement plan that is often, but not always, offered as part of your employer’s benefit program. It allows an employee to divert a portion of their wages to a retirement investment fund.
Although there are some key differences, the similarities between both plans are the way in which they invest your money, the existence of their tax-differed versus traditional sister-accounts, contribution limits, and management fees.
Investment Control:
A 401k is a set investment plan with fewer options than an IRA. For example, a lot of your investment options in a 401k are pre-determined baskets of investments with names like “2060 Retirement Portfolio” or “High-Risk Retirement Portfolio”. This makes it easier for the investment firms to maintain plans across millions of companies and hundreds of millions of employees. An IRA, as an individual account, has more flexibility and specificity in what you can invest in, much closer to a personally-specific mutual fund where you can allocate different investment types - stocks, bonds, commodities, as a percentage of your retirement plan. IRAs often outline suggested amounts of each security based on your retirement date - the further out and the lower the amount desired for retirement, the less risky the investments.
Roth v Traditional:
Both the 401k and IRA have Traditional and Roth types of accounts. The important distinction between these two types of retirement account are when you are taxed on the investment contributions.
In a Roth IRA or Roth 401k, you pay taxes on how much money you contribute to the fund when you first invest. The benefit of this is that when you finally take out your money in retirement, you don’t have to pay any taxes! This way, you know exactly what your retirement amount will look like when you finally need it. This is often the better choice for people starting their retirement funds earlier on and who believe they will earn more money in the future than they are today. The reasoning for this is that if you are making $40,000 a year today, you are in a lower tax bracket than you will be in 30 years when you are making $150,000 as a senior member of a team. If you were to use the other type, a Traditional IRA or 401k, that means you would pay taxes upon completion of the fund target date, or when you remove money from the account. Overall, the basic rule of thumb is that if you are staring your 401k or IRA early, you would want to open a Roth account. If you are starting later, you would want a Traditional.
Contribution Limits:
A large difference between a 401k and IRA are the contribution limits - aka how much you can invest in your account at a given time. For an IRA the limits are much lower, and as of 2020 you can only invest $6000 per year if you are under 50 years old. For a 401k, the maximum limit is $19,500. As you can tell, the 401k is a much more effective retirement instrument if you have more money to contribute. If unfortunately your company does not offer a 401k plan, it is best to start with an IRA as early as you can, and then when you transfer to a company that has a 401k plan, place as much money as possible within your budget towards the 401k. A lot of companies even allow for a ‘employer match’ whereby an employer will match a percentage of your contributions to the 401k! For example, say you contribute $1,500 a year to your 401k, then your employer will also put $1,500 to your account. This is a great way to increase the amount of compensation you actually receive from your company and should be taken advantage of when possible.
Management Fees and Penalties:
Both 401ks and IRAs have management fees where the broker, bank, or institution make their profit from managing your money. Any management fee or continuing activation fee which is greater than 1% of your overall contributions is considered excessive and your should consult several parties to find the best rate. Another aspect of retirement accounts to keep in mind are early withdrawal fees. Seeing as these investment plans are made for retirement, there are penalties for breaking that covenant. If you are to withdraw money from an IRA before the age of 59 and a half, you are subject to a 10% additional fee on top of any taxes due depending on whether it is a ROTH or Traditional account. There are some exceptions to this penalty, for example if the money is used to replace a lost job or medicinal bills, but in general it is unwise to take early distributions form your retirement accounts.
Early Bird Gets the House in Florida:
Many crusty old people warn you to create your retirement accounts as soon as possible. This time around, the crusties are correct and this concept is all build around the idea of compound interest - or “interest on interest”. A common example of this for retirement is the three investor scenario:
Investor A - Puts in $300/month at age 25
Investor B - Puts in $300/month at age 35
Investor C - Puts in $600/month at age 40
At age 65, which would have the most if they have the same 5% interest rate? If your familiar with typical gotcha questions, the answer is Investor A at just under $500,000. Investor B would end up with around $250,000 and Investor C with around $350,000. Since there is compounded interest each year, the factor that contributes most to overall savings is time! The above example is not the maximum contribution that one can make either, and if done appropriately, you can be a millionaire just from your 401k and IRA savings.
In summary, start with an IRA until you are able to take advantage of a 401k. If you are younger, it is probably more beneficial to open a ROTH account over Traditional as you will likely make more more and pay more taxes when you are older than you do today. If you have any questions on how to open a 401k or IRA, feel free to send us a note, or consult your financial advisor or employer!