(The follow-up post will be about how to apply this knowledge: the pros and cons of using different types of retirement accounts; suggestions about the investments that go into your retirement accounts, including Socially Responsible Investing/SRI options; and some guidelines for thinking about how much to save.)
Why start saving for retirement now?Well, aside from the fact that it's generally wise to start saving early for a big goal rather than have to play catch-up later, there are two big reasons that it's especially smart to save for retirement today:
- Compounding returns: It's basic math, but the results of investing early are more dramatic than you'd guess. Compounding returns are the benefit you get from re-investing the returns you get each year. For example, if you invest $1000 and earn 9% a year on it, you'll have $1090 after one year, $1188 after two years ($1090 x 109%), $1295 after three years, etc. Not impressed yet? Think about exponential growth-- it takes 8 years for your money to double at an 9% yearly return. So if you have $20,000 invested at age 25 growing at 8%, it will double five times by the time you turn 65, and become $640,000. If you don't have the $20,000 invested until you're 33 so it only has time to double four times by age 65, you only have half as much-- $320,000. Make sense now? This is such a big deal that (with those 9% annual returns) you actually end up much better off saving $4,000 a year for ten years from age 25 to 35 and stopping than saving $4,000 a year for thirty years from age 35 to 65-- by a margin of $806,303 to $545,230.
- Employer contributions: If you have any kind of retirement option at work that involves employer contributions, like many 401(k)s or 403(b)s do, it's probably a very good deal. I'll talk more about the details in a minute, but the important thing to remember is that your employer is offering you extra money in exchange for you saving some of your own money.
How does retirement savings work? What kinds of retirement accounts are there?
The main difference between regular savings and retirement savings is that retirement savings accounts are tax-advantaged. With regular savings or investing, you put your after-tax money into a savings/investment account and then pay taxes on the earnings (in most cases.) But with retirement savings, you save on some of the taxes. There are two basic types of tax savings, and that's one way to divide retirement accounts into two categories:
- In a traditional IRA or 401(k) [more on IRA vs 401(k) in a minute], you use before-tax money. In other words, if you put $1000 into the account, your taxable income is lowered by $1000, which means you pay less in taxes (for example, $250 less if you're in the 25% tax bracket, which would mean that you add $1000 in the account but only have $750 less in your pocket than you otherwise would.) It's like getting a discount on saving $X amount for retirement. However, once you retire, you do have to pay taxes on what you withdraw.
- In a Roth IRA or Roth 401(k), you use after tax money-- putting $1000 into retirement savings means you have $1000 less in your pocket than you otherwise would. But then you never have to pay taxes on the earnings. If that $1000 turns into $32000, you can take all that money out after you retire without paying taxes on any of it.
- Work-related: 401(k)/Roth 401(k), 403(b), etc. These are taken out of your paycheck at work, and are set as a percentage of your income. [You may also/instead have a pension-- a "defined benefit" retirement plan-- at work, especially if you have a unionized job and/or work in the public sector, but that's a topic for another post. We're talking about "defined contribution" retirement plans here.]
- 401(k) vs 403(b)? They're basically the same except that the 403(b) is for employees of non-profits. There's also the Thrift Savings Plan for federal employees which is very similar.
- 401(k) vs Roth 401(k)? Just plain "401(k)" or "403(b)" means it's a traditional account that uses pre-tax money (see above); Roth 401(k)s and 403(b)s are new as of 2006, and use after-tax money. (In other words, if you get $1000 a paycheck and put 6% into a regular 401(k) you get taxed on $940 a paycheck; if you put 6% into a Roth 401(k) you get taxed on $1000 a paycheck.) As described above, the benefit for the Roth 401(k) is that you won't be taxed on the earnings later.
- Employer match or no match? Many but not all employers offer a match to your 401(k)/403(b) savings. If so, they will probably match some percent of your contributions-- perhaps 25% or 100%-- up to a certain limit-- perhaps 4% or 6% of your paycheck. (For example, if they match 50% of your contributions up to 6% of your paycheck, and your paycheck is $1000, then if you put aside 2%/$20 they'll add $10, if you put aside 6%/$60 they'll add $30, and if you put aside 10%/$100 they'll still put in no more than $30.)
- Vesting rules? You should keep an eye out for vesting rules which might say that you have to stay at your employer for a certain length of time in order to keep the employer's contributions when you leave. (You always get to keep your own contributions!) Sometimes there is partial vesting-- you may get to keep 20% of the employer match after 1 year, 40% after 2 years, etc.
- Rollovers? When you leave your employer, there are a couple choices of what to do with your money. You can leave it in its original 401(k) plan, if your employer allows it (they have to let you to keep it there if you have more than $5,000 in it, but if you have less, they can make you move it.) If you have to or want to move it, there are a few options: take the money in cash (generally a bad idea, since not only does it decrease your retirement savings but you also have to pay a 10% penalty on top of the taxes), roll the money over to a 401(k) account at your new employer, or roll the money over to an IRA. What's an IRA? Read on...
- Non-work-related: IRA/Roth IRA. IRAs and Roth IRAs are non-work-related; IRA stands for "Individual Retirement Arrangement."
- How and where? There are several places you can open an IRA, including banks, mutual fund companies, and brokerages. Your choice will limit what investment goes in the account, so it generally makes more sense to first pick the investment you want and then open an IRA with whoever offers that investment. This means you may end up with multiple IRAs to hold different investments, which is perfectly allowable, although there are some drawbacks like the hassle and possibly higher administrative fees. (More on how to decide on investments coming soon in the follow-up post!)
- Contribution limits? You can put in up to $5000 a year combined across all your IRA/Roth IRA accounts in 2008 ($6000 if you're over 50 years old); this will go up in future years to adjust for inflation. However, if you earned less than $5000, you can only put in as much as you earned (there's an exception if you're married where you can contribute based on your spouse's earnings.)
- Income requirements (as of 2008)?
- Traditional IRAs (if you have a work-based retirement option available): If you're single, it starts to phase out at $53,000 AGI and you're totally ineligible to contribute tax-free once you hit $63,000. If you're married filing jointly, it phases out between $85,000 and $105,000.
- Traditional IRAs (if you don't have a work-based retirement option available): No income limit, unless you're married filing jointly and your spouse has a work-based retirement option while you don't, in which case it starts phasing out at $159,000 and you're totally ineligible at $169,000.
- Roth IRAs: Starts to phase out at $101,000 AGI for single tax filers/$159,000 for married filing jointly; you're totally ineligible at $116,000 for single filers/$169,000 for married filing jointly.
Now what?In part two: so how do you apply this knowledge? We'll talk about the pros and cons of using these different types of accounts, ideas about how to pick investments within your account (including some of my favorite socially responsible options), and some thoughts about how much to save.
Any questions about what we've covered so far? Any additional information-- or clearer ways to explain things!-- that you want to include in the comments?
Disclaimer: I am not a financial professional. While I consider myself well-informed and try my hardest to be accurate, it's possible that something in here could be wrong. Please try to verify things yourself before making important financial decisions!