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The World’s Easiest Guide To Understanding Retirement Accounts

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I want to be clear about something: I’m sincerely interested in doing less and less work as I go through my life. That’s why I’m always puzzled when I meet people on a career path that will have them working more, not less. That’s like being a real-life Mario Brother, where every progressive level you beat means your life gets harder. Why would you do it?

This is why retirement accounts are one of the best investment tools I’ll write about on this site. I’ll go into the details in a minute, but first let’s dispense with some of the reasons that most of us haven’t done anything about our retirement accounts yet:

  • “Retirement is too far away”
  • “I don’t have any extra money to save right now”
  • “I don’t have time right now
  • ” ” (haven’t thought about it at all)

I’m not going to preach, but I am going to call your ass out: All of those reasons are dumb. Retirement accounts let you do less work. All you have to do is start now, which I’ll show you how to do today. Now that we’ve acknowledged all these reasons, just read this entire post. At the end, if you’re not convinced…don’t do anything! Congratulations. But if you want to use one of the best ways to get rich, you’ll know what to do.

The magical benefits of retirement accounts
Many people think mistakenly think that retirement accounts are just places for you to save money until you’re 65. Actually, they offer you humongous benefits if you agree to save for a long-term horizon. Let’s compare regular (taxable) investing accounts with retirement accounts.

Regular investing accounts. When you open up an account at ETrade or whatever, you’re generally opening up a regular investing account, which is also called a taxable account. This means that when you sell your stocks, you’ll pay taxes on your gains–and if you sell your stocks in less than a year, you’ll pay a huge amount (regular income-tax rates, like 15% or 30%).

Let’s not get bogged down in the details, okay. As I’ve written on this site, buy-and-hold investing wins over the long term. And because of the way taxes are structured, you pay a penalty for trading too frequently. See how the pieces fit together? It’s paternalism at its best. But there’s an even stronger advantage to holding your money for longer–say, until retirement.

Retirement accounts. Retirement accounts, quite simply, give you huge tax/growth advantages in exchange for your promise to save and invest for the long term. Now, this doesn’t mean that you have to hold the same stock for 30 years. You can buy and sell shares of almost anything as often as you want. But with a few exceptions, you have to leave the money in your account until you get near retirement age.

Here’s how the magical benefits work. In a retirement account, you get big tax benefits. While 10% or 20% may not seem like much in 1 year, when you compound that over 30 years, it becomes a gigantic amount. In fact, start a retirement account next week and two things will happen: (1) You will be more financially prepared than 99% of your peers, and (2) you will be rich. Yeah, I said it: If you start a retirement account in your early 20s and fund it regularly, you will be rich.

Let’s look at a simple comparison of investing in a retirement account vs. just investing in a regular, taxable account:

Leggmason_ira_roth_growth.gif
Image from Leggmason.com

 

Don’t worry about the exact amounts. Just notice the difference in how much you earn–especially at the end. A retirement account–whether it’s a Roth IRA, 401(k), or something else–lets your money grow at an accelerated rate with hardly any extra work from your end. Now let’s get into the details.

Your 401(k)
A 401(k) is a type of retirement account. If you work for a company, chances are you already have a 401(k) offered to you.

Here’s how a 401(k) works: You put pre-tax money into the account, meaning you haven’t paid taxes on it yet.

Let’s look at why that’s important. In regular, taxable investing accounts, you pay taxes on your income and then invest it. So for every $100 you make, you might actually only be able to invest $85 of it. 15% (or whatever, depending on your tax rate) goes to the tax man.

A 401(k) is different. You can invest the entire $100 and let it grow for about 30 years. That extra ~15% turns out to make a huge difference as it gets compounded more and more.

401(k) matches
There’s an extra benefit, too: Your company might offer a 401(k) match. For example, a 1:1 match up to $2,000 means that your company will match every dollar you invest up to $2,000; therefore, investing $2,000/year really means you’re investing $4,000/year. Woah. This is free money and you absolutely, positively need to participate if your employer offers a 401(k) match. It doesn’t matter what kind of debt or expenses or whatever you have–if your company offers a match, do it.

So what exactly happens when you contribute money to your 401(k)? Basically, it goes into an investing account where a professional investing company manages it. You can choose from a bunch of different investing options, like aggressive, mixed, international, etc. Honestly, it’s like McDonald’s for investors: anyone can do it. The hardest part is making the first phone call to HR to get it set up.

Summary of 401(k) advantages: There are a lot
We’ve covered the advantages of a 401(k) account: You get to put pre-tax money to work (i.e., money you haven’t paid taxes on yet, so there’s more of it to grow). Your company might offer an insanely lucrative 401(k) match, which you must take. And it’s not that hard to set up–your company does most of the work. In fact, you can instruct them to automatically withdraw a certain amount from every paycheck. Don’t worry about switching jobs; if you leave your company later, you can take your 401(k) with you. And be aggressive with how much you contribute to your 401(k) because every dollar you invest now is worth many more times that in the future.

firsthandfunds ira_comparison.jpg
Image from firsthandfunds.com

 

401(k) restrictions
The 401(k) isn’t tax-free, though. There are a few restrictions. First, the government has to get its tax revenue sometime, so you’ll pay ordinary income tax on the money you withdraw around retirement age. (Remember, though, that all that money has been growing “tax-deferred” for ~30 years.) Second, you’re currently (in 2008) limited to putting $15,500/year in your 401(k). Third, and this is important, you’ll be charged a big penalty of 10% if you withdraw your money before you’re 59.5 years old. This is intentional: This money is for your retirement, not to go out drinking on Saturday. Finally, there are some other esoteric restrictions, but you can read about them from some links I’ll give you later.

You can get around the restrictions!
Not to get too complicated, but there are also exceptions to some of the above restrictions that let you withdraw your 401(k) money penalty-free. For example, if you’re buying a house or a couple of other things, you can withdraw money penalty-free. But for all intents and purposes, this is money you’re putting away for 30 years.

401(k) summary
$15,000 annual limit
Pre-tax money (money isn’t taxed at the beginning; it grows until you withdraw and is taxed at the end)
Company matches supercharge growth even more–this is free money you must take

Let’s talk about dumb people and 401(k)s in general
A lot of people are dumb. Let’s just have a look at some recent findings:

  • “One out of four workers simply fails to sign up.
  • Only one in 10 contributes the maximum allowed.
  • Nearly half don’t contribute enough to get the full company match.
  • Many take too much or too little risk, and most fail to rebalance their accounts to manage their risk.
  • About half cash out when they change jobs. (Admittedly, this is a squishy statistic. Hewitt Associates research says it’s 42%; Munnell’s research says 55%.)”

Your company wants you to invest in your 401(k)! Yet many people still don’t invest, or they invest poorly, or they invest too late in life. Sorry, but we all need to take responsibility for this stupidity.

But they’re not the only ones to blame. Your employers and the 401(k) companies make it insanely hard to understand what the hell a 401(k) is, or how to get started. Have you ever read one of their prospectuses? I have, and even though I do this stuff every day, I wanted to jump off a bridge while perusing the latest 401(k) literature so maybe I could try to cram in some more time of reading that incomprehensible garbage. You need all the help you can get with this stuff.

But there’s even more blame to go around. The stupid personal-finance media and pundits have overhyped everything money-related. Unfortunately, now we just tune it out–even when it’s good for us. When was the last time you heard something about retirement accounts? Probably pretty recently, but you tuned it out because most of what’s marketed to us is trash. Finally, the government is a dismal failure at properly educating us on personal finance and retirement issues–even though it’s in the government’s interest.

Opening your 401(k)
I have to tell you that blaming everyone has a very satisfying quality to it. I really enjoyed that. But realize one thing: Of all the parties I mentioned and want to scream at, the only one you can change is you. Call up your HR representative on Monday and get enrolled in your 401(k). Start an automatic-payment plan so money is taken directly from your paycheck. Trust me, you’ll learn to live without it. And if you have questions, leave a comment on this post.

401(k) links

Your Roth IRA
A Roth IRA is another type of retirement account. Every person in their 20s should have a Roth IRA. It’s simply the best deal I’ve found for long-term investing.

Remember how your 401(k) uses pre-tax dollars and you pay income tax when you take the money out at retirement? Well, a Roth IRA is different than a 401(k). A Roth uses after-tax dollars to give you an even better deal. With a Roth, you put in already taxed income into stocks, bonds, index funds–whatever–and you don’t pay when you withdraw it.

Here’s how it works: When you make money every year, you have to pay taxes on it. With a Roth, you take this after-tax money, invest it, and pay no taxes when you withdraw it. If Roth IRAs had been around in 1970 and you’d invested $10,000 in Southwest Airlines, you’d only have had to pay taxes on the initial $10,000 income. When you withdrew the money 30 years later, you wouldn’t have had to pay any taxes on it. Oh, and by the way, your $10,000 would have turned into $10 million.

Think about it.

You pay taxes on the initial amount, but not the earnings. And over 30 years, that is a stunningly good deal.

Roth IRA restrictions
Again, you’re expected to treat this as a long-term investment vehicle. You are penalized if you withdraw your earnings before you’re 59.5 years old. (Exception: You can withdraw your principal, or the amount you actually invested from your pocket, at any time, penalty-free. Most people don’t know this.) There are also exceptions for down payments on a home, funding education for you/partner/children/grandchildren, and some other emergency reasons. And there’s a maximum income of $95,000 to make full contributions to a Roth. But you can read about those later.

What’s the big takeaway from all those restrictions and exceptions? I see 2 things:

  • First, you can only get some of those exceptions if your Roth IRA has been open for 5 years. This reason alone is enough for you to open your Roth IRA on Monday. I want you to research it this weekend, and I want your Roth IRA opened by next week.
  • Second, starting early is crucial. I’m not going to belabor the point, but every dollar you invest now is worth much, much more later. Even waiting two years can cost you tens of thousands of dollars. Currently, the maximum you’re allowed to invest in your Roth IRA is $4,000/year $5,000 a year (updated in 2008). I don’t care where you get the money, but get it. Put it in your Roth and max it out this year. These early years are too important to be lazy.

Opening your Roth IRA
It’s easy. You can go through your current discount brokerage, like ETrade or Datek. You can also go through an independent service like Vanguard. Call them up, tell them you want to open a Roth IRA, and they’ll walk you through it. By the way, if you’re afraid of using the phone, you’re lame.

Special note: These places have minimum amounts for opening a Roth IRA, usually $3,000. Sometimes they’ll waive the minimums if you set up an automatic payment plan depositing, say, $100/month. Other times, you’re out of luck. Shop around.

Once your account is set up, your money will just be sitting there. You need to do things then: First, set up an automatic payment plan so you’re automatically depositing money into your Roth. How much? Try doing as much as you’re comfortable with, plus 10%. Second, decide where to invest your Roth money; it can be in stocks, index funds, mutual funds, whatever. Read my introductory articles for more on how to choose. I also created a video about how to choose a Roth IRA.

Here’s a quick illustration of the power of continually adding money to your investment account:

hffo.cuna.org666_chart.jpg
Image from hffo.cuna.org
Roth IRA links

401(k) or Roth IRA?
The simple answer is both: These accounts, while conceptually different, work together pretty well.

Here’s how I think about it. First, I would max out any 401(k) match that my company provides. Second, I’d max out the $4,000 $5,000 for my Roth IRA. Third, I’d max out the rest of my 401(k), up to $15,000. Finally–if your employer doesn’t offer a 401(k), you’re not employed yet, or you still have money left over–I’d open a regular, taxable investment account and put money there in stocks, index funds, etc.

Why max out your Roth before your 401(k)? Well, there’s a lot of dorky debate in the personal-finance world, but the basic reasons are taxes and tax policy: Assuming your career goes well, you’ll be in a higher tax bracket when you retire, meaning that you’d have to pay more taxes with a 401(k). Another common reason for the Roth is that tax rates are considered likely to increase. Remember: Your 401(k) money is taxed at the end, while Roth money is taxed right away and then grows tax-free.

What to do today
It’s Friday today. I want you to spend the weekend getting educated about 401(k)s and Roth IRAs. On Monday, I want you to open up your retirement accounts and start funding them. Call your HR department and get your 401(k) squared away. Call a few discount-brokerage firms to get a Roth account, too. Don’t worry about where to invest your money just yet. Take it one step at a time and just open your accounts.

Oh yeah, and one more thing: I already anticipate 1 billion comments debating fiscal policy, the effectiveness of Roth IRAs vs. 401(k) vs. Keogh plans vs. SEP IRAs vs. Simple IRAs, and other crap. Please don’t waste your time on this minutiae. The problem is not debating the tiny details. The problem is that most people don’t have retirement accounts. The problem is that most people don’t fund it as regularly as they should, even though $100/month makes a big difference. And the problem is that most people don’t open retirement accounts early enough.

So let the fools debate. For you, just get your accounts open.

Rich doesn’t happen by accident
Lots of people believe that they’ll just get rich somehow. In fact, “more than one in five Americans believe the best way to get rich is to win the lottery.

That’s not a joke.

You need to think ahead. And I don’t just mean to retirement. Are you going to need a car in a few years? A wedding? A honeymoon? A house? The money for that doesn’t just appear. Unfortunately, most people put off thinking about this stuff, which results in them wringing their hands, saying things like “We’re always struggling to make ends meet.” Some of them (not all, but some) got there because they didn’t plan for anything. So get over the initial excuses. Yes, it’s hard to pick up the phone. But think about what time you’re living in. Here you have a site with thousands of other readers who are in exactly the same boat as you–and even better, the experienced ones will help you through it.

Set up your retirement accounts now. Your future self will thank you.

 

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83 Comments

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  1. Ramit,

    My employer has a 401k plan but offers no match instead encouraging employees to participate in an employee stock purchase program. Additionally, the investment options available in the 401k are all mutual funds with relatively high management fees. As of right now, I’ve opted out of the 401k because, even giving up the pre-tax benefits of the 401k, I think I can do better on my own. I’m certainly contributing to my Roth but I’m also planning to buy into some index funds (perhaps Vanguard) and I’m considering the stock purchase plan on the more aggressive/risky end of my portfolio.

    I’m curious what you have to say about 401k’s like my employers(no match, backed by mutual funds exclusively). I have to admit that I’ve not run the numbers and I’m going with my gut that I can do better than a non-employer matched 401k.

    Thanks.

  2. Good article. I agree with you on the importance of starting and funding a retirement account early, and I am currently contributing $75 per month to my roth IRA. What I want to know is, how do you expect people to come up with $4,000 a year? I have to start paying for college this year and I will end up borrowing a lot of money to do it. Borrowing more money so that I can invest the maximum in my roth IRA just doesn’t make sense for me. My parents are not college-educated, do not own a home, and do not have company health insurance. They are very careful with their finances. They document everything, and they or I cannot find anywhere where they could save money, and every month they spend more than they make. How do you expect people like my parents, or college students paying their own way, to contribute the maximum to a retirement account?

  3. Hey Ramit,

    I work as a Software Developer doing contracting. They offer a 401k plan, but have no match. So what I did yesterday was open up a Roth IRA with 1000 (after tax dollars) and will fund it with 500$ contributions per month until the end of the year. And then scale back to make 330$ (4000 / yr) contributions in 2007.

    The question I have is… with the Roth being my focus for now, how should I go about with my 401k? They do not offer a match (because I am sub contracting). Is it still worth putting my money in a 401k without a match?

    I am soon to be 25. Any tips or help is appreciated.

  4. When you leave a company, roll the 401K immediately over to a traditional IRA fund somewhere that earns decent returns. After than, be careful about rolling all that into a Roth at once, as that can easily put you into a higher tax bracket so you pay higher taxes on your own retirement investments.

  5. Being 19 years old right now, I consider starting up a Roth early this year one of the smartest things I’ve done. :)

    Nice post.

  6. So if you make more than $110,000 a year, you can’t open and contribute to a Roth IRA?

    That doesn’t seem right to me.

    I sure as heck hope that I will be making that much. But if I do, I basically can’t take advantage of a Roth.

  7. One thing that is not mentioned in the article is that a married couple can only contribute to a ROTH if their combined income is less that 150K. This number is easily exceeded if both a husband and wife have been in IT for a while.

  8. This is pretty standard advice, and I think for your 20something readership good advice.

    However, Robert Kiyosaki says that 401Ks are a waste of time, and that one should buy real estate (because you can earn an income from it) as opposed to a 401K, which you can’t earn an income from without withdrawing.

    Care to reply?

  9. After reading your article and the comments, I feel lucky to be at the company I’m at now.

    I’m a late bloomer, graduated in December at 31. Worked PT at this company while I was finishing my undergrad and I went FT in March. As soon as I was eligible, when I was still PT I began socking away money in the 401(k). Even when it was really a stretch financially.

    I work for a financial company…annuities, mutual funds, retirement plans etc.

    They encourage everyone to get into the 401(k) and even make you set up an account just in case we have profit sharing. (Which we did last year.)

    We even have the benefit of advice from a financial planner paid for by the company.

    When I got a raise in March, I slid that money into my 401(k) rather than getting used to having a few extra dollars.

    One thing I would say about the article as far as 401(k)s are concerned, most companies (mine for sure) require the employee to be there for X number of years before we can roll our money over if we leave.

  10. Nathan: I’ve written a little bit about employee stock purchase plans here. They can be a good deal, but you need to run the numbers.

    James: $75/month is a great start, and that’s more than most people do, so don’t feel too bad. If you can’t contribute the full $4k/year, that’s ok. There are basically 2 ways to contribute more: cut costs or make more money. Check out my section on personal entrepreneurship for some ideas.

    Eric: There are still tax advantages to having your money in a 401(k), even if there’s not a match–but there are tradeoffs like having your money illiquid. Read the links in the article to get a better idea of exactly how 401(k)s work, with or without a match.

    Jon: I don’t think much of that advice. I’ve written about Robert Kiyosaki here, and a little bit about real estate here. Real estate may be a good investment–may (read that last link)–but it’s certainly not the first place to get started.

    JB: Good point, thanks. There is often a vesting period on 401(k)s that I’ll cover in an upcoming article.

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