The world’s easiest guide to understanding retirement
How does retirement work? For most people, it’s like this: you reach a certain age and start thinking about spending your days on the golf course. Then you look at your bank statement and freak out, and think about taking on a second job instead.
I want to be clear about something: I’m sincerely interested in doing less and less work as I go through my life.
This is why retirement accounts – your 401(k) and your Roth IRA – are one of the best investment tools I’ll write about on this site.
Retirement accounts let you do less work. All you have to do is start a retirement account NOW, which I’ll show you exactly how to do.
Here’s what we’re going to cover in this beginner’s guide to retirement accounts:
- How do retirement accounts work: the magical benefits
- Understanding your 401(k) – A beginner’s guide
- Understanding your Roth IRA – A beginner’s guide
- 401(k) or Roth IRA: Which retirement account should you start?
- What to do about your retirement accounts today
How do retirement accounts work: the magical benefits
Many people 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 how retirement accounts work.
Regular investing accounts vs. 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, OK? 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 retirement accounts work, and where the magical benefits kick in. 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:
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.
Understanding your 401(k) – A beginner’s guide
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 until retirement. That extra ~15% turns out to make a huge difference as it gets compounded more and more.
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.
Image from firsthandfunds.com
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 limited to putting $19,000/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 401(k) 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.
- $19,000 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
Ready to take control of your finances (without tedious budgeting?) Get the first chapter of Ramit Sethi's NYT Bestselling Book below.
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.
Understanding your Roth IRA – A beginner’s guide
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 $137,000 to make full contributions to a Roth (updated in 2019). 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 labor 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 6,000 a year (updated in 2019). 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.
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:
Image from hffo.cuna.org
Roth IRA links
401(k) or Roth IRA: Which retirement account should you start?
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 $6,000 for my Roth IRA. Third, I’d max out the rest of my 401(k), up to $19,000. 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 about your retirement accounts 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.
You're right about the employer stock purchase; it's risky. If your employer has problems, you may find the stocks worthless at the same time you are laid-off. After maxing out IRA, the only two options are the 401k or a taxable account. Usually, even in a bad 401k plan there will be an index fund with fairly low costs (not Vanguard's 5 basis points, but something less than 100). You really only need one such fund. The tax deferral is apt to be worth more than the fees (depending on your tax bracket and time to termination). At termination you can roll it over to an IRA, for more options and lower costs. Money is nothing but numbers. Run the numbers. Use a computer spreadsheet; it's easy to learn, easy to do.
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 $4,000 a year? I have to start paying for college this year and I will end up borrowing a lot of money to do it. Borrowing more money so that I can invest the maximum in my roth IRA just doesn't make sense for me. My parents are not college-educated, do not own a home, and do not have company health insurance. They are very careful with their finances. They document everything, and they or I cannot find anywhere where they could save money, and every month they spend more than they make. How do you expect people like my parents, or college students paying their own way, to contribute the maximum to a retirement account?
You're in college; that's your investment now. Make sure you study something that pays well. After you land the job you start building wealth. You buy a used car that you can pay cash for instead of a new one you can't afford. You buy a two family house and rent it out the other unit. You drink at home. You visit Salvation Army and Goodwill regularly. You vacation at home and use the time to improve that house you bought. You send the kids to public schools and tell them they need to fund their own college, as you did. Don't worry about your parents; they made their choices; now it's your turn. Your parents taught you how to be poor. Decide to be rich and do whatever it takes.
Hey Ramit, I work as a Software Developer doing contracting. They offer a 401k plan, but have no match. So what I did yesterday was open up a Roth IRA with 1000 (after tax dollars) and will fund it with 500$ 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.
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.
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.
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.
Nathan: I've written a little bit about employee stock purchase plans before. 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 starting a business 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. Real estate may be a good investment--may --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.
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.
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?
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.
Great article. I've got a couple of questions: 1) Does the $15,000 include money matched by your company? For example, if my company matches 1:1 up to $2000 and I contribute the maximum amount in a year, does this mean the total amount invested is $17,000? 2) What is the incentive for companies to match 401(k)s?
Excellent insights, Ramit. After you start setting aside that retirement money every month, you'll barely notice it's missing. To everyone who thinks they can't afford to part with that money...just keep in mind that there is a guy somewhere that is earning $100/month less than you, and probably supporting a wife and 3 kids on it. Incidentally, there is an ironic typo in the 2nd paragraph under the 'Your 401(k)' heading. "Pre-Ax" may actually be a pretty appropriate word to use. Looking at the taxes I pay every 2 weeks, I definitely feel like I'm being taken out to the woodshed!
Thanks, Jon. It's fixed now.
Great information! Thanks! (dugg, added to furl & delicious)
Hi Ramit -- great article. Right now I'm putting all of my retirement savings into a 401(k) that has no company match, and sadly no index funds. The Roth IRA sounds like a great place for me to redirect some of my monthly retirement savings, but I have a question about the mechanics of investing with a Roth IRA:
It looks like TD Ameritrade, for instance, has a $49.99 commission for mutual fund trades. So each month that I put $333 into the Roth IRA, I assume that means I need to pay an extra $50 fee.
Given that, does it makes sense to make larger, less frequent contributions (like a couple times a year) instead of smaller monthly contributions?
Just use Vanguard for IRA and taxable accounts. Buy their index funds. Super cheap.
Thanks, Adam. Matthew, call to ask about an automatic investing plan. If you agree to automatically contribute $X/month, many places will waive the fees.
TD Ameritrade does have "no transaction fee" funds, so that is one way to get around the $50 commission. Additionally you could let the money pile up for a year, which would been $50 a year in commissions instead of $600. There's other ideas, but those two work well if you plan to stay with TD Ameritrade.
Don't forget about the new Roth 401k-- http://www.roth401k.com/
Great stuff here... I knew a lot of this but I'm guessing 75% of the population knows absolutely nothing about it. One question... I've got a regular taxable discount brokerage account that also offers a Roth IRA account. I'm invested in stocks and a mutual fund, with the purpose that the well picked stocks would rise and I would eventually sell for a down payment on a house, keeping the mutual fund. Is it possible to roll over/move my mutual fund from the regular taxable to the Roth? I know I can ask my brokerage, but I just thought I'd ask first.
I am 52 and have a simple IRA with only 37,000. Can I roll over to Roth IRA?
If you have a 401k and work for Cisco, Microsoft or Oracle, or you have a Roth IRA, I recommend you check out pariveda.com. They give investment advice, which has been doing incredible this far. It's free and they disclose everything.
I have a ROTH and 401(k). My question is, does anyone know where you can pay for your ROTH trading fees (i.e. commisions) using money that doesn't come from your ROTH
Greetings. Here in Portugal, there is no 401(k) plans but one can open a PPR account (“Plano Poupança Reforma” which means “Retirement Savings Account” in English). In this one I put 50€/month (2% interest rate). I also opened an “Investment Funds” account which is a bit less restrictive in terms of cash movements. In this one I deposit 50€/month (interest rate variable: 2 to 4%). I have to admit that the financial area is not really my strongest area of expertise but, like everyone here, I’m worried about the Future in the long term. That’s why I decided to start investing now and why I make the effort of contributing with 12% of my monthly income. My advice for everyone is START SAVING SAVE NOW.
A retirement account with 2% interest rate? Wouldnt just leaving your money in a HSBC or ING savings account be better?
Hi, Ramit. I'm very much interested in starting my retirement savings. I'm 22 right now, so it would definitely be a good time. One problem though, I currently have a balance outstanding on an educational line of credit, from my university costs - I pay interest on it of prime + 2%. The question is, is it still worth to open 401(k) or Roth, before paying that off? Thanks in advance for your help, Camellia.
Good post! I live in Canada, and am a pretty novice investor (but at least I've started). Anyone know if Roth IRAs offer the same benefits to Canadians?
I started it!
Ramit, Previously for mutual funds you statied that 85% of mutual funds fail to beat the market and that putting money in a mutual fund was stupid for us to do. A 401k is typically made up with a wide variety of mutual funds for diversification. Following your previous advice on mutual funds, then it would seem that one should only invest in the index fund in a 401k. Is that what you're advocating?
My employer is now offering both a traditional 401(k) and a Roth 401(k) and I can open both, essentially having two separate accounts, and still get the employer match. The combined max contribution I can make is still $15000. Do you think it is wise to open both the traditional and Roth 401(k)'s instead of just having a traditional 401(k) and opening a Roth IRA elsewhere?
I would consider myself ahead of the retirement account game, but in terms of knowledge and funds put away. My employer has a FANTASTIC match - I put in 4.5% and they put in 8.5% for a total of 13% - to my 403(b) with Fidelity. I also have a Sharebuilder.com RothIRA that has no minimum to start and low transaction fees. My 403(b) wtih Fidelity only offers funds to invest in; no stocks - speaking to comment #1 by Nathan. But what I've discovered is that there are some excellent funds out there that are making serious money. One I've invested in, which invests in energy/oil companies, is up over 20% YTD! At first I was surprised that my Fidelity account didn't offer stocks, but now I'm not bothered at all. Another great feature of my 403(b) at Fidelity is that they have funds already created with pre-mixed asset allocation strategies. They have 4 levels to choose from, from aggressive to safe. The funds already balance, and rebalance, the appropriate mix of domestic and int'l stocks, bonds, and short terms. And better yet, these funds have target retirement periods (i.e. the year 2025 or 2030), so as the time gets closer, the fund is rebalanced in to less riskier allocations for wealth preservation, since you are so close to the point of beginning the withdrawls. So, to reiterate, I liked the article, but there was nothing new for me in it. However, I will spend time reading other information in the site, as I am sure there is new material here for me to absorb. As for anyone who isn't investing for the future, it's never too late, but it's never too soon either.
Ramit, American Renaissance (your lottery link) looks kind of sketchy...
James: Personally, I would borrow more money to invest it in a Roth IRA. Over the long term you can probably get 9% to 11% in the Roth. Student loan interest rates are much lower than that. This is called interest rate arbitrage and it is one way in which banks make money, but there is no reason for you not to do it. Then consider that you'll get tax benefits both coming and going - the Roth will be tax free down the road, and you may be able to use the student loan interest as a tax deduction.
Agreed with #32. Borrow money now so that you can put into your Roth. Your tax rate now is probably pretty low and the interest rate on borrowing is lower than what you'll get out of your investment. My g/f's parents made her put 3000 of her earnings from her summer jobs since high school. That will probably pay off significantly more than if she had blown it on the summer. I wish my parents had known about Roths back then. I would do the same thing with my kids. Set up a matching system where for every dollar they earn, I match it into their Roth account and still let them keep the money they earn. Technically this would be considered gift (tax-wise).
Suppose your 401(k) earns 1 million when you want to withdraw it (you are over 59.5). You only need to pay tax. However you probably need to pay more than 30%, even 40%, in taxes. My question is whether it's still worth putting money in 401(k) knowing that you will be likely in a super HIGH tax bracket by the time you retire. Suppose you don't have 401(k). You pay tax on your income but you are in much lower tax bracket than you would in the first scenario...See what I am getting at? Great post!
I just started one today!
What would your advice be for a 52 year old retiring from a state public employees retirement system that allows you to take a lump sum payment, but reduces your monthly payments? Some people are saying to take the big lump sum and invest it and be further ahead?
There are some previous questions about how to max out your 401k when you are just getting started. My first year, I contributed enough to get my company match. After that, I took all or a portion of my yearly raises and added that to my 401k. A 2-4% annual raise came out to $50-$100 a month. After taxes, that raise made little impact on my overall debt (including college loans). Instead, I added the full $50-$100 a month into my 401k and over the year, and I could actually see an increase in my 401k. It took a few years, but it was a relatively painless way to reach the 401k maximum.
The company I work for has just started offering a Roth 401(k), and I've learned that contributions to it get the employer match. So I could maximize the match, regardless of if I'm paying tax on my contribution now, or later (the match would always be pre-tax money). Given what you said under "401(k) or Roth IRA?", if I get the match either way, would the rule of thumb be: Maximize the Roth 401(k) first?
Are these Roth IRA and 401(k) for US citizens only?
The yearly 401(k) *employee* contribution limit is $15,000. Employer match is not included in this. In fact, the maximum total contribution is $44,000! That's one serious employer match! You can also open your own 401(k), called a Personal 401(k) (or Self-401(k)). If the IRA limits ($4,000 in 2006) annoy you and you really want to lower this year's taxes, get a Personal 401(k) and sock away another $15k, or more. Then chute you can borrow up to half the value limit $50k, and the interest is paid back to yourself... lower your taxes, and yet the money's right here in your hands. CAVEAT EMPTOR
Can I withdraw from my TSP account to build a house tax free? I am 68 and will need to witdraw it when I am 70. I would like to build a house with the $200,000 I currently have in the TSP Thanks for your answer
Ramit, I found your site through 43folders.com and even though I am horrible with numbers (seriously, anything whatsoever having to do with numbers at all, I was an Art major after all), my parents instilled in me the notion of being financially responsible for my future as far as credit and retirement plans go. Because of this, I opened a 410k at my first job out of college. It was open for 2 years and was of course matched by my employer. My issue here is that my current employer only offers a Simple which my 401k cannot roll into. They are mutually exclusive. What do I do with what is sitting in my 401k? Thanks for the help and inspiring me to start to get things done about my money now!
In the Uk, the equivalent to a 401(k) would be a type of company pension called money purchase or direct contribution. Pretty much all largish companies have them. Mine is set up so that I contribute 1.5% and my employer contributes 3% of my pre-tax salary. Similar to a traditional IRA (where you pay in pre-tax and get out taxed) is a stakeholder pension. There is nothing exactly like a Roth IRA, but you could invest in a stocks and shares ISA. You pay in with taxed money and it grows tax free and you can withdraw money tax free at any time. The maximum you can invest is £6000 per year but you need to check the rules of your scheme.
I am investing in both a 401K and a Variable Universal Life fund. Should I start up a Roth IRA. I am 40 years old.
You should add that people should choose an institution with low or no custodial/management fees. I don't mean commisions/transaction fees. For example, a full-service broker like Citigroup's Smith Barney charges $40/yr as a "custodial" fee on IRAs. Given the maximum contribution of $4k/yr that's a 1% fee haircut before you start talking about fees to buy/sell funds and expense ratios of funds. Then if you decide to move your IRA to another broker there's a $50 account termination fee. So BE CAREFUL - USE NO-FEE BROKERS if you can. Also, I think there was legislation this year to allow employers to opt-in employees to 401(k)s BY DEFAULT. This will hopefully change the terrible statistics you mention above about 25% of people failing to even sign up for a 401(k) - assuming many businesses adopt that practice. As for people in the comments that point out you don't like mutual funds (I assume especially mutual funds with loads and/or high expense ratios) - to that I say, as long as your employer is matching contributions (let's say 1:1) you start out with a 100% gain on your money so even a miserable fund that only returns enough to cover fees - you still DOUBLE YOUR MONEY. (side note: I heard on CNBC that the NFL has one of the best 401(k)'s around - they match 2:1 !)
Agree with #31..Not sure why you are linking to White Supremicist websites. ( Though if the stat is correct I'm sure you could find it somewhere else).
Ramit - I know this was posted a while ago but hopefully you are still responding: I'm 23, and I have had a Roth for sometime. At my current job, we have a SIMPLE IRA, which I invest in to the match (3%). The thing is, our plan only offers mutual funds, or at least that is what our fin. advisor told us. In fact, he only gave us the option of those already set fund make-ups such as "aggressive growth". The fees on it are absurd (as it is loaded funds), and recently they have increased even more because a new fund company bought out our old plan! I spoke with our partners, asking them if we can add an index fund of any type; but they are so confused by the plan that they don't think we can add one either. They said that only 401K's can offer index funds. I'm not sure if this is true and information on SIMPLE's is not as readily available as other retirement accounts that I have found. Any advice? Do you know if there is a reason why we could not add an index fund to our plan options? Right now I'm at the whim of our not-so-great financial advisor who strongly dislikes me simple because I'm knowledgeable and don't want to fund his life at my expense.
For personal reasons I have to close a Roth IRA. Can I roll it into my TSP account through my employer to avoid 10% penalty?
Common advice is to accumulate an emergency fund of 3 to 6 months expenses. Since I can withdraw my contributions to a Roth IRA, should I use the Roth IRA as my emergency fund?
I'm very much convinced that I need to start at least a Roth IRA this weekend, so I'm starting by asking some questions here. I can't seem to find the term Roth IRA in my country, Singapore. Is the Roth IRA a purely American affair, and can a foreigner like me set up an account through the internet (or is it no longer sensible to do so)? I'm 20 turning 21 this year, about to finish my national service liability and about to enter University. I'm confident I can find enough money to max out my Roth IRA yearly (if i can set up one to begin with). Any assistance on a 401(k) account in my country would be greatly appreciated as well, because I'm planning to do short-term work. Thanks in advance.
One can take an interest free loan from their 401K. Check with your HR dept. about if they allow 401K loans or not.
i'm a retired md and cfp. i have been impressed with the financial awareness of the questions posted. if you wish to pick my brain or receive my financial emails [free, pay back to a world that has treated me well] send me your thoughts.
Today I'm at >100K/yr income and at retirement (60) I'll be drawing $200K from my 401K investments... How is my 401K tax differed...?
I have a question regarding rolling over the traditional 401k into an a existing Roth IRA and if it is possible to have early distribution of the principal tax free and penalty free. Let't take the following scenario.: "You are contributing maximum 15k per year, over 5 years, and then decide to change jobs, in that year, let's say you rolloed over the whole amount of 85k (including interest) to a Trad IRA and then reconvert to a Roth IRA, paying taxes in that year. The question is:"Can you withdraw the 75k penalty free(the principal), that was initially deposited in 401k, if you rolloved this amount into a Roth IRA account that you have opened more than 5 years? Thanks.
Hey Ramit, Great article. Need some advice. I plan to go back to India in 7 years. And I would like to withdraw my money at some point...preferably when I go back in 7 years. Do you think 401K and Roth are for me?
I appreciate the frank/blunt approach to 401k and Roth investing.
I am 27 and make $27,500 a year and looking for some guidance. I really liked the clear and easy to understand explanations you provided. I just bought "Investing for Dummies" and neither IRAs nor 401Ks were adequately explained, but I got my questions answered here for free! I am returning that book! My employer says that our 401K matching program is 50% at 6%. Could you clarify what that means? Also, I heard that when you leave a job you have to roll a 401K over into an IRA, but if I open both on Monday as you suggest and max out my IRA, what happens to the 401K rollover money?
Ramit, This is some excellent advice. I'm eager to jump into investing as a recent college graduate. However, I'm not sure what the best situation for me is. I have about $50,000 in student loans, and after I return to grad school in 2-3 years, that will be 100-150k in student loans by the time I finish. Given this, is it wise to start investing in something like a Roth? What would you recommend to someone in my situation? Thanks
Good Lord, you poor poor bastards overseas!! 401(k) and 403(b) are references to the United States tax code. Mr. Rammit's suggestions pertain only to US workers. If you are in Ceylon, or wherever, and you are somehow paying tax on your income to the US government.... thank you??? Of course these are not plans for you, for Pete's sake. Evan, avoid [as much of] those massive student loans, if possible. I'm still paying off professional school. I have nowhere near the total loan amount you describe, and I nevertheless feel the pinch every month. I have colleagues who literally had to move out of state to make a salary that would permit them to service a 100K+ student loan. The difference between having to pay back 50K versus 150K is HUGE when it comes to your standard of living. I don't care how much you expect to make. The increased loan principal v. Roth advantages is a calculus I'm not qualified to make. I also don't know how young/old you are. Generally, the Roth IRA is more attractive the younger you are.
OK, after reading this I am definitely planning to open up a Roth IRA, but I'm not sure whether to go with Etrade, Datek, or Vanguard, or if it even matters. When I logged onto the Etrade website, the website was malfunctioning and wouldn't let me sign up for an account, so I took that as a bad sign. I'm wondering if anyone has any preferences between the three (or other discount-brokerage services they prefer).
And one more question. I'm the artistic director of a small non-profit theater company and am wondering if there's some kind of pension plan I can set up for employees of the company to supplement my Roth IRA.
This article should be updated so that the max for the ROTH IRA says $5000 now, since it got raised for 2008.
My wife and I are 26 years old. Both of us have Bachelor Degrees and work. Neither of us have a Roth IRA, but I plan on changing that next week. We currently have $0 in debt, and have managed to save up $31,000.00 over the last year, currently in a 4.35% money market account. Our currently combined yearly gross income is $60,000 but we live on only one income, saving 100% of the other. I am thinking the best to do is to open a Roth IRA account for each of us (One at Vanguard and another at TRowe to minimize risk?) and fund each with $4000 for our last year 2007 contribution, and then add another $5000 for this year (2008) contribution. For a total of $18,000 in our Roth IRAs. Would this be the best thing to do? This would still leave us with around $13k in our Money Market for emergencies. Are we on track?
I would FINALLY like to start a Roth IRA. Im kicking myself for not doing it sooner, I am 37, I made 84K last year as a pipefitter. I understand that I have until April 15th to contribute $4500 for 2007, but how do I contribute for 2008 when Im unsure if i will $95K mark. Overtime is unpredictable. Maybe I should consider a long vacation to Mexico if i get close in December? Im prepared to make that sacrifice if need be. Id like to contribute monthly for 2008 rather than use my tax refund this time next year. Z
I have invested in a traditional IRA since I was 24. I then converted it to a Roth when that came out. I go through Vanguard and have a mixed basket of growth stocks. I have maxed it out every year. I am now 38 and have only $46,557. I'm starting to feel like I will never have enough for retirement. Since the economic downturn at the beginning of the century, it seems like we have taken a huge step backwards in our earnings and it's looking like it will happen again. Also, my husband and I don't have enough to max ours out for the year 2007 (we have enough to fund it about $6,000). Should we borrow from our equity loan (at 6.5% until we transfer to a 0% credit card) to fund it? Especially in these tougher economic times.
You're just not saving enough. Down size your lifestyle now, save and grow rich. Or live it up now and plan to be poor in your old age. It's up to you.
Hi Ramit, the 2008 401k for employee deferral contributions limit is actually $15,500...
I have been wanting to invest in something, however I am not a full time employee with all of the benefits. I have been saving up and would like to invest about $5,000 to an account this article has really helped me out. I will invest in mutual funds most likely, unfortunately it will have to be taxable... Sometimes I don't like the government :(
Ramit, you're right - I'm an idiot. I just found out that my company contributes a flat 5%, regardless of my contribution, you just have to have an opened account. Now I'm going to do that and start contributing myself. Where would I be without you. (poor and destitute?)
Ramit, First off great articles not to much mumble jumble is great, im currently 21 and graduating in one year, my question is I make about 500 a month and only about 1000 CC debt and only about 12000 in educational loans. I want to start a roth account what do you believe would be a good amount to start with as of right now, once i graduate I will be in a public school system as a HS teacher, but before that happens I want to know what i can do as a full time student with a limited income so that i can get started? Thanks, really appreciate the article and website.
Hi Ramit, I need some advice. I'm 22 years old and just graduated in college. I have roughly 30,000 in college loans as well as a small credit card balance that I anticipate to have paid off very soon (I'm not a big spender thanks to my very humble childhood). I'm nearly convinced that a Roth IRA is right for me. However, I'm expected to join the Peace Corps in September (a life long goal of mine). I'm working full-time this summer, making $8 an hour (which is good for where I live.) Should I start investing or should I wait until I return from the Peace Corps service two years from now, when I will have a more stable income? Also, should I pay off my student loans first? I should mention that my parents have always struggled with money and have extremely high credit card debt, so they will not be able to help me out and I currently have very little in savings. I would like to some day be able to help them live a comfortable life because they have made so many sacrifices for me. Thanks for your help, any advice will be greatly appreciated!!! Liz
I'd add another advantage to the Roth over the 401(k) for some of us. If you change careers/jobs a lot, you may end up having to move money around from one 401(k) to another or into an IRA at disadventageous times. Right now, I fund in this order: - 401(k) to get a match - Roth IRA - financing self-employment/business - additional 401(k)
When my husband and his former wife divorced, the divorce settlement included a share of her 457 (b) to be granted to my husband. This is the governmental equivalent to a 401 (k), as she works for a non-profit governmental agency. My husband's share was deducted from her 457 (b), and set up in a separate 401 (k) account by her employer. We have tried and tried to get this money out, and into one of our other retirement accounts, with no luck, even though I have been told it is possible. If my husband cashes out the 401 (k) and immediately puts it into a Roth IRA, can he avoid the early withdrawal penalty on the 401 (k)? Or if he were to put it into a Fidelity regular IRA account that he already has? I hope you can shed some light on this. I am trying to minimize the accounts we have, and have the money where we want it, not in his ex-wife's employer account. That just doesn't sit well with either one of one. We'd like to make more of a financial break from her. Camilla
Ramit - I have been studying this area for a couple of years now & found your article right on! Thanks! I would appreciate your "take" on my situation, however. I am in a 403B with no match & the company DOES NOT not put the $ in until after the entire year! I am 54 & am fully funding a Roth IRA but have some additional $ that I could invest somewhere. I could have my employer take it out & add to my 403B but again, it would not go into the acct until AFTER the year. Would it be better to NOT put that additional $ into the 403B but to open a regular brokerage acct, or do you have any other cool suggestions? Thanks again for your work! - David
Ramit, You omitted one important remark on the topic of 401(k) mechanics. I did some calculations, and you can check if they're correct on this google docs document: http://spreadsheets.google.com/pub?key=pZxgx4HEDOBSJjntfiuGvZA You list pre-tax money going to 401k as a benefit because of the compound interest on otherwise-taxable amounts. However, it's not a benefit in itself: Here's the math: scenario 1 (401(k) style): we put pre-tax $X dollars into an investment account every month, and after 30 years, we have $Y amount on our account, but when we withdraw it, the tax of Z% is applied, so we have (100-Z)% of $Y. scenario 2 (regular investment): we put post-tax (100-Z)% * $X into the investsment each month, and after 30 years, since it was already taxable, we end up with - lo and behold! - (100-Z)% of $Y. It's the same. So it actually will most likely be a disadvantage - because taxes may rise (you said it somewhere later in the post or comments), or because we are "stuck" with all this money until we're 59.5+. The actual benefits are those you list later (matching contrib. from employer, no tax if buying a house etc.) - and those are the real reasons one should think about it. Still, I'm not saying 401(k) sucks - just that its value isn't coming from the compound interest from the untaxed money on each contribution.
Ok reading all the posts completely have me confused now. I thought after reading the article that I would invest but now I'm questioning on exactly what it is I need to invest in! Roth IRA an 401K's are basically like investing in stocks, is that what you are saying??? So I might as well just open a portfolio then?? I'm soo confused now!!! HELP!
Confused as well. I already max out my 401k, put $500 a month to my ING Account and $100 a month to a Vanguard mutual fund. This is my last step and I want to max out my soon to be Roth IRA, but I am confused on the below... My base salary is less than $95K. But if you add in co stocks, co car, bonus...that kicks me over $100K. How do I determine this so called "max income"? Just base salary or does it include all the other perks? From my readings, if i am over $100K/yr I can contribute less than the max ($5K)...but how do I know how much that is? Vanguard said they cannot give tax advice, so they are not helping me. I didn't think this was a tax question, I just want to be in compliance so my accountant and Uncle Sam don't come after me. Any insight is appreciated. Thanks!!
Thank you for this article. I currently have a 401K, a mutual fund, Simple IRA, Roll-over IRA, and HSA (Health Safety Account). Currently, I am only investing into my 401K and mutual fund. This all happened before I knew anything about retirement funds and investing. Had I known more, I would have consolidated my funds and started a Roth-IRA. I would have used my HSA to invest in the mutual fund instead of opening up a separate account. I feel that if I were to start a Roth-IRA now, it would be too much for me to keep track. What do you suggest? Also, do you have any articles about how to re-invest your retirement funds? Right now, my simple IRA, roll-over IRA, and HSA are just sitting there with zero or minimal interest. I have not re-invested them into anything. I am probably losing money on my HSA, because of the management fees.
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Thanks for the great post, Ramit! Do you have any where you address Roth 401(k)'s and/or traditional IRAs? I tried to search on your site, but got a bit overwhelmed. Also, would you still recommend a Roth IRA, versus a traditional IRA or other investment vehicle, for someone whose income exceeds the maximum income to make full contributions to a Roth IRA? (Even though I'm under 30, I'm a lawyer at a big law firm, so I'm in an unusual situation financially for someone my age.) Thanks!
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I'm making enough money at work that allows me to put some of it into retirement investments, so it will help me to know more about a Roth IRA. It's useful to know how it's different from a 401(k). Putting already taxed income into stocks, bonds, and index funds seems like it could be a good way for me to expand my wealth without having to pay when I withdraw it. I've considered starting to invest in a 401(k), so investing in a Roth IRA would also be a good choice. Thanks for posting this!
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Did you say anything at all in this to someone that has invested already? Going on a mere join us campaign is the context that came across. Im looking for the understanding that the employers and financial companies are helpful in keeping from me.
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Ramit, now that there also exists the Roth 401(k), does that change any of this advice? Should we go for 401(k) + Roth IRA, or just full Roth 401(k)? How does Roth 401(k) plays in all?
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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.