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Getting yourself set up with a retirement account can seem a bit daunting initially. It definitely seems unnecessary at first if you're in your 20's. When people start telling you to start saving for retirement, you probably think to yourself, “are you serious, that's so far away who even cares?”
Retirement doesn't even seem real!
You'll be working for almost twice as long as you've been alive so far. And it feels like you've been around for a long, long time so, whatever, it's totally fine if you brush off saving for retirement for a few years right?
Well, the fact of the matter is starting in your 20's vs your 30's can give you an advantage of about $200,000 in some cases. Even more, if you're really diligent with your savings. The miracle of compound growth gives you a tremendous advantage at an early age, so start as soon as you can.
So basically, there are 4 main places you can invest for retirement. This is done through a 401k, a Roth 401k, an IRA and a Roth IRA. If you don't know anything about the significance of each one, don't worry, after reading this, you'll know all you need to know in order to get started, it really isn't that complicated.
So this is the most popular method you hear about. It's the employer's traditional 4o1k. This is the thing you always read about in the benefits section of a job offer or the benefits you see on Glassdoor. “We offer a competitive benefits package along with a 401k matching plan.”
Yea okay cool, but what does that even mean?
Basically, the 401k is a place where you can contribute a portion of your pretax dollars from your salary into a savings account for your retirement. This is great because you don't have to get taxed right away, the full dollar amount goes straight into the 401k for you.
Typically, if you work at a bigger company, you can easily set this up on your computer and change the contribution rate as frequently as you want. At least that's what I've experienced regarding the frequency of adjusting the rate you contribute.
In these plans, companies may offer what's called a matching plan. You might see in your company handbook the employer offers 50% of your contribution up to 6%, which is really just a fancy and confusing way of saying they will contribute 3% of your total salary if you contribute at least 6% of your salary towards your 401k. This is where a lot of people go wrong. They don't even match the contribution rate.
IT'S FREE MONEY. You can't shrug this off, it's extremely important you don't miss out on this if it's available to you. Literally, it's free money I'm not kidding. The only catch is you might have to wait a certain time period before the contribution plan is available. I had to wait a year myself. Other than that, it's a no-brainer, you have to take that extra money.
Say you make $65,000 a year and never get a raise (not likely) and you reach the match of 6%. Over 40 years that extra 3% from your employer would end up being $445,739 if invested in an S&P 500 index fund at a 7% performance rate. That's insane!!
If you're fortunate enough to somehow max out your contribution each year for 40 years at $18,500 each year at a 7% rate for 40 years that turns into $4,228,805!
Even better, the maximum amount increases after the age of 50 to $24,500, so really if you maxed out every year you could make $5,462,380 if you retired early at 65. I say early only because you don't get full social security benefits until you turn 67 if you were born after 1960. Think about that. $5,462,380 just from maxing out your 401k.
But, I know that's unrealistic, because first of all, the maximum contribution limit changes every few years because of inflation. And second, you might not be able to afford the maximum limit due to your living circumstances. That's cool too no worries, I can't max it out anymore either for the time being since I moved out of my parents' house and live in the Greater New York City Area.
Okay, so the Roth 401k is a little different. You may not have even heard of it and that's fine too! I had no idea what this even was when my dad told me to ask HR if they offered it when I got my first job. He actually told me to ask about that and if they had a matching plan and I had no idea what that meant either. I was also at an SEO software startup then, so the HR lady laughed at me about the matching plan. Whatever.
A Roth 401k is the same thing as the traditional 401k, except the money you put into the Roth 401k is after-tax dollars.
Meaning, the percentage you want to contribute is taxed first and then put into your savings account for retirement. This means the money you have in the Roth 401k will never be taxed again no matter how big it gets. It could get to $1 billion and all of that money is actually the amount you have because you can't get taxed twice.
There is also the $18,500 limit you can contribute to it, same as the traditional 401k. But the great thing is, there is no income limit to contributing to a Roth 401k. I say this because there is an income limit as I'll discuss later, in order to contribute to a Roth IRA.
You can contribute to both a 401k and a Roth 401k at the same time, but the total between the two cannot exceed $18,500. I don't recommend that though, especially because if you're young, you want to take advantage of the fact you will probably be in a lower tax bracket now than in the future and max out your Roth 401k if possible. Overall, there's no reason to not use it anyway.
An IRA is an account that is set up for you at a financial company, like a Charles Schwab or a Vanguard. It stands for Individual Retirement Account. It's a savings account primarily with a focus on preparing for retirement.
The maximum you can contribute to an IRA account as of this year is $5,500 if you are under 50 and $6,500 if you are over 50 years of age. If you reinvested the maximum amounts for 40 years at the age of 25, you could turn that into $1,284,100 with an S&P 500 index fund.
I use them, but I'm not personally a fan of the whole idea of IRAs, simply because I think it's ridiculous there is such a low maximum limit for them. Call me cynical but I think it's because the government doesn't want us to save as much as we really can and wants us to spend some money to keep the economy going. I don't know.
There are zero reasons why you can't save over $5,500, I don't care who you are. If you try to look hard enough at what your Coffee Habits are, I'm sure you'd find more than enough.
What I do instead is use this but also use my brokerage account to invest in great companies (i.e. Apple). With that money, I promise myself I will never use it for personal use until I retire.
The money I want to use in the short-term, say for a down-payment on a house, will come from the money I have in my brokerage account in my S&P 500 index fund and cash. I'm not sure if that's the best way to go about it, I'm still relatively new to this after all.
Maybe I should just park it in money market funds, but for now, I feel okay about it. The only thing is though, then the market could go down by like tomorrow or something and go on a run of -40% over a few years, so who knows. If you have suggestions, let me know.
A Roth IRA is basically the same idea as an IRA, except just like a Roth 401k, it contains after-tax dollars. So just like the Roth 401k, you are taxed upfront, so you don't get taxed later when the savings compounds into a much larger amount. You would rather be taxed on $5,500 each year rather than say $500,000 later on with the same tax rate. With the $500,000 that is the exact dollar amount you have to spend, it will never get taxed again.
Why would you want to contribute to a Roth 401k and Roth IRA?
A Roth 401k and Roth IRA are better for you if you believe your tax rate will be higher at retirement than it is right now. Basically, if you think you will be making more money in the future, you will be placed in a higher tax bracket.
Because of this, you will want to have your money taxed now at a lower rate and let it compound over the years into hundreds of thousands and even hopefully millions of dollars. When you retire, all of that money will be allowed to be taken out without being taxed, because it already was when it was a much smaller amount.
You should get all the money you can in there, especially if you do not like the idea of researching companies to invest in and doing your own thing. For me, I view a Roth 401k and Roth IRA as places to be very conservative, so I invest my money in an S&P 500 index fund.
Just think about how nice it would be to have at least $1 million tax-free. That's the good life, my friend.
What if you're a business owner?
Depending on your salary and age, you could contribute a whopping $55,000 or $61,000 if you're 50 years or older. This is done through what is called a Solo 401k.
There are two types. The first one is an Elective Deferral or known as Employee Contributions. The contribution limit for this in 2018 is $18,500.
The second type is called Profit Sharing, or also Employer Contribution. This amount cannot be more than $55,000.
However, if you max out the $18,500, you can “only” contribute $36,500 regarding the Employer Contribution for a total amount of $55,000. Still awesome, though.
Penalties for early withdrawal
Life isn't all rosy with these accounts though. If you withdraw early from a 401k or an IRA, you will essentially be double taxed, which really sucks.
First, you will be taxed on the withdrawal as if it is income. So whatever tax bracket you are in, you will be taxed on the amount you withdraw at that rate. On top of that, there is also a 10% penalty on the amount you withdraw early.
The 10% penalty doesn't apply to your regular income from your job since this is assuming you still have a job because you aren't retired and are taking money out early. So whatever you do, just leave all of this hard-earned, saved and invested money alone in your retirement account.
You deserve an awesome retirement. You don't want to ruin it all because you became too impatient to wait. Don't be an idiot like Marco Rubio. Be smart, plan ahead to give yourself peace of mind for your older self.
Required Minimum Distributions:
There are, however, required minimum distributions once you get to 70 years old for a traditional IRA. If you aren't retired by 70.5 years old as of this writing, you will be automatically required to take a minimum distribution.
You also won't be allowed to contribute any more money to your IRA after you reach 70.5 years old.
But if you have a Roth IRA, this isn't an issue for you in the future. There are no age limits on when you have to stop contributing, and you don't even have to withdraw a minimum amount.
Hopefully, you won't be in a situation where you need to work and qualify for a Roth IRA at that age, because as I show in the table below from the IRS' chart, you can only make so much until you're not allowed to contribute to a Roth IRA anymore.
Click here to check out the Roth comparison chart provided by the IRS
Note there is no limit based on salaries for an IRA account, just a Roth IRA.
So ideally, you're here because you're in your early to late 20's or even early to mid, even late 30's. You will make more money in the long run. I always read typically people make the most money in their careers in their 50's. If you take advantage of having a Roth 401k and Roth IRA now, you won't even have to think twice if you have enough for retirement, especially if you can contribute the maximum limits.
What's your thought on this are you contributing to a Roth 401k or IRA? Why or why not?
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