Good Morning FFD(Finance and Fitness Dreams),
As the year ends and we start thinking about Christmas, New Year's Resolutions, and Taxes I thought it might be a good time to run down my thoughts and directions on a 401K and Roth IRA, two of the best investment vehicles around. I don't pretend to be an expert and despite my stays at the Holiday Inn, I am not any smarter on the matter because of it. But what I can do is give a brief common sense picture of what each one is and how I use them in our investment strategy.
First let's start with the 401K. This is the definition from Investopedia, it's a little wordy but it gets the job done.
Definition of '401(k) Plan
A qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.
So a 401K is a place where you keep your investments, depending on what your company offers as a selection it's usually mutual funds and index funds. What happens for most people is they make a selection when they first start working to take out a % of there pay. The good news is this is all done pre-tax before the government takes out Federal, State, and Social Security. So for example if you get paid $1000 each pay period and you have elected to have 1% taken out this would take out $10 from each paycheck and be put into the mutual fund or index fund you have chosen. By taking this out before taxes it also decreases your tax bill overall since the government has less to be able to tax . The 401K part is really just a way of saying this is how we are going to tax or not tax your investments.
Your 401K is for the long term, we are talking retirement and when I say retirement this time I mean the earliest you can take this money out is 59.5 years old, otherwise they penalize you and we don't want that. I won't get into to many specifics on each rule because that's not the purpose of this little blog. The main points are this money is growing from your pre-tax money so it's a little larger % then if it would be taken out if Uncle Sam got a hold of the pay check first. Your investment grows tax-free, so when you pile up all this money it's growing and growing and you are adding more and more, which allows it to become a huge monster snowball along the way.
One of my favorite features that a lot of companies utilize is what they call the company match. I like to call it my Retirement Bonus, they give it to me every year as long as I promise to not spend it till I get to be old and don't want to work anymore. What they say is OK if you put in 3% of your money all year, you know what we will match that and put it in your 401K account at the end of the year, free of charge. So using the example of someone who makes 50K, you would have put in 3% or $1500($300 for every 10K), they would then put that same amount of $1500 in your account and congratulations you just got a Retirement Bonus!!! They most commonly put this in as cash or some form of the company stock, but either way it's yours.
Here's a little summary of the Pro's and Cons of 401K so far:
PRO
- Money is taken out pre-tax allowing you to save a little extra(this also decreases your tax bill)
- The investments grow tax-free
- Company match or Retirement Bonus
- Automatic way of Saving Money
CON
- This is a retirement account and you will be penalized if you take out this money before you get old and want to retire
- You do have to pay taxes on the money(Death and Taxes people), so whatever your current tax rate is when you retire, you have to pay Uncle Sam
- Limited Choices of Investments and Not very much guidance from investment professionals on what you should invest in
Here's another option becoming more and more available with employers, but first a definition from Investopedia.
Definition of 'Roth 401(k)
An employer-sponsored investment savings account that is funded with after-tax money. After the investor reaches age 59.5, withdrawals of any money from the account (including investment gains) are tax-free. Unlike the Roth IRA, the Roth 401(k) has no income limitations for those investors who want to participate - anyone, no matter what his or her income, is allowed to invest up to the contribution limit into the plan.
So the main difference between the 401K and Roth 401K is the money is funded after tax money, which limits the initial investment, but like the 401K this is allowed to grow not only tax-free, but when you decide to take your withdrawls after 59.5 these are also taken out tax free! For me on this one it's a horse a piece as an old saying goes, since you are contributing to a retirement investment account, I would worry less about which one you are investing in and instead rather that you are investing period.
So what do I do?
Currently I invest 4% of my salary, which is what my company matches as well, I have no plans of changing this now or in the near future. This is my retirement account, so I treat it like an old man, quiet, nice, and a little boring. I invest in index funds, which are low cost funds that mimic the stock market. I have them spread over a broad range, but I have them split between 3 or 4 investments, including the S&P 500, International, Small Cap, and a Target Fund(this overlaps some of the previous index funds). These funds are low cost, boring investments just how I like it for my retirement. I don't plan on touching this money until I am at the earliest 59.5 and if my plan goes as I have it drawn up, this will actually be money that I do not rely on and instead is more of a bonus account when I get to when the world thinks you should retire age.
My suggestion is if you have a 401K option at your place of employment that includes a company match, start it today and put your investment percentage to receive the maximum your company offers. I believe the 401K is a great tool to help you in retirement. Even better ask a few people you know who are in the retirement age and see what they did. Are they living off Social Security? 401K? Real Estate? Still Working? Pensions? Annuities? Would they have done things differently if they knew what they knew now? I'm a believer in the 401K I don't think it's the answer to everyone's retirement problems, but I certainly think it should be apart of everyone's and it's apart of mine that's for sure. Here is a link to a short video that encourages you to invest as well, take a look it might get you excited to start one today!!
http://www.investopedia.com/video/play/understanding-your-401k/
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