The what, how and where of saving for retirement can be quite confusing especially for someone who is just getting started with their retirement savings or who wants to learn more about how it all works and the different options available. And so in this post, I'm answering the most common questions I get about saving for retirement.
"Investing for the long term is one of the keys to building real wealth and your retirement savings falls under this category."
Where can I save for retirement?
You can start saving for retirement either in an employer-sponsored retirement plan, in your own independent retirement savings account (both of which have specific tax benefits) and/or in a non-retirement account (which does not have tax benefits but is still a means of saving). I explain the different retirement account types by name below:
401k - Employer-sponsored
A 401k is a retirement plan that only an employer is allowed to offer. It allows their employees to save and invest for their retirement on a tax-deferred basis - meaning you don't pay taxes right now until you actually start taking distributions from your retirement savings. These contributions are deducted from your salary, pre-tax.
Note: In addition to the traditional 401k, many employers offer a ROTH 401k to their employees. It works the same way a ROTH IRA way does (see below), as described below, but the main difference is the contribution maximum is much higher and similar in terms of the amount to that of the traditional 401k.
403b, 457b - Employer-sponsored
Similar to the 401k, the 403b is specific to employees of public schools, certain tax-exempt organizations, and certain ministers while the 457b is specific to governmental and certain non-governmental employers and their employees.
Traditional IRA - Can be independent or employer-sponsored
A traditional IRA is an individual retirement account that allows you to make contributions pre-tax income up to a specified amount each year. Come retirement, you will have to pay taxes on any withdrawals you make on the account.
Roth IRA - Can be independent or employer-sponsored
A Roth IRA is an individual retirement account that allows you to make contributions after-tax income up to a specified amount each year. Come retirement, your withdrawals will be tax-free and that includes your earnings.
Note: It's important to keep in mind that the eligible retirement age for the accounts listed above is 59 1/2 and withdrawing funds earlier than this age from these accounts can result in penalties and taxes. You can find out about 401(k) contribution limits on the IRS website HERE and IRA contribution limits on the IRS website HERE.
Non-retirement accounts - Independently set up
Saving for retirement can happen outside of a "retirement savings" account as well. You can save for retirement in non-retirement accounts which are basically brokerage accounts where you invest your post-tax money.
While you won't have the tax benefits that come with actual "retirement" accounts, you'll still be saving money and because you have paid taxes on your deposits you'll only be required to pay taxes on your earnings and there are no withdrawal penalties - you don't need to wait to age 59 1/2 to take out your money if you need to.
Should I contribute to my employers' retirement plans?
While the offering in your employers plan might be limited or might have high expenses (it depends on who your employer is and what they offer), employer plans like 401ks, 403b and 457b have much high contribution maximums than traditional and ROTH IRAs, so it makes sense to contribute there and take advantage of those tax benefits especially if you can max out your contributions.
How does contribution matching work?
Matching is something that some employers offer when you contribute up to a specific amount in their employer-sponsored retirement savings plan. For example, a common matching plan is a match of 100% for contributions up to 6%. This basically means that, if you put up to 6% of your salary in your 401k, your employer will match it by contributing 100% of up to 6% in your retirement account as well.
Essentially, a match is free money and if your employer offers one you definitely want to take advantage and get ALL of the free money they are offering you.
Should I contribute to a traditional IRA or a Roth IRA? Traditional IRA vs. Roth IRA?
They are both great ways to grow your retirement savings but if you were to chose between the two you have to determine what works best for based on what you think your future tax bracket will be. If you think your future tax bracket will be lower than what you currently pay now, then a traditional IRA might be best for you since you don't pay taxes until later.
However, if you think your tax bracket will be higher than what you pay now, then a Roth IRA might be best for you since you would have already paid taxes on your contributions.
Many people have both types of IRA because ultimately they are able to save more by leveraging the benefits of these retirement plans over the long term.
What happens to my money in a retirement savings account?
When you put money into your employer-sponsored retirement savings accounts you will have a few (although limited options) to invest in various stocks, fundsand/orr target date retirement funds (Target date retirement funds are funds in which the level of risk adjusts the closer you move to your target retirement age).
When you invest in your own individual IRA you can make selections from the entire stock market - I'm personally a huge fan of investing in index funds. It's also important to do your own research on how to invest and HERE'S a great place to start.
What about taking my money of my retirement savings account?
By design, once you reached retirement age of age 59 1/2, you are allowed to begin making withdrawals from your retirement account penalty free. Because retirement can last upwards of 20+ years, when you retire you are not going to instantly begin withdrawing all your money in one go.
Your money actually still has more time to keep growing and you should have an investment strategy in place that transitions to making your investments more conservative as you age to hedge against major losses that could occur from a market decline.
If you do however decide to make early withdrawals from your account (i.e. before the retirement age of 59 1/2 - not a good idea), you will be subject to penalties as well as any taxes you would owe on the distribution.
Should I roll over my current retirement savings to my new employers' retirement plan?
Yes, you can rollover your retirement savings from one employer to another if permitted by your new employer BUT it is important to keep in mind that in many instances, employer sponsored retirement plans are typically very limited in terms of the options you can invest in and they also typically have higher fees.
If you are moving jobs, its better to move your retirement savings into your own IRA with a brokerage e.g. Betterment, Vanguard, Fidelity etc where you have access to the entire stock market and potentially much lower fees - I'm a huge fan of index funds.
Investing for the long term is one of the keys to building real wealth and your retirement savings falls under this category. If you haven't already, I highly recommended getting started as soon as you can and if you are already contributing to retirement savings but are not maxing out your contributions, put a plan in place to make gradual increments over time until you get to the point where your contributions are fully maxed out each year.