My previous post on ROTH IRA generated quite a bit of traffic and feedback. Big "Thank You" to all my readers! What I didn't realize was that I may have jumped the gun by talking about ROTH IRAs when quite a few people did not even know the basics of the different retirement plans. So let's take a few minutes to address the ABCs:
- Retirement - When you stop working and therefore stop generating earned income.
- Retirement Plan - A plan for when you stop working. This can be done in many ways. In my culture, the traditional retirement plan is the expectation that your children will care for you when you are older. But we live in Ameeeeerica! So let's talk about how you can stash money away during your working years for your retirement - like how squirrels stash nuts away for the winter.
Tax-advantaged Retirement Plans - IRS-designated financial vehicles to encourage people to save for retirement. These allow you to save on your taxes, either now (pre-tax) or in the future (post-tax) if you are lucky enough to have ROTH option.
- 401(k) - created by section 401(k) of the Internal Revenue Code, the 401(k) allows private employers to set-up retirement saving plans where an employee can defer a portion of their compensation by saving it in a employer-sponsored 401(k) plan. That money is "deferred" since you don't get it until after you retire. The main benefits of a 401(k) are:
- Tax-free Contributions - money you put into a 401(k) are deducted from your income when it comes time to file for taxes.
- Investment earnings are tax-deferred - you don't pay income tax on earnings until you withdraw from the plan after you retire.
- Relatively stress-free - most employer sponsored 401(k)s are managed professionally where are you have to do is to pick a "Target Retirement Fund". Saving you from having to learn all the details about investing.
- BEST BENEFIT: Employers will often MATCH your contribution up to a certain percentage of your income - translation: FREE MONEY!!!
- Example: Latrell makes $50,000 a year working for Company A who will match his contributions to a 401(k) plan dollar for dollar up to 3% of his income. Which means Company A will put up-to 3% x $50,000= $1,500 into Latrell's 401(k) on his behalf. That's an immediate return-on-investment of 100%! You'd be hard-pressed to find another investment with better returns.
- 403(b)/457 - analogous to the 401(k). The 403(b) is for nonprofit employees, public schools, churches etc. The 457 is for state and local government employees.
- Individual Retirement Arrangements (IRAs) - unlike the 401(k), anyone can save in an IRA, no employer required. Most of the benefits under 401(k) above apply to IRAs. However, since there are no employer involved, don't expect any employer matching contributions.
- Finally, most of the above plans may also be found in a ROTH option, depending on your specific employment situation. Which to me is a better alternative. See my previous post on ROTH IRAs for details on why.
Taxed Retirement Plans - Basically any other investments that are not tax-advantaged: Savings accounts, Certificates of Deposit (CDs), Money Market Accounts (MMAs), Brokerage accounts, Real Estate etc.
Hope that sheds some light on the basics of retirement planning in the good old USA. Have a great weekend!