This is the third step in our complete series of Getting Started Investing. If you’re a beginner who’s looking to make your first investment and build wealth for the future, then read on.
Eventually, when you get older, you’ll want to retire with dignity. Or perhaps you’re nearing retirement and need to play a bit of “catch-up” on your retirement savings. The only way to do that is by investing in your future. Of course, the younger, the better since compound interest can be your best friend — if you let it.
The problem is, investing for retirement can be confusing! It’s an alphabet soup of acronyms.
There are several types of accounts, and you may be overwhelmed trying to choose the one that is best for you. Here’s a basic rundown of what you need to know:
Types of Retirement Accounts
401(k) or 403(b)
A 401(k) is an employer sponsored retirement plan. For non-profit entities they are called 403(b), but for the purpose of this discussion they are the same.
You can choose to use a traditional 401(k) or Roth 401(k). This account is easily opened up through your company’s HR department.
Benefits of a 401(k):
- Automatic withdrawals from your paycheck means you will consistently contribute.
- Often there is an employer match. ALWAYS contribute enough into your 401(k) to get the full employer match. Anything less is leaving money on the table. It’s like getting an automatic 3-4% return of your money.
Drawbacks of a 401(k):
- You have limited investment options. Your employer likely has a fund group that chooses the available funds and evaluates existing funds each year.
- Annual fees can be high (greater than 1%)
- You cannot move these funds into an IRA until you leave your company.
IRAs
An IRA, or individual retirement account, is not employer sponsored. You will open this account yourself at your brokerage firm of choice. Both traditional and Roth IRAs are available, click here to learn the difference between each.
Benefits of an IRA:
- You can pick and choose whatever investments you want — with complete and total control.
- This account can be rolled over into another IRA at your discretion.
Drawbacks of an IRA:
- You will not receive any sort of match for contributing to an IRA.
- The contribution limits are much smaller for an IRA than for a 401(k).
For 2015 the 401(k) contribution limit is $18,000, and the IRA contribution limit is $5,500. (Source) If over 55 years old, you can add an additional $6,000 to your 401(k) plan. For IRA accounts it’s an additional $1,000 for individuals who are older than 55 years old.
A SEP IRA, or Simplified Employee Pension plan, is primarily used by small business owners. It differs from a traditional or Roth IRA because it allows for much higher contribution limits. For 2015, the lesser of 25% of your compensation or up to $53,000 can be contributed. (Source)
To learn more about the difference between using a SEP IRA or a traditional 401(k) as a small business owner, read SEP IRA vs. Individual 401(k).
Pension
A pension plan, otherwise known as a defined benefit plan, focuses not on your retirement contributions, but rather on what you receive in retirement. This is in contrast to the other retirement options I discussed, which are all considered defined contribution plans. Unfortunately many companies no longer offer this an option and opt with just 401(k) plans.
A defined benefit plan is set-up based on your age, and years worked for the company. If your company does offer a pension, make sure you opt-in. Read up on the plan and what happens to the pension when you retire. Each company plan, and terms are slightly different.
If you are self-employed it is possible to setup your own pension plan. This plan allows for incredibly high tax deferred contributions, up to a possible combined $210,000 savings for 2015!
Read Self-Employed? Save for Retirement with a Defined Benefit Plan for more information on this unicorn of a retirement plan.
The Difference Between Traditional and Roth IRA’s
A traditional retirement account is pre-tax. This means that you only pay taxes when the money is withdrawn at the appropriate age of 59 ½. You will also pay taxes on the earnings when you withdraw. A traditional account is recommended for those individuals who believe they’ll be in a lower tax bracket at retirement than they are now.
A Roth retirement account is post-tax. You pay taxes now as opposed to when you withdraw the funds. The benefit here is that you also don’t pay taxes on the earnings. A Roth account is recommended for those who believe they will be in a higher tax bracket at retirement than they are now. It is also recommended for younger investors who have plenty of time for growth and earnings.
How to Open a Retirement Account
The easiest way to invest is by taking the guesswork out of it. Set up automatic payroll deductions through your employer into a 401(k). If you don’t have a 401(k) option available, direct deposit a portion of each paycheck into an IRA .
See, it’s easier than you thought it would be! For further information on the subject, read How to Start Investing When You Have No Money.
You are ready to invest but you aren’t sure where to go? Picking out a good online discount broker is an art form. Before you make any decisions, ask yourself these questions:
- Does the broker’s ideals match my investment strategy?
- What are the broker’s trading fees?
- Does the brokerage offer banking services?
- Do they offer investment advisory services?
- Does the broker offer any research tools?
- What can I invest in with this broker?
- What type of customer service options do they have?
For a breakdown of these questions, check out 7 Things to Look For in an Online Broker.
On the other hand, you may want to leave the investing up to the professionals, if you want to invest but don’t want to do the legwork.
Strongly Consider an IRA Account
If you are under the AGI (Adjusted Gross Income) limits for a Roth or traditional IRA, you should open one. There’s absolutely no reason why you shouldn’t be saving for retirement. IRAs are easy to get setup and contribute.
Fortunately there’s always brokerage promotions going on. To either transfer existing 401(k) accounts into them (i.e. when you change jobs), or open up an account with an initial deposit. So it always makes sense to take up on one of these IRA offers we update on our site.
If you are one of those lucky individuals (or unlucky depending upon how you see it) who makes above the AGI limits for a Roth or Traditional IRA it does not excuse you from saving for retirement. Simply open a taxable account in the worst case situation, if you have no method to defer taxes.