If you’re anything like me, when someone brings up retirement savings, investing, or your 401(k) match at a cocktail party, your eyes immediately glaze over and all you hear is the “wonk wonk” of the adults from a Charlie Brown special. Inside my head is the flashing red light and loud voice signaling “Danger. Danger. You are engaging in a discussion of a topic you know nothing about. Abort conversation to avoid massive embarrassment.”
But the truth is that investing and retirement accounts are something worth knowing about. Even a financial neophyte like me knows that if you start socking away for retirement early in your career you have a huge advantage. In this case, time really is money.
So, we interviewed financial blogger phenomenon and author of Your Money: The Missing Manual, J.D. Roth, for the Cliff’s Notes of Retirement 101. He gave us almost enough to get you through a cocktail and conversation with a financial planner without faking it.
401(k), 403(b), Roth IRA: Retirement Account Alphabet Soup
First, let’s decipher the numerical and alphabetical soup of retirement plans. The names of these plans have always struck me to be as random as the combinations my kids get in their spoonfuls of Spaghetti-O’s.
401(k) and 403(b) retirement plans are employer-sponsored, while a Roth IRA is something you’d set up individually with help from a financial adviser. According to J.D. Roth (no relation to Roth IRA, FYI), for-profit companies offer the 401(k), while government and non-profits offer the 403(b).
The primary difference between a 401(k)/403(b) and a Roth IRA is the way Uncle Sam collects the rent. “The 401(k) and the 403(b) are both tax-deferred retirement accounts, which is just a fancy way of saying you don’t pay taxes on the money you put into the accounts — or the earnings — until you pull that money out,” said Roth. “With a Roth IRA, you’re taxed on the money before you contribute to the account. As a result, your earnings grow tax-free.”
So, in a 401(k)/403(b), you put your happy pre-tax dollars into a savings account. When you finally withdraw from that retirement plan, hopefully 20 years, 30 years or more from now, it will be considered income, taxable just like your paycheck. Big red flag: retirement accounts are not meant to be used for a beach trip, your sister’s wedding or the mortgage. If you remove the money before age 59 ½, you will pay a severe tax penalty, typically 10 percent. On the other hand, with a Roth IRA, you have already paid a tax on your contributions, so your withdrawals are tax-free.
Confused? Here is all you really need to know:
- 401(k)/403(b) = no tax now, pay tax when money is withdrawn (major penalty if early)
- Roth IRA = contributions are taxed, no penalties or taxes when money withdrawn
Is There Really Such A Thing As Free Money?
Another important thing to know about the 401(k) and the 403(b) is that employers often offer to match their employees’ savings up to a certain amount. For example, your employer might match 100 percent of the first two percent of income you contribute, and 50 percent of the next two percent, for a maximum of three percent of your income. Yes, that means if you contribute four percent, your employer will do three more. But you can’t spend it until you retire, and it will be taxed when it is withdrawn. “This isn’t ‘free’ money, but it’s pretty darn close,” says Roth.
Think of an employer match kind of like an optional raise. If you think you deserve a raise, invest at least the minimum required for your employer to kick in, and … voila. The only downside is that you can’t use your raise now for an 82-inch plasma flat screen. You’ll use it to buy dinner at Piccadilly when you’re 60.
So How To Pick The Retirement Account For You?
“Choosing between them is like choosing between apple pie and chocolate cake — both taste great, but which you select depends on your needs at the moment,” says Roth. Lucky for you, moneybags, J.D. Roth broke it down into the following easy steps:
- If your employer offers matching contributions to a retirement plan (401(k), 403(b), or another plan), contribute to that first. Contribute enough to max out your employer’s match.
- After you’ve reached your employer match, then contribute up to the maximum to a Roth IRA. (That’s $5,000 in 2010.)
- Finally, if you still have money to invest for retirement, go back and max out your 401(k) or 403(b). You can always contribute more than your employer will match.
How Much Do I Really Need To Save? Do I Have To Start Now?
According to Roth, you need a lot, and yes, start now. “People who start investing early in their career have a huge advantage over those who start late,” says Roth. “Compound returns are the snowball-like effect that occurs when you let your retirement investments grow over time. They grow slowly at first, but eventually are like an unstoppable avalanche.”
Roth’s rule of thumb is that you should be saving at least 10 percent of your pre-tax income for retirement. “This can be tough at first. When I first started, I couldn’t afford 10 percent. I couldn’t even afford 1 percent. Instead, I just contributed $25 a month for a few months. Once I got the hang of that, I contributed $50. Eventually, as I paid off debt and freed up money, I contributed as much as I could to retirement.”
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