I know this seems a long way off, but starting as early as possible is the best way to go. Just think about it. If you want to retire when you're 65, and you don't die until you're 90, which is pretty common nowadays, you need to find a way to support yourself for 25 years without any income. Retirement is all about compounding, which is a fancy word for adding onto what you already have, and the earlier you start setting aside money for it, the more you compound.
I'm going to share with you the 3 most common types of retirement accounts and the pros and cons of each type over three different posts (retirement accounts can get pretty heavy). So here goes...
The 401K: If you work for any company with standard benefits, you'll be offered the opportunity to start with a 401K, the very basic retirement account that everyone talks about. So what is it? It's an account that you own, and will continue to own, for the rest of your life. Even if you change jobs, you don't lose it. It's yours. You put money into it and choose how to invest it and hopefully make more money out of it. Different companies have different plans (i.e. mutual funds) on how to invest. There are some that are higher risk, but have greater returns. Some with lower risk, but smaller returns. Some are very actively managed so you may have to pay extra fees. Usually big companies will match a small portion of your contributions, but that varies depending on where you work and how long you've worked there. Regardless of whatever plan you choose to go with, the main purpose of this account is to save you money and make you more money for retirement.
Pros: The great thing about putting money aside into a 401K is that you can make your contributions to the account pre-tax. That means the money will come out of your paycheck before you are taxed, which means you get a tax deduction for it. By getting a tax deduction, you will reduce your adjusted gross income (AGI), which will in turn put you in a lower tax bracket and allow you to pay less taxes throughout the year. Another good thing about putting in the money pre-tax is that you're able to build more interest over time (i.e. it grows tax deferred, which is a fancy way of saying you pay taxes on it later). For example, putting in $100 pre-tax will build a lot more interest over time than putting $65 after-tax and having it build over time.
Cons: You can't touch the money until you're 59 1/2 years old or you will be hit with a 10% fee. There are some exceptions to this, like if you take money out to buy a house or get really sick and need money for medical expenses or even qualified education expenses. Another big con about this account is that because you contributed to the 401K pre-tax aka tax deferred, you will get taxed when you take the money out. So yes, that 10% early distribution fee seems rather small if you decide to pull out money before you're 59 1/2, but you're also going to get taxed 35% when you take the money out. Another thing to be cognizant of is that the amount of money you can put in is capped at $17,500 per year. This changes slightly year to year.
Things to Consider: Tax rates. Taxes will never, ever go away. In some ways I'm grateful for taxes because I work as a tax accountant, and I'd be out of a job if we didn't have taxes, but it also makes you reconsider where you put your investments. What if taxes in 40 years are really high and your retirement plan is only half of what it could be? On the other hand, what if the taxes are really low when you retire and you end up with a lot more than you expected? Taxes are a big reason why people diversify their retirement investments, particularly people with lots of money where taxes can really affect how much money they put in their pockets at the end of the day. Another thing to consider is the type of plan you choose to invest your 401K. You can choose a plan that invests mainly in stocks or a plan that invests mainly in bonds. Stocks are riskier, but will generate much larger returns, whereas bonds are relatively risk free and generate very tiny returns. It all depends on how you feel about risk, which is simply a personal preference.
More on retirement plans to come!
Cheers!
Ali
I'm going to share with you the 3 most common types of retirement accounts and the pros and cons of each type over three different posts (retirement accounts can get pretty heavy). So here goes...
The 401K: If you work for any company with standard benefits, you'll be offered the opportunity to start with a 401K, the very basic retirement account that everyone talks about. So what is it? It's an account that you own, and will continue to own, for the rest of your life. Even if you change jobs, you don't lose it. It's yours. You put money into it and choose how to invest it and hopefully make more money out of it. Different companies have different plans (i.e. mutual funds) on how to invest. There are some that are higher risk, but have greater returns. Some with lower risk, but smaller returns. Some are very actively managed so you may have to pay extra fees. Usually big companies will match a small portion of your contributions, but that varies depending on where you work and how long you've worked there. Regardless of whatever plan you choose to go with, the main purpose of this account is to save you money and make you more money for retirement.
Pros: The great thing about putting money aside into a 401K is that you can make your contributions to the account pre-tax. That means the money will come out of your paycheck before you are taxed, which means you get a tax deduction for it. By getting a tax deduction, you will reduce your adjusted gross income (AGI), which will in turn put you in a lower tax bracket and allow you to pay less taxes throughout the year. Another good thing about putting in the money pre-tax is that you're able to build more interest over time (i.e. it grows tax deferred, which is a fancy way of saying you pay taxes on it later). For example, putting in $100 pre-tax will build a lot more interest over time than putting $65 after-tax and having it build over time.
Cons: You can't touch the money until you're 59 1/2 years old or you will be hit with a 10% fee. There are some exceptions to this, like if you take money out to buy a house or get really sick and need money for medical expenses or even qualified education expenses. Another big con about this account is that because you contributed to the 401K pre-tax aka tax deferred, you will get taxed when you take the money out. So yes, that 10% early distribution fee seems rather small if you decide to pull out money before you're 59 1/2, but you're also going to get taxed 35% when you take the money out. Another thing to be cognizant of is that the amount of money you can put in is capped at $17,500 per year. This changes slightly year to year.
Things to Consider: Tax rates. Taxes will never, ever go away. In some ways I'm grateful for taxes because I work as a tax accountant, and I'd be out of a job if we didn't have taxes, but it also makes you reconsider where you put your investments. What if taxes in 40 years are really high and your retirement plan is only half of what it could be? On the other hand, what if the taxes are really low when you retire and you end up with a lot more than you expected? Taxes are a big reason why people diversify their retirement investments, particularly people with lots of money where taxes can really affect how much money they put in their pockets at the end of the day. Another thing to consider is the type of plan you choose to invest your 401K. You can choose a plan that invests mainly in stocks or a plan that invests mainly in bonds. Stocks are riskier, but will generate much larger returns, whereas bonds are relatively risk free and generate very tiny returns. It all depends on how you feel about risk, which is simply a personal preference.
More on retirement plans to come!
Cheers!
Ali
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