When you start your first job, it’s overwhelming enough to have to deal with actually starting your job, you don’t really have enough mental energy to also worry about retirement – something you actually won’t do for another forty-something years. In fact, with all the acronyms and numbers and letters, it’s very easy to be discouraged, especially if you’re tired from working, and leave it for another day… then another… then another. However, if you take a few minutes to read what follows, I guarantee that everything will sort itself out quite nicely and you’ll be able to take advantage of the one resource you actually do have quite an abundance of – time (even if you don’t believe it).
In our age group, saving for retirement comes in one of two forms – IRA or 401(k). Both are easy to understand and I’ll explain them both right now.
401(k) is named after the chapter and section of the IRS Code that governs them but essentially it’s a pre-tax contribution that grows tax free and its disbursements (withdrawals) are taxed at your marginal tax rate. That means when you contribute money, you are not taxed on that money so you get a tax benefit from that; it’s as if you never made the money in the first place, but it’s put into your 401k account. When you start taking payments in retirement, that’s when that money is taxed. This allows a larger pot of money, because you aren’t taxed, to grow tax-free, which is great.
401(k) employer matching is when your employer offers to match a certain amount of your contribution and it is a very popular way for employers to offer a retirement benefit in lieu of (or in addition to) a pension. I don’t understand why employers make such complicated rules when it comes to how much they will match but if you take a few minutes, I’m certain you’ll be able to sort it out. One of my former employers said they’d match 100 cents on the dollar for the first 2% and then 50 cents on the dollar for the next 2%. Basically meant that they’d give you 3% on a contribution of 4% of your salary, though they couched it in language that made it sound so complicated.
401(k) vesting schedule is an explanation of how long it takes for your employer’s match to actually be yours. If it vests immediately, then that means the matching funds they put in is yours immediately – even if you left tomorrow. This is often too good to be true and companies often have a schedule where it vests over a course of X years, such as 3 or 5. If it vests over 5 years, that means you get to keep 20% of the total match if you leave after a year, 40% after two years, etc… until 5 years, then it’s all yours. It’s usually not a rolling schedule, so it’s not like Year 1’s funds are fully vested in Year 5 but Year 2’s are not – the vesting treats the whole block of matching funds as one.
IRAs are separate from 401(k)’s and they’re also very valuable retirement vehicles. IRAs generally come in two forms – Traditional and Roth. The Traditional IRAs are very similar to 401(k)’s and how they can be used depends on whether or not your employer even offers a 401(k).
Roth IRAs are creatures you have to become knowledgeable about because they are extreme powerful for young folks. The Roth IRA is a retirement account that takes post-tax contributions whose funds grow tax free and are not taxed when you take disbursements. That is, you do not get a tax deduction when you contribute to a Roth IRA, but you also are not taxed when you make withdrawals in retirement. That’s right… it grows tax free and you get the funds tax free, you get the tax benefit on the back end instead of the front end. It’s a great way to diversify your tax profile, especially with the uncertainty of taxes in the future. The only downside of the Roth IRA is that you are limited to a contribution of $4,000 (in 2007) and perhaps even less depending on income.
That’s it… understanding 401(k)’s and Roth IRAs and taking advantage of both will give you a significant leg up on your peers when it comes to retirement planning. As for what you want to select in those funds, that’s for you to decide, but I use index or target retirement funds, and outside the scope of this article. See how easy it was? Not complicated at all! Go forth and prepare yourself for retirement!