Saving & Investing for Retirement
In another article I wrote about the importance of saving. Some of the things we talked about saving for was to build an emergency fund, to buy a new car, and for the down payment on a house. The only thing that I deferred discussing was saving for retirement. Here is that discussion.
Good-bye Company Pension, Hello Do-It-Yourself
At one time, workers in many industries in America had a pension plan at their place of work. Employees would work for thirty or forty years for one employer and when they turned 65 they would get a gold watch and a generous pension for life. Sometimes all their health insurance was covered as well.
Those pension plans were called Defined-Benefit Plans because the monthly income the pensioner was promised was known in advance and guaranteed. Company pension plans invested pension funds in bonds or stocks and used investment gains to meet their obligations to the pensioners. Even if the market had poor returns, the company stood behind the pension funds.
There was the rub. A company is taking on a lot of risk with their promise to pay pensions. If investment gains don’t materialize, they are in trouble. So American companies have been phasing out Defined-Benefit Plans for the past two decades.
Today the only workers that still have good defined-benefit plans are government workers–state, local and federal. If I could do one thing over in my life it would be to get a government job. Because nowadays, most companies have shifted the burden of saving and investing for retirement to the workers.
These retirement plans that make the employee responsible for her own retirement are called Defined-Contribution Plans because only the amount you contribute is defined. There is no promised payout or guaranteed monthly payment at the end. The risk that investment gains won’t be realized has been placed on the shoulders of the workers. Each worker is responsible of saving and investing for his own retirement.
Most people will save for retire using three kinds of accounts.
1. Company 401(k) Plans
The most common Defined-Contribution Plan is the 401(k). (Don’t ask me why it’s called a 401(k), that’s a long story for another day.) This is a tax-deferred plan which means that you can put money into your 401(k) account before Uncle Sam takes out taxes. And your money grows tax free until you start withdrawing it many years later.
Many companies provide matching funds for your 401(k). So this is really free money. You should fund your 401(k) before other investment accounts. Make sure that you contribute to your 401(k) so that you get the company match.
2. Individual Retirement Accounts (IRAs)
This is a second tax-deferred plan for retirement savings. There are actually two kind of IRAs, the Traditional IRA and the Roth IRA. With a Tradional IRA, you contribute before-tax money and taxes are deferred until you start making withdrawals in your old age. With a Roth IRA, you contributions after-tax money, but then your money grows tax-free and you never pay taxes on it ever, even when making withdrawals. Most people would be better off using a Roth IRA.
3. Taxable Accounts
The third investment account would be an ordinary taxable account. You open an account at a brokerage firm or mutual fund family and fund it with your after-tax savings. You must pay the IRS taxes on investment gains in a taxable account every year.
To save enough for retirement, you must use all three: 401(k), IRA and a taxable account. Max out your contributions to your 401(k) first. Then contribute to your Roth IRA up to the limit. Any extra money that you have laying around you can add to your taxable account. (Like we all have extra money laying around the house. Check you sofa cushions!)
When To Start Saving for Retirement
When should you start saving for retirement? From your very first paycheck. When you are hired and going through orientation, make sure you get enrolled in the company’s 401(k) plan so that you get the company matching funds. Your 401(k) contribution will get deducted from you paycheck each pay period so you’ll never miss it. Automatic savings at work!
You may find some of these books useful to understand IRAs, 401(k) plans and other retirement plans.