Retirement investing

I. 401k

401k is a type of employer-sponsored retirement plan that allows you to invest part of your income pre-tax. While your money is in your 401k plan, you never pay any tax on it, even if you sell funds in the course of reshuffling your portfolio, until you start drawing from it in your 60s and 70s and beyond. These tax advantages are absolutely huge. 401k is generally not something any employee should pass up.

“I don’t particulate in 401k because I don’t care…” Here is why you should care: A recent college graduate who manages to amass $20,000 in their 401k can expect to wait ~40 years before they can withdraw from it. Assuming the market returns 10% each year on average, that $20,000 will multiply 50 times in those 40 years. People should start saving for retirement as soon as they start their first job because it has never been so easy to make one million dollars! (This is a fairly common calculation you can arrive using a compound interest formula with 10% as the interest.)

You also benefit in that you can subtract your total 401k contribution from your income tax, thereby lowering your tax bracket. If your salary is $60,000 and you contribute $10,000 to your 401k, you only pay tax on $50,000!

And if you are the type of person who keeps your savings in a saving account, then chances are that taxes and inflation will have eaten away any interest rate gains you make from your savings. Take a moment to figure out how much money you can put into your 401k and how much you need in your savings/checking account to get by, and if you still have surplus after you’ve maxed out your 401k, consider investing your money in a brokerage account (or your house if you own one).

“I don’t particulate in 401k because I can do better on my own…” I was surprised when I found that a friend of mine thought that he could do the same or better investing money from his savings account in the stock market than by participating in 401k. This is not the case because of 401k’s extreme tax benefits.

Let’s say that the stock market returns 10% per year regardless of whether you invest it yourself or through 401k. You end up with the same amount of disposable income at retirement either way; the only difference is that you pay income taxes on payday for personal investment versus at retirement for 401k. But chances are you will do far worse because:

1. unless you never sell a stock or fund, you will pay taxes on each sale, whereas 401k protects you from the taxes you would otherwise pay when you reshuffle your portfolio.
2. you will have to pay expensive trade commissions every step of the way, whereas 401k essentially makes it free to buy more stocks/funds on each payday.
3. you would otherwise be tempted to touch that money you had supposed set aside for retirement, whereas 401k makes it prohibitively disadvantageous to take out that money. Imagine filling out your children’s college financial aid forms and having to disclose that large sum of money supposedly “set aside for retirement.” That won’t fly – they will simply expect you to fork over that money to pay for your children’s tuition, and then next thing you know: money gone!
4. you don’t even get the benefit of lowering your tax bracket by contributing to 401k each year you work.

In short, 401k investing is AWESOME. To anyone with access to a 401k plan and is living within their means but does not contribute to 401k, I would cajole them, ridicule them, call them all variations of stupid if it were my business. That’s because it is utterly irresponsible to think that it is anyone’s responsibility than your own to support yourself in your retirement, and equally irresponsibility to behave as if it were by not investing. This is especially true for young people for whom time benefits the most because they have the longest investment horizons before retirement.

“What’s this Annual Contribution Cap…?” You can contribute up to $15,500 in 2008. This limit applies even if you change jobs in the middle of the year

I personally contribute the maximum amount to my 401k each year and I strongly encourage anyone who can to do the same. Again, the benefits are that it lowers my tax bracket and that the little bit of money I contribute now will grow to huge sum when I retire.  This IRS website has updated info on contribution caps.
“My employer matches my 401k contributions…” Lucky you. That’s free money. You should of course take it.

“I wish I could contribute to 401k, but I don’t have access to one…” If this is the case, it is probably because you work at a non-profit or for yourself. There are some retirement investment options including the IRA (individual retirement account) and the Roth IRA.

II. IRA and Roth IRA

IRAs actually work very similarly to 401k in ideal situations in that your contributions are tax-deductible (ie they lower your taxable income) and you don’t pay tax on them until you withdraw from the account. Apparently, there are times when this is not the case, and the maximum annual contribution is much lower than 401k ($4,000 in 2007). I don’t have any experience with these, so just look online – there are lot of sites that explain the IRA or compare it to 401k.

Roth IRAs are far superior to plain old IRAs, I think, for people who are in a position to choose between the two (by lacking a 401k option). When you contribute to a Roth IRA, your contributes are post-tax, so you have already paid the income on them, but when you withdraw from your Roth IRA at retirement you never have to pay any more taxes on them. This is extremely advantageous if your current tax rate is fairly low because you might otherwise be paying a higher tax rate when you are retired. (The money retirees receive from their investment accounts and other sources are still taxed as income.) This is the perfect retirement option for people making less than a yuppie wage! As with the traditional IRA, the annual contribution cap was $4,000 in 2007.

If I were in a situation to choose between IRA or Roth IRA, I would choose the latter. Actually, I both max out my 401k and contribute to my Roth IRA. Here is a comparison between the two retirement options.

“I want to withdraw from my retirement account…” Don’t do it, you idiot. It is intentional that it is prohibitively expensive for you to withdraw your retirement money before you retire.

III. Roth 401k

Some companies offer Roth 401k plans to their employees. That seems like a very interesting opportunity to invest in retirement. It seems like it is basically a Roth IRA with the annual contribution cap of a 401k – ie the perfect option for someone who wishes the Roth IRA contribution cap were higher than $4K in 2007.