It is easy to get confused about retirement planning, but it’s important to get started, especially if your company offers a 401(k) matching program.
The differences between retirement plans:
401(k) and 403(b) are both employer-sponsored retirement accounts. The 401(k) is offered by companies that are for-profit and the 403(b) is offered by educational institutions and some non-profits. Most of these plans are traditional and tax-deferred, but occasionally a company will offer a Roth 401(k).
Individual Retirement Accounts (IRAs) come in two flavors – traditional and Roth. IRAs are opened by an individual through a brokerage firm such as Schwab or TD Ameritrade.
In an IRA, there are many more options for investments and many of them are lower cost than what’s offered through an employer-sponsored plan. That being said, many employers offer some sort of matching of what you deposit into the account.
If your employer offers some sort of matching you MUST take advantage of this. If you’re not, you’re passing up free money.
Traditional vs. Roth: Traditional retirement accounts are what are known as tax-deferred. This means you invest money in the account before taxes, but when you withdraw the funds upon retirement you pay income taxes at your future tax rate.
Roth plans are the opposite. You pay taxes on the income today but do not pay taxes in the future when you withdraw.
If you withdraw from any of these accounts before the age of 59 1/2 you will pay a penalty on the withdrawal of 10% plus income tax on the funds withdrawn.
When it comes to deciding on whether to pay off debt or investing in a retirement account, if your debt is low-cost (5% or so), it typically makes sense to invest and continue to pay off loans over time while investing as well.
If your debt is credit card debt in the 12% to 18% range, most planners recommend paying off the debt as quickly as possible and investing at a later point.
It is important to think about the emotional benefit of beginning to save for the future. For some, even though it makes more sense to pay off the High rate credit card, it may be more important to put away money for their future.
When it comes to planning your financial future in retirement many financial planners assume that your expenses will be about 75% of what they are right before retirement. I believe it makes more sense to assume that you are going to spend about the same amount in retirement that you were spending right before retiring. The tricky thing to think about is what the impact of income taxes will be. On the one hand, in retirement you will no longer have income in the traditional sense of income coming from a job. On the other hand, you will have income coming from your retirement plans. If these plans are traditional, tax deferred plans, you will have income tax that is based on what you are withdrawing from your investments.
Retirement planning often fails people a when they approach retirement investments by simply putting as much money in ways they can without thinking about how much they will need. One of the most important elements in financial planning is trying to figure out what the appropriate rate of return should be on your investments. For example, a couple that puts away $20,000 a year in retirement plans but invests in investments that pay either too low of a return or take too much risk may not have as much money as a similar couple would have by investing $15,000 a year in investments that are well suited for their goals.
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