I was having a discussion with some friends the other day about retirement accounts, and I realized that there is enough confusing terminology and conflicting theories of advice, that it would be a good idea to go over some of of this stuff in detail. If you don't yet have a retirement account, or if you have one, but you don't really know what to do with it, follow me below the fold for some basic info. I'm focusing in this article on tax advantaged plans, ones that are subject to IRS regulations, because they generally provide some extra tax advantage, but keep in mind that there is nothing stopping you from putting your retirement savings into a standard savings or investment account or instrument.
Disclaimer: I am not a professional in any financial field. If you catch any errors I've made below, please correct me in the comments.
Pension Plan vs. 401K
Chances are, if you work for a large employer that offers benefits, one of these benefits is some sort of retirement plan. Large companies would traditionally offer a pension plan to their employees. Once the employee had worked a certain number of years (i.e., was fully vested in the plan) the retirement benefits were supposedly enough to ensure a fairly comfortable life after retirement. The problem with this system is that if the employee leaves before the fully vested deadline, the retirement benefits are generally a small fraction of the full benefits. In addition, there was the danger that if the company went out of business or just made bad (or even criminal) investments with the pension fund, suddenly the former employees discovered there was nothing for them in their golden years.
So congress came up with a new type of retirement account called a 401K (or 403B for educational institutions) where the plan is managed by the employer, but the employee owns the account and can take it with him if he leaves the job. Most big employers seem to offer these now and most of the time, the employee is offered a variety of funds that they can choose to invest in. The contributions are deducted directly from your employee paycheck and so this is a relatively pain free way to build your retirement savings and it is particularly attractive to employees who don't expect to spend their entire careers working for the same employer.
401Ks vs. IRAs
401Ks are great, but what if you're employer doesn't offer one? Or what if you are self employed? In that case you can open and Individual Retirement Account (IRA). Pretty much every investment institution, including banks, credit unions and brokerage houses are happy to help you set up an IRA account and anyone who earns a paycheck of any kind can do so. If, for example, you already have a pension plan or 401K at your employer, your IRA contributions may not be tax deductible, but you can still open the account and take advantage of the tax deferred gains (see below for more info).
The big benefit to all of these accounts, 401K, 403B and IRA is that they allow you to grow the account without paying any taxes before your retirement. Every time you sell an investment outside one of these accounts, you must pay a tax on the gain, but these accounts get to grow tax free. That can be a huge advantage over the years, assuming that you buy and sell different investment vehicles. If your investment strategy is to just buy a single index fund and hold it forever, these accounts may not benefit you very much and the restrictions they impose, such as tax penalties for early withdrawals, may be overly limiting. Unfortunately there is no one right answer when it comes to retirement investing and you have to decide what is best for you.
Employer Matching Contributions
This sort of employee benefit is a bit less common than it was a few years ago, but still many employers offer some level of contribution matching for your 401K deposits. For example, an employer may match 50% of your contributions up to 5% of your salary. So if you make $50,0000 a year in salary, and you contribute $500 per month to your 401K, your employer will also contribute $250 a month into your account, but only for the first 10 months of the year (capping the contribution at $2500). This is a huge benefit and you should always make sure to contribute enough to take advantage of the maximum matching they offer. To do anything less is to leave free money laying on the table.
Tax-Deferred vs. Tax-Free Gains, i.e. Traditional vs. Roth Accounts
Traditional 401K and IRA accounts (generally) allow take your contributions as a tax deduction in the year you make them, and then allow all the gains grow tax free. (Note that initial contributions are not always tax deductible, more on that below.) When you reach retirement age, and start withdrawing funds from the account, you will pay taxes on those withdrawals. At first glance, this may seem like a bad deal, since you will pay ordinary income tax rates on those withdrawals while you would only have had to pay capital gains taxes on the gains if you had kept them in a regular investment account but there are two reasons why tax deferred accounts usually are beneficial to most investors.
Firstly, while it's true that long term capital gains tax rates are lower, the fact that you didn't have to pay them at the time you made the gain means that you get the benefit of all that extra capital helping your investments grow over the years. Secondly, both your initial contribution and any interim short term gains would normally be taxed at your ordinary income rate. If you are like most people, your ordinary income tax rate when you are in your retirement years is going to be significantly less than it is when you are working and earning a full paycheck.
There is a second type of retirement account that is even more beneficial for most investors called the Roth account. There are both Roth 401Ks and Roth IRAs. Roth 401Ks are relatively new, so you may have to ask your employer if they offer them. In Roth accounts, the initial contribution is never tax deductible. If you are in a situation where that tax deduction is key to balancing your household budget, you may not be able to take advantage of these. However, if you can, you definitely should try to use the Roth type of accounts. In these accounts, your contributions not only grow tax-free, but you also do not pay taxes when you take any withdrawals. This is a huge benefit for most people. Not everyone can open a Roth account (you have to meet income limitations) but if you are eligible, and if you can afford to do without the IRA tax deduction, you should probably take advantage of these. In addition, you may want to consider converting your existing traditional accounts to Roth accounts, but there is more on that below as well.
Pre-Tax (or Tax Deductible) vs. After-Tax Contributions
As I mentioned above, most traditional 401K and IRA contributions are tax deductible. In the case of 401K contributions, they are actually made with pre-tax dollars and are so noted on your year end W-2 statement from your employer. In the case of IRAs, your contribution is subtracted from your AGI on your tax form. In either case, you don't pay taxes on the contribution, but you do pay taxes on the entire withdrawal when you make it. For Roth accounts, the initial contribution is taxed at your ordinary income rate, but all the gains grow tax free.
Some people may not qualify to make tax deductible contributions to traditional accounts, and may not meet the restrictions for contributing to Roth accounts can still make after-tax contributions to traditional accounts. This allows you to take advantage of the account's ability to grow tax free. You need to keep precise records of the contributions you have made that weren't tax deductible so that when it comes time to make withdrawals from that account you don't have to pay taxes on the entire amount, but only on the portion that was gain.
Rolling Over and Converting Accounts
As I said above, one of the benefits of 401K accounts is that if you leave your employer, you can take the account with you and convert it from your employer's control to an account that you control. This process is called rolling over your 401K into an IRA account and again, pretty much any financial institution will be happy to help you with this process.
If you have traditional IRA accounts, whether they were initially started as IRAs or whether they are rollover accounts, you may want to consider converting them to Roth accounts. When you do a conversion, you will need to pay taxes on the entire current balance of the account, so it makes sense to do this conversion now, while the account value is depressed. You must meet certain income limitations to qualify for the conversion. However, in 2010 those income limitations will be lifted. If you have IRA accounts you want to convert, that may be just the right year to do it. There are a lot of specialized issues to consider when you are trying to decide whether this conversion is right for you. I may want to devote an entire diary to this topic in the future. If this is of interest, let me know in the comments.
Contribution Limits
One of the tricky things about all of these kind of accounts is that you are limited in how much you can deposit into each of the different kinds of accounts each year. The total contribution to each account is subject to one limit while the tax deductible portion of the account is subject to a different limit. There are further limitations based on your income level both at the low end and at the high end and if you are married filing jointly, your limits will be affected by your spouse's income and employment. That said, in general if you are under the age of 50, you can contribute up to $5000 in an IRA for 2009 and if you are over the age of 50, that limit is $6000. You have until April 15, 2010 to make this contribution for 2009.
For most employees, the maximum contribution to a 401K account for 2009 is $16,500. For employees over the age of 50, this limit is $22,000. These amounts do not include your employer's matching contribution.
Choosing Your Investments
For most people, your employer or your financial institution will offer you the choice of several different funds you can choose to invest your 401K and IRA contributions. In addition, IRAs can be invested in individual stocks, bonds, or other investment vehicles. The choices can be extremely confusing for most investors. One nice investment vehicle that many institutions are now offering is a target lifecycle/retirement mutual fund. You buy into the fund that corresponds to the year you expect to retire. The fund manager then adjusts the investments to balance risk versus return that is appropriate for your age. Younger investors can tolerate more risk for the hopes of higher returns while older investors need to limit their risk, even at the cost of lower returns. The nice thing about these types of mutual funds is that there is someone whose full time job is just making these determinations. They may not always get it right, but unless you spend quite a bit of time doing your own research, they are more likely to do a better job than you.