When starting a new job, sorting through benefits packages–can be one of the more challenging parts of the first week. Like health care or life insurance, many retirement plans are complicated to understand and easy to ignore. But skipping the retirement enrollment can cost you thousands or more in future assets.
For many of us, and especially for 20-somethings, retirement feels like a long way away. And it is tempting to ignore or file away the package of retirement plans with a new job. Maybe you’re thinking “I’ll get to it someday soon.” Or “I’ll start putting money aside for retirement when I’m making more money.” But waiting could leave money on the table unclaimed, instead of working for you for the next several decades.
In this post, I’ll explain the basics of employer-based (e.g., 401k) and individual (IRA) retirement plans work. I’ll also discuss how you can get started saving and investing for a secure retirement. And by the end, you’ll have the tools to start or increase contributions to your plan.
Related: Six Powerful Steps to Level Up Your Personal Finances After College
(This post is written for informational and educational purposes and is not professional financial advice. If you are looking for advice suited to your particular situation, seek out a financial professional such as a certified financial planner or CPA).
Table of Contents
How did we get to this system?
Fifty years ago, most employers offered pension programs as their primary retirement benefit. When you retired after working in a company, you would receive a monthly pension benefit. This plan was based on your years of work and previous salary. These were also known as Defined Benefit Plans–the amount of money you would get each year was set by a formula and predictable.
Pensions have primarily left the job scene, except for some (mostly government) employers. Where they do exist, pensions are usually meant to be just a part of your support in retirement. Pensions declined for a few reasons:
- They are expensive for companies to run. And they rely on the employer to stay in business and fully fund its pension program well into the future.
- Employees are less likely to spend 20 or 30 years with a single company. This means that retirement programs based on a single employer are not an excellent solution for many workers.
401ks and 403bs and TSPs, oh my!
In place of pensions, most employers shifted to offering a type of retirement account called defined contribution plans. An employee makes contributions to a tax-advantaged retirement account that is then invested in stocks, bonds, or other assets.
Defined contribution plans are commonly known as 401k plans at most employers. But they could instead be 403b plans for nonprofits or 457 programs for some teachers or law enforcement officers. The Thrift Savings Plan (TSP) is the equivalent for military service members and other federal employees. The different names mostly come from different parts of the IRS tax code that govern them, but they are mainly equivalent for the sake of this post. So we’ll use the term 401k.
These programs provide a way for employers to offer retirement investment accounts that employees (and sometimes employers) pay into.
401k plans generally work like this:
- Your employer selects one or more companies to administer a 401k for its employees.
- Employees sign up to participate in the plan.
- Employees select an amount that they want to contribute to their retirement account for each paycheck, up to a total annual limit. ( In a traditional 401k plan, these contributions are tax-deductible, lowering your overall income tax burden.
- Employees select the investment profile they are interested in, among the options offered by the plan. These could range from all cash or money market (almost no opportunity to grow) to all stocks (high growth, but higher risk in the short term).
- Many employers will also match employee contributions up to a certain amount (remember this).
What about IRAs?
An IRA is an individual retirement account that is not tied to a job. There are a few main differences between IRAs and 401ks.
- Availability. Some jobs (whether with small employers or for freelance or contract work) don’t offer 401ks. For employees in these situations, the IRA is essential as a tax-advantaged account.
- Investment limit: As long as you don’t make more than the salary limitations (which, as of 2021, are $125,000 for a single tax filer), a single tax filer can contribute up to $6,000 for the year. This is lower than the $19,500 limit for a 401K, but it offers…
- Choice and flexibility: Many different types of financial institutions offer IRA accounts. (Here’s NerdWallet’s list of the top IRAs for July 2021). The options for how to invest your IRA funds can vary widely. Meanwhile, for 401k programs, you must choose among the limited options provided by your employer.
401ks and IRAs are not mutually exclusive. If you fall within the income limits for an IRA, you have the option to contribute to one or both, up to their respective contribution limits.
What is Roth?
IRAs (and some 401ks) come in two flavors, traditional or Roth. Both account types offer tax benefits, but they differ in when those advantages come into play.
Contributions to a traditional IRA are tax-deductible. This means that any amount you pay into your IRA will be deducted from your adjusted gross income (AGI) when you file your taxes for the year, lowering your tax bill. While the funds stay in your account over the next years or decades, you won’t have to pay taxes on any dividends or growth in your investments. However, when you begin to withdraw from a traditional IRA (usually after age 59 ½), any amounts you withdraw be taxed as regular income.
Contributions to a Roth are called “post-tax” contributions. This means that you will not get a deduction on this year’s taxes for money you put into a Roth IRA. However, you won’t be responsible for federal income taxes on any future investment gains or dividends, as long you claim them after age 59-1/2.
So what does this mean for me?
At this point, you may be asking yourself, “if retirement is 40 or 50 years away, why should I contribute now, when I’m making a lower salary, aiming to pay bills or student loans?”
I want to discuss three reasons why it’s key to think about retirement savings now. Company matches, the magic of compound interest, and the gift of automation.
Reason 1: earning and getting a company match
While you can individually fund a 401K up to $19,500 in a year, your employer may also contribute to your 401k account, essentially providing a tax-free addition to your salary. In most 401k plans, the employer contributions are made as matching gifts. For example, for every 1% of your salary that you contribute to your 401k account, your employer may provide a matching 1% of your salary to your account, up to a total of 5% of your salary. This represents free money that you wouldn’t receive if you don’t contribute to your 401k. And unlike your salary, employer contributions to your 401k are not considered taxable income, so they are not taxed.
One note of caution–depending on your company, you may see what is called a vesting schedule for your employer’s contributions. This means that if you leave a company before a certain time (commonly 1 or 3 years), you won’t be able to keep the full amount of the company match. That said, your employee contributions will be available in your account, regardless of how long you have worked theres
Takeaway: If your company offers a match and you don’t contribute enough to get that match, you’re leaving free money on the table.
Reason 2: the magic of compound interest
Put simply, compound interest is “interest earned on your interest.” And it can definitely add up. This video from TD Ameritrade does a good job of showing how:
Want to know how compound interest can work for you? Try inputting some possible figures into a compound interest calculator, such as this one at Investor.gov. Or check out this example:
- Sarah invests $500 a month for 10 years (from age 22-32) in her retirement accounts, then stops making contributions for the rest of her career. If the money grows at a 7% annual rate, the $60,000 she invested will be worth almost $500,000 by age 67.
- Meanwhile, Aidan skips investing in retirement in his 20s, thinking he’ll make more in the future. At 32, he’s ready to start contributing to retirement. With the same 7% interest rate, he would need to contribute over $600 every month for 25 years–a total of about $183K–to reach the same $500,000 total.
Takeaway: Money invested in your 20s has the potential to grow far more significantly than money invested in your 30s or 40s.
Reason 3: the gift of automation
One great thing about an employer-sponsored retirement plan is that the money goes into your retirement account automatically. It never enters your checking account, so you will not consider it as money that could otherwise be spent.
Want to supercharge the benefits of automation? Each time you get a raise, use a portion of that raise amount (maybe 50%?) to increase the amount that you are sending to your retirement account. You’ll still see a larger paycheck, and you’ll be improving your future financial security at the same time.
Takeaway: Automated investment allows your savings to grow regularly, rather than just when you have the conscious thought and willpower to save.
Okay, I’m sold on contributing to retirement. What should I do now?
How to set up your 401k/403b/TSP retirement account:
- Choose your plan provider: Some employers offer only one plan. Other employers offer a choice among different 401k or 403b providers. It’s worth researching what’s available at your company. There are several “discount” brokerage companies that offer retirement plans that provide lower administrative or account management fees (such as Vanguard, Fidelity, or Charles Schwab).
- Fill out and submit the necessary paperwork with your HR department. This step will enroll you in the retirement plan, and let you select an amount to be withheld from each paycheck and deposited into your retirement plan.
- Log onto the website of your retirement plan provider and select an investment portfolio. Your options will be limited to those offered by the retirement plan, but will likely include a range of actively-managed mutual funds, index funds, and/or target date funds. (Not sure what those are? Investopedia provides a good breakdown). Many individuals choose a target date fund to get started quickly. As you learn more about investing, you may decide to shift your allocations in the future.
How to set up an IRA:
- Choose a company to open your IRA, and how you want your money invested: you have many options of where to open an account. These include brokerage companies that allow you to choose from any publicly traded stock or index fund. They also include robo-advisors, such as Wealthfront, Betterment, or M1 Finance, which will invest funds automatically, based on some profile questions you ask.
- Make a deposit or set up recurring deposits. Recurring transfers from your checking account can be made to line up with your paydays.
Takeaways
Congratulations! You’ve made it to the end of this post and hopefully now know more about how retirement accounts work. Before you close this window, put an appointment on your calendar to explore through your employer’s offerings and set up a 401k or IRA plan. Or if you already contribute to retirement, make sure that your contributions are being invested effectively.
Further Reading:
- CNN Money offers a retirement age calculator to help you determine your allocation between stocks, bonds, and other assets.
- JL Collins’s “Stock Series” blog posts make a compelling case for investing your retirement funds in a total stock market index fund for most of your working years. He revisits the argument in his book, “The Simple Path to Wealth.” Partly as a result of Collins’s writing, many people in the Financial Independence community will sing the praises of a VTSAX-only investing strategy.
- For federal employees, Government Worker FI offers a ton of great resources on how the federal retirement system (including the TSP program) works.
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