(cut-n-paste of an old HTML FAQ on the subject)
Retirement
How do I start saving for retirement?
There are two major tax-advantaged ways to save for retirement: employer sponsored plans such as a 401k (private employers) or 403b (public employers like schools) and Individual Retirement Accounts (IRA). The numbered names may look funky but they are named after the IRS codes that established them. Employer sponsored plans are only available through your employer and only if your employer offers one. Anyone can open an IRA as long as he/she meets the IRS criteria for contributing to an IRA. Although there are other ways to save for retirement, these are the two places to start.
Note that neither of these options is actually an investment. Rather, they are containers for investments. Think of them as a lady's purse. A woman does not use her purse to buy things and unless she has a handbag fetish the purse isn't worth a whole lot, but the purse is a container for her cash and credit cards, which are very valuable. Likewise, a 401k and IRA are value-less containers that hold investments (mutual funds, stocks, bonds, etc) and provide tax advantages to any investments held within them. Although people commonly refer to "investing in a 401k" they are not actually investing in a 401k. They are investing in shares of a mutual fund, for example, inside the 401k.
How do I contribute to a 401k?
Through your employer. You will specify how much of your paycheck you want to contribute (usually as a percentage) each pay period at the time you sign up. You can always change the amount later. The designated amount is then taken out of your pay before taxes are calculated. This is called pre-tax money; you have not paid any income taxes on the money in your 401k (or 403b). This lowers your tax liability in the tax years in which you contribute.
That's great. So when do I pay taxes on the money in my 401k?
When you withdraw money from the 401k in your retirement years, distributions received from your 401k account are taxed in the year you receive them and at the tax bracket in which you find yourself at that time, not the tax bracket you were in when you put the money into the account.
What does it mean when my employer says they "match" my 401k?
Many employers encourage you to contribute to the company 401k by offering to match a portion of your contributions. For example, your employer matches 50% of your contributions up to 6% of your salary. (This is a fairly common match amount although some employers will match 100% or may only match up to 4%. It varies by employer.) Your gross pay per period is $2,000 and you contribute 6% to the 401k. That is $120. Your employer matches half of that and contributes $60 on your behalf. That is an immediate 50% return on your $120 investment. If your employer matches, do not pass that up.
Please note that if you contribute more than the 6%, your employer will only match the 6%, or the $60 in this example. There are IRS limits to how much you can contribute to a 401k so make sure that you are not contributing too much above the match early in the year so that you render yourself ineligible to contribute later in the year and thus miss out on a portion of the match.
What does it mean when my employer talks about how I am "vested" in the 401k?
Vested refers to how much claim you have to the portion contributed by the employer to your 401k on your behalf. As an incentive for employees to stay with the company, the company may lay out a vesting schedule for milestones at which you increase your claim to the company match. An example may be:
Until one year of service, you are 0% vested. This means you have no claim to any amount of the company match if you leave before one year of service.
After one year of service, you are vested in 25% of the company match. If you leave after one year of service, you will only be able to take 25% of the company's matching contributions with you.
After two years of service, you are 50% vested. At this point, you would be able to take half the matching contributions with you when you leave.
After three years of service, you are 75% vested.
After four years of service, you are 100% vested. If you leave after four years, you can take all the matching contributions made by the employer with you.
What types of IRAs exist?
There are several types of IRAs and I can't cover them all here. The two basic types of IRAs that are available to almost everyone (subject to income limitations, which I'll explain later) are Traditional IRAs and Roth IRAs. (Trivia: Traditional IRAs used to be simply called IRAs until the creation of other IRAs, such as the Roth IRA, which was created in 1997 and named after Senator William Roth who created the IRA bearing his name.)
A Traditional IRA is funded with pre-tax money, much like a 401k or 403b. The contributions do not come out of your paycheck, however. You will contribute money on your own to your IRA and then take a tax deduction on your tax return the following April, which makes it pre-tax money. Distributions from a Traditional IRA are taxed in retirement like a 401k.
A Roth IRA is funded with after-tax money, unlike a 401k or 403b. You will contribute money on your own to your IRA but you do not get the tax deduction if you contribute to a Roth IRA. The tax-advantage here is that your distributions from the Roth IRA are completely tax free, provided you are at least 59.5 years of age and the account has been open for a minimum of 5 years. If you are younger than 59.5 or the account is younger than 5, you may always withdraw your contributions free of tax or penalty but the earnings must remain in the account until those two conditions are met.
What are the limits to contributing to a Traditional or Roth IRA?
First you must qualify to make contributions to a Traditional or Roth IRA. You must have taxable income during the year. For a Traditional IRA, you must be younger than 70.5 years of age and you will only qualify for the tax deduction if you make less than the modified adjusted gross income (MAGI) limit defined by the IRS for each tax year. For a Roth IRA, you may not contribute at all if you make more then the MAGI limit.
If you qualify, you are then limited to how much you can contribute to an IRA in any given tax year. For the purposes of IRA contributions, the tax year runs from January 1 to April 15 (or the designated tax day which may fall on the 16th or 17th) of the following year. At the time of this writing (2006), the limit for IRA contributions per person is $4,000 per tax year. The contribution limit applies to all IRA accounts of all types in an individual's name. You can contribute to multiple different IRA accounts during the year but the total contributions across all accounts may not exceed the annual limit.
Do I have to choose between a 401k and IRA?
Absolutely not. You can have both types of accounts open at the same time and you may contribute to both in the same year.
What if I don't have money for both a 401k and IRA? How do I choose?
The general rule is to contribute to your 401k up to the point where you max out the employer's match first. If that is 6%, contribute 6%. No more for now. If you have more money you would like to contribute to retirement savings, you then contribute to an IRA, preferably a Roth IRA if you qualify. If you are maxing out the IRA and still have money left to invest for retirement, go back to the 401k and contribute above the amount of the match but of course not more than the annual IRS limit. If you still have even more money to invest after you max the 401k, that is beyond the scope of this FAQ. Post separately or seek advice from a good financial adviser.
Which is better: Traditional IRA or Roth IRA?
Both have advantages; however, if you're young you'll probably see more benefits from the Roth IRA. There is a very real possibility that tax brackets will go up in the future (by the time you retire) so paying taxes now when you are young and probably not in a very high tax bracket (after all, you can't be in a high tax bracket if you qualify for the Roth to begin with) is better than leaving it to chance on what tax brackets will be and how much money you'll have when you retire.
In addition to when you pay taxes, Roth IRAs have other advantages. Your contributions (the money you put in) are always accessible to you. You can withdraw it at any time without penalty or tax. Although you shouldn't do this unless you really need the money, it is nice to have this option in the event of an emergency. Getting money from a 401k or Traditional IRA before retirement age is limited to certain situations and is almost always a ripoff.
Also while a Traditional IRA mandates Required Minimum Distributions, in other words you must begin withdrawing money from a Traditional IRA at age 70.5, a Roth IRA does not require this. If you get to retirement and do not need the money in your Roth IRA (maybe you have money from other sources), you are not required to ever withdraw money from the Roth during your lifetime. You can pass the account to your heirs untouched. You may also continue contributing to the Roth IRA if you still qualify after age 70.5, unlike a Traditional IRA.
Where do I open an IRA?
At an investment firm. Or a bank, but I don't recommend opening an IRA at a bank. Some popular firms with good service and low fees are, in no particular order: Charles Schwab, Muriel Siebert, Fidelity, TD Ameritrade, Vanguard, T Rowe Price, and Etrade.
Keep in mind that an IRA is, itself, not an investment; it is merely a container for investments. Pick a company that offers the investments you want to invest in. Most of these companies offer many of the same funds so your choice may come down to minimum opening balances or annual maintenance fees. Annual maintenance fees are somewhat common and usually very small, but vary by company, and they are acceptable. What is not acceptable (in my opinion) are loaded mutual funds that charge you simply to buy and sell them. Avoid "A share" and "B share" funds; these are loaded funds.
Annual fees will often be waived if you have an account balance over a certain amount. All the more incentive to save.
My employer says I can take a loan from my 401k if I need the money before retirement. Should I do this?
Absolutely not! Taking a loan from a 401k is one of the biggest mistakes you can make with money. Remember your 401k is funded with pre-tax money. When you repay the loan, you are paying it back with post-tax money. Now when you retire and take distributions from the 401k, guess what.. you get to pay taxes all over again on the money you used to repay the loan and on which you've already paid taxes. Most people don't like paying taxes once, let alone twice!
Also another thing to keep in mind is that if you terminate employment with the company for any reason (you leave, get fired, get downsized, etc) while you have an outstanding 401k loan, the full balance of the loan is due IN FULL within 30 days of your departure from the company. If you do not repay the loan within that period, the outstanding balance will be taxed and penalized as an early withdrawal which means you will pay a 10% penalty and have to claim the balance as income on that year's tax return (thus owing taxes on it).
What do I do with a 401k account when I leave an employer?
If you have a large amount of money in the account, you may be allowed to leave it with the employer. If you have a smaller amount, you'll probably have to move it or they'll force a cash-out. The only bad option is cashing-out because it's treated as an early withdrawal and will be both taxed and penalized.
The best option is usually a rollover. There are two types of rollovers: indirect and direct. An indirect rollover (often called simply a "rollover") means the 401k plan administrator gives you the money and then you have 60 days to invest that money in a qualifying retirement plan (such as a traditional/rollover IRA or the 401k plan of a new employer) without owing tax or penalty. If you don't complete the rollover in 60 days, you will be taxed and penalized for an early withdrawal.
The preferred method of rolling over funds is a direct rollover (also called a "trustee-to-trustee transfer"). This means the 401k plan administrator cuts a check for your assets that is directly payable to the new qualifying retirement plan. For example, you open a rollover IRA at Vanguard and tell your employer you wish to roll over your 401k to the Vanguard IRA. The plan administrator cuts a check payable to "Vanguard FBO (for the benefit of) Your Name Here" and then either sends it directly to Vanguard or mails it to you and you send it to Vanguard. You can usually do this entire process online or by telephone and it is very easy. Even if they send the check to you, it is a direct rollover as long as the check is not payable to you.
Can IRAs be converted between types?
You have never paid taxes on money in a Traditional IRA so you can convert a Traditional IRA to a Roth IRA by paying taxes on it. You must be eligible to make Roth IRA contributions to do this but it does not count toward your annual contribution limit. If you make $50,000/yr that is all taxable and you wish to convert a Traditional IRA worth $10,000 to a Roth IRA, you will end up claiming $60,000 in taxable income for the tax year in which you convert.
Be careful when converting. Since the converted amount counts as income, you could potentially render yourself ineligible to contribute to a Roth IRA by converting a large amount at once. It could also bump you into a higher tax bracket. If you're contributing a large sum, it's best to break it up and convert smaller amounts each year over a period of several years.
