by Erin Lowry
$7,400
$39,900
$88,600
$148,100
$220,800
$350,300
$610,800
$999,300
$7,800
$650
$8,000
$43,200
$96,000
$160,500
$239,200
$379,400
$661,700
$1,082,500
$8,400
$700
$8,600
$46,600
$103,400
$172,800
$257,600
$408,600
$712,600
$1,165,800
$9,000
$750
$9,200
$49,900
$11,080
$185,200
$276,000
$437,800
$763,500
$1,249,100
$9,600
$800
$9,800
$53,200
$11,8200
$197,500
$294,400
$467,000
$814,400
$1,332,400
$10,200
$850
$10,400
$56,500
$12,560
$209,900
$312,800
$496,200
$865,300
$1,415,600
$10,800
$900
$11,000
$59,900
$133,000
$222,200
$331,200
$525,400
$916,200
$1,498,900
$11,400
$950
$11,700
$63,200
$140,400
$234,600
$349,600
$554,600
$967,100
$1,582,200
$12,000
$1,000
$12,300
$66,500
$147,700
$246,900
$368,000
$583,800
$1,018,000
$1,665,400
Table courtesy of Vanguard.
Compound interest. She’s a beautiful, beautiful thing—when she’s on your side. She’s a real bitch when it comes to paying off debt.
SETTING UP YOUR FIRST RETIREMENT PLAN
A 401(k), 403(b), or IRA is often a person’s first experience with investing. But just figuring out how to pick investments in a 401(k) can be dizzying, as I mentioned in my own experience. The paradox of choice can leave you frozen, akin to logging in to Netflix with the intention of finding a new show to watch and then defaulting to that same series you’ve watched all the way through at least four times.
Colleen Jaconetti, CFP®, a senior investment analyst for Vanguard Investment Strategy Group, explains the three simple steps you should take when setting up your first retirement plan:
Step One: Decide how much you want to save.
“At least try to save up to the point where you get the employer match,” advises Jaconetti.
Step Two: Decide what types of investments you want.
“It’s important to know what your time horizon is. Young folks will probably have a much longer time horizon, and generally speaking, the longer your time horizon, the more likely you can incur some kind of risk. Obviously, it’s a personal decision, and people need to gauge their comfort with risk,” says Jaconetti.
“I would recommend, if possible, for people to consider an all-in-one fund. They could have a balance of stocks and bonds, or some funds (like lifecycle funds) that would get more conservative through time. Those funds also rebalance themselves, so an important thing when you’re figuring out what asset allocation you’re comfortable with is sticking to that allocation through time. Generally, we would say people have to rebalance, but if you pick an all-in-one fund, you wouldn’t have to worry about rebalancing. The fund would do it for you. If you pick a fund that becomes more conservative through time, then you don’t have to consider when you want to become more conservative.”
I should jump in here and mention that some financial advisors rail against the all-in-one fund (also known as the target-date fund). Historically, target-date funds have come with higher fees than when building your own portfolio, and in some cases, investors could find themselves invested at a risk level that doesn’t align with their tolerance when nearing retirement. While the criticisms are all fair, the advantage of a target-date (aka all-in-one) fund is that it gets you started. It removes the overwhelming paradox of choice and makes sure your retirement money is invested in a manner that’s somewhat aligned with your time horizon. Besides, you can always jump back into your portfolio in the future and rebalance or build your own once you’re more confident in picking your own investments.
Step Three: Consider the costs of the funds.
“It’s important to consider cost. It’s not the most important factor, but it is a significant factor to figure out over the long term that every dollar you pay in fees is a dollar less you have for yourself or for future growth,” says Jaconetti. “Some funds can charge higher fees, which just eats into the amount you have in retirement.”
In chapter 6, we’ll give a more comprehensive overview of fees, how to understand them, and the impact they have on your portfolio.
Now that you’re convinced you must contribute to a retirement plan (or you’re feeling smug about your decision to already do so), let’s chat about those retirement-specific terms you should know that I promised to overview in chapter 2.
RETIREMENT TERMS YOU NEED TO KNOW
401(K) AND 403(B): Both 401(k)s and 403(b)s are retirement savings plans, typically offered by an employer, but 401(k)s are offered by for-profit companies and 403(b)s by nonprofits. Your company may offer only a traditional 401(k) or 403(b), but some, like my former employer, offer a Roth option as well.
TRADITIONAL: Investing with pre-tax dollars up to the annual limit. You have the potential to lower your taxable liability today by contributing to a traditional retirement plan.
ROTH: Investing with post-tax dollars up to the annual limit. The Roth 401(k) doesn’t give you a tax advantage today, but you do get to withdraw the money tax-free in retirement.
You can generally invest in mutual funds, index funds, ETFs, company stock, bonds, and other forms of investments in your 401(k) or 403(b). Employers sometimes contribute to an employee’s retirement plan, known as an employer match. You usually are required to contribute to the plan yourself in order to get the match from your employer.
EMPLOYER MATCH: One of the few terms that is just exactly like it sounds. Your employer puts money into your retirement plan, matching your contribution up to a certain percentage, but usually on the contingency that you contribute as well. For example: “We match you 100 percent up to 4 percent.”
Say Hillary earns $40,000. In order to get her full 4 percent employer match, she must contribute at least 4 percent of her salary into her 401(k). That means she puts $61.54 per biweekly paycheck into her 401(k), and so does her employer. Hillary saves $1,600 a year in her 401(k) and receives an additional $1,600 from her employer, for a total of $3,200.
This is why you’ll hear that failing to take advantage of an employer match is like leaving free money on the table.
VESTING SCHEDULE: Alas, sometimes an employer adds in fine print that the match will be subject to a vesting schedule. A vesting schedule determines when you’ll actually be able to walk away with the money your employer is putting in your retirement account. Keep in mind that you get to keep the money you’re putting in. The vesting schedule applies to the contributions your employer is making. There are three main types of vesting schedules:
Immediate: This is the ideal vesting schedule, which also makes it less common. The money is yours as soon as your employer matches your contribution. You could work there for three months and leave with the contributions your employer made.
Cliff: You will get all the money, as long as you wait out the vesting period. This could mean you need to work at the company for five years before you get to walk away with any of the employer match. But as soon as you hit your fifth anniversary, all that money has vested and is yours. If you leave before it’s fully vested, you don’t get any of the employer match.
Graded: A percentage of the employer match vests each year. Often it will go something like: 0 percent in year 1, 20 percent in year 2, 40 percent in year 3, and so on, until you’re 100 percent vested. If you leave the company before reaching 100 percent, then you could take the eligible percentage. Say you left a job after three years and your employer had contributed $6,000 to your plan. You get to take 40 percent of $6,000, or $2,400.
Vesting schedules are used as a tool to retain employees because you may be incentivized to stay until the end of the vesting schedule. If you don’t stay, then it can save the company money, because when you forfeit the employer match, the money goes back to the company. Again, the money you contributed is yours to take. This only applies to the employer match.
TARGET-DATE (AKA ALL-IN-ONE) FUND: Target-date funds are a convenient way to save for retirement, especially when you feel overwhelmed about which investments to put in your 401(k), 403(b), or IRA. You select a year that’s closest to when you believe you’ll retire, such as Target Date Fund 2055. Usually the funds are offered in five-year increments, so choose the closest approximate year. The fund’s managers will then automatically invest you in a primarily aggressive portfolio now and then rebalance it to be a more conservative portfolio by the time you plan to retire.
INDIVIDUAL RETIREMENT ARRANGEMENT/ACCOUNT (IRA): IRAs are another way to save up for retirement by investing in stocks and bonds or by leaving money in cash reserves. There are tax advantages to putting money into an IRA, which differ depending on the kind you use. Two of the most common IRAs are traditional or Roth, just like with a 401(k) or 403(b).
TRADITIONAL: Investing with pre-tax dollars up to the annual limit. You have the potential to lower your taxable liability today.
ROTH: Investing with post-tax dollars up to the annual limit. The Roth IRA doesn’t afford you a tax advantage today, but you do get to withdraw the money tax-free in retirement.
If you’re under fifty-nine and a half, you can’t withdraw the funds in your IRA without paying a tax penalty. There are some loopholes to this rule. For example, Roth IRAs provide more flexibility for penalty-free withdrawals before retirement age because you’ve already been taxed on your contributions. Also, when you buy your first home, you may be allowed to raid some of your IRA without triggering a tax penalty. But please don’t make any rash decisions about early distributions from a retirement plan before speaking to a tax professional and understanding all the implications.
The IRS does impose limits on how much a person can contribute at what age. In 2018, for example, those under fifty could contribute up to $5,500, and those aged fifty and older could contribute $6,500. Your tax deduction for contributing to a traditional IRA may be limited depending on your income and whether you or a spouse is eligible for a workplace retirement plan. Your eligibility to contribute to a Roth IRA can be limited and even phased out based on your modified adjusted gross income (MAGI), which you will find out when filing your taxes.1
ROLLOVER: You don’t want to leave your retirement savings behind when you leave a job, so the option is something called a rollover. You can, without triggering tax penalties, take your money out of your existing retirement plan at work as long as you’re moving into another retirement plan (e.g., a 401(k) with your new employer or an IRA). It is possible to leave a 401(k) in the hands of your old employer, depending on the stipulations of your plan. However, it’s often nice to simplify and bundle all your retirement accounts together instead of having a plan with each of your former employers. Companies like Vanguard, Fidelity, Charles Schwab, and Betterment make it pretty painless to roll over your old 401(k)s or IRAs. I found talking on the phone to a real human helpful the first time I had to do a rollover, just to be extra certain I wouldn’t screw anything up.
BENEFICIARY: The person who will receive your money in the case of your death. You’re usually asked to designate a beneficiary upon opening a retirement account. You can update your beneficiary at any time, and doing so should be on your to-do list right after any major life events like marriage or becoming a parent. Fun fact: beneficiaries can override a will. A professor of mine shared a story once about karma and beneficiaries. His client’s ex-husband had cheated on her and divorced her for his mistress. He died unexpectedly, and while he’d updated his will, he’d never bothered to update his beneficiary on many of his investment accounts. So much of his estate actually went to his first wife instead of the mistress.
HEALTH SAVINGS ACCOUNT (HSA): It may seem strange to include an insurance product in the retirement investing chapter, but an HSA offers you both a tax-advantaged savings vehicle and a way to prepare for future medical expenses, even as far out as retirement. Contributions to your HSA lower your taxable liability, then the money grows tax free, and withdrawals used for qualified medical expenses are also tax free.
You aren’t required to spend the money within a certain period of time like you are with a flexible spending account (FSA). There are contribution limits depending on your filing status: e.g., in 2018, they were $3,450 for an individual and $6,900 for a family. Unfortunately, you’re eligible for an HSA only if you have a high-deductible health plan.
Now for the reason it makes sense to include this term in a retirement investing chapter (other than the fact that you can save for medical expenses in retirement): The money in your HSA can be invested instead of just sitting in a savings account waiting to be used on medical expenses. Your HSA investment options depend entirely on your provider, but generally there are mutual-fund options.
A shout-out to all my fellow self-employed (or side-gigging) readers.
SIMPLIFIED EMPLOYEE PENSION IRA (SEP IRA): Don’t get too excited by the word pension. We often wax poetic about the glory days of employers offering pension plans, but this is really just a retirement account
for small businesses and the self-employed. It works akin to a traditional IRA: you get a tax deduction for contributions, and your investments grow tax-deferred until you begin to make withdrawals in retirement. In terms of earning potential, a SEP IRA can trump a traditional IRA because the contribution limits are (potentially) much higher.
In 2018, you can contribute the lesser of 25 percent of your compensation* or $55,000—or in some cases 20 percent of compensation for sole proprietors. That really blows the $5,500 contribution limit on the IRA out of the water. For simplicity’s sake, let’s say you earned a net profit of $50,000 in self-employment income in 2018 and contributed 25 percent to your SEP IRA. That’s $12,500 instead of getting capped at $5,500 for a traditional or Roth IRA.
You’re also allowed to contribute to a SEP IRA with side-hustle income, even if you’re contributing to a retirement plan through your full-time employer.
A drawback of the SEP IRA is that if your business grows and you acquire employees, you could be required to contribute the same percentage of income to your employees’ SEP IRAs as you take yourself.
SOLO (OR INDIVIDUAL) 401(K): This plan is a good fit for a self-employed person who isn’t planning to hire full-time employees. You can set it up for yourself and a spouse. A big perk of the solo 401(k) is that you can contribute as both employee and employer, which, depending on your business income, could mean contributing more than you could for a SEP IRA. In 2018, an employee could contribute up to $18,500, and the employer can contribute up to 25 percent of compensation, with a cap of $55,000.2 The solo 401(k) can also come as a Roth option.
MAXING OUT (AKA CONTRIBUTION LIMITS): Putting the maximum allowable contribution into your retirement account during the year. In 2018, that was $18,500 for an employee contributing to an employer-sponsored 401(k) or 403(b), or up to 100 percent of your income if you made under $18,000. You can find tax information, including the latest contribution limits, at https://www.irs.gov/retirement-plans.