Your Money_ The Missing Manual - J. D. Roth [143]
One of the great things about retirement accounts—investment accounts specifically for retirement savings—is that they let you put off income taxes until a later date (that's why they're called tax-deferred), meaning you get to hold onto and profit from your money longer. And a Roth IRA (which you'll learn about shortly) lets your money grow tax-free!
There are lots of places to put your retirement savings, so it can be difficult to know where to start. Each person's situation is different, but most folks can follow these simple guidelines:
If you have a 401(k) or similar program at work, contribute to get the employer match (Disadvantages of 401(k)s). If your employer doesn't match contributions, go to the next step.
If you qualify, open a Roth IRA (Learning to Love Roth IRAs) and contribute as much as you can (up to the maximum allowed).
If you have money left, put as much as you can into your 401(k) (see Funding Your Future with a 401(k)).
Once you've done all of the above, then put your money in regular investment accounts (see Chapter 12). You might also consider paying down your mortgage.
Following these steps is one the best ways to take control of your financial future. The following pages cover each step in more detail.
Funding Your Future with a 401(k)
According to the Congressional Research Service, nearly half of American workers participate in retirement plans offered by their employers (http://tinyurl.com/CRS2007pdf). About one-third of these folks have defined-benefit plans, while two-thirds have defined-contribution plans.
With a defined-benefit plan—which most people simply call a pension—when you retire, you receive a fixed monthly payment for the rest of your life. (The amount you get paid is based on how long you worked for the company and how much you earned.) With a defined-contribution plan, on the other hand, your benefits aren't fixed; they're based on how much you (and your employer) put into the plan and what kind of returns your investments earned.
The 401(k) is a specific type of defined-contribution plan that, over the past couple of decades, has become much more common than traditional pension plans. (The name 401(k) comes from the section of the tax code that defines these plans.) Let's look at the pros and cons of 401(k)s.
Note
There are a variety of defined-contribution retirement plans out there. For-profit companies offer 401(k) plans, while nonprofit organizations and governments offer 403(b) plans. And if you work for the federal government, you may have access to the Thrift Savings Plan. Though these plans aren't identical, they're similar, so you can generally apply the advice in this chapter about 401(k)s to other defined-contribution plans, too.
Advantages of 401(k)s
401(k)s have a lot going for them. For one, they make contributing to your retirement automatic: Once you sign up for your company's 401(k) plan, your retirement saving comes directly out of your paycheck. You can "set it and forget it," only making changes when you want to increase (or decrease) your contributions. This takes the human element out of the equation, preventing you from gumming things up (and that's a good thing—see Being on Your Best Behavior).
Even better, your contributions and earnings are tax-deferred. In plain English, that means you don't have to pay taxes on the money you put into a 401(k) until you withdraw it. You're not taxed on the profits (the returns the account earns) until then, either. This is a big advantage over a regular investment account. For example, if you earn $50,000 per year and you put $5,000 into your 401(k), your taxable income drops to $45,000; if you're in the 25% tax bracket (see Know what you owe), say, that would save you $1,250 in taxes. And you won't be taxed on that $5,000 contribution (or any returns it earns) until you take the money out at retirement, so your investment has a chance to grow even