Personal Finance 101: 401(k) Plans and IRAs
It wasn’t till I started my first full-time job last fall that I started considering my personal finances more seriously. I had a lot of questions, like: My employer offers a 401(k)—what % of my pay should I contribute? What’s the difference between Roth and traditional? What is an IRA? Should I purchase discounted company stock? Which health insurance plan is the right choice? SO MANY QUESTIONS. NOT ENOUGH ANSWERS FROM ORIENTATION…or from school for that matter. I definitely could’ve spent less time memorizing thermodynamic reactions in college and more time learning how to do taxes and save for retirement. Alas, we’ve only graduated with the knowledge that the mitochondria is the powerhouse of the cell.
Before I went on a Google binge for answers, I asked my 31 year-old brother to chip in two cents about what he’s learned over the past couple years of living on his own (see our silly iCal invite below). Coupling that with the research I gathered from the internet, I’d like to think I’ve attained a better idea of how to manage my personal finances, so I’m sharing what I’ve learned below. Of course, I’m no professional investment advisor, so any direction that I recommend you take is my own opinion, and you’re absolutely welcome to take my info with a grain of salt.
Moneyunder30.com is a solid site for, you guessed it, people under 30. For crowdfunded advice, Reddit is my preferred source (behold, r/personalfinance and r/financialindependence) since it’s real people chiming in about their experiences and thought process behind their decisions. The Mad FIentist’s page is a good resource too, for those interested in the Financial Independence Retire Early (FIRE) movement. In the FAQ below, you’ll find some some key pieces of information that I would’ve loved to know before I overwhelmed myself with the 39284 questions I tried to answer during my Google binge. This is Part 1 in a series on personal finance that I’ll be putting out, because there’s a TON of info that I want my readers to know in order to make better-informed financial decisions in their lives. Stay tuned for parts 2 and 3!
Embedded links will either bring you to the aforementioned site or to additional resources. No affiliate links here, aside my referral to Schwab, where you get $100 and I get $0 (not a typo)!
What’s the difference between Roth and traditional?
You have to pay taxes on the money that you put into 401(k)s and IRAs regardless of whether it’s Roth or traditional money; the difference lies in when you get the tax break: now as the money goes in vs later when you’re withdrawing the money (typically after age 59.5).
Traditional contributions means you’re contributing pre-tax money to an account. You save by avoiding paying taxes on the money going in, which decreases your taxable income, and don’t pay taxes until you withdraw that money after age 59.5
Roth, on the other hand, means you’ve paid income tax on the money going in, and then don’t pay taxes when you withdraw the earnings and original contributions.
What is a 401(K)?
A 401(k) is a savings plan offered by your employer, which not all workplaces offer. It lets employees save for retirement by contributing a part of their paycheck, either before taxes are taken out (traditional) or after taxes are taken out (Roth). Generally, you leave the money to grow until you reach 59.5, because any withdrawal prior to then incurs a 10% penalty. When you leave your employer (e.g. quit or retire), you can either keep the 401(k) with your old employer as is, lump it into your new employer’s plan, roll it over/convert it into a traditional IRA, or cash it out (not recommended; let your money grow until you’re 60!).
What does a 401(K) do?
Your 401(k) contributions are invested in the stock market, and there’s a number of funds (e.g. bonds, small to large-cap stocks, international stocks, target date funds) that you can choose to invest your 401(k) money in. If you don’t choose, your funds are auto-invested according to the default mix set by your employer.
What I do: contribute the max to 401(k). For Jan-Dec 2020, the max limit a person can contribute to their 401(k) is $19,500. This does NOT include your company match.
What’s a company match?
Some employers, to incentivize their employees to contribute to their 401(k)s, will match up to 50% or 100% of what you put in.
For example, my employer will match 100% what I contribute to my plan, up to 6% of my salary. If my salary is $100,000 and I put $5,000 toward my 401(k), Accenture will throw in a free $5000 to match. (6% of salary limit not reached). If I save up and put in $19,500 over the course of a year, which is the Jan-Dec 2020 401(k) limit, Accenture will cap out at giving $6000 (6% of $100k). I’d advise looking into your employer’s policy and seeing whether they offer a company match. If they don’t, I’d suggesting prioritize maxing out your traditional IRA or roth IRA first. If your employer does offer a match, you should contribute enough of your paycheck to get the max company match—don’t leave free money on the table! Some employers don’t start giving you a company match until after your first full year of working.
Photo by Punch Debt In The Face
What % of my salary should I contribute to my 401(k)?
Answers widely vary on this. The Jan-Dec 2020 401(k) limit is $19,500, but my employer will only match me up to $6,000, so why would I want to contribute more than 6% ($6,000)? My answer factors in the following:
I want to save as much as I can for retirement while I can afford to set this money aside, because TIME VALUE OF COMPOUNDING INTEREST. My living expenses as a 23-year old are relatively low—I share an apartment with my roommate (cheaper than living alone), I don’t have car payments to make, and I don’t have kids. I like cooking so I don’t eat out everyday, and my boyfriend & I share some expenses because we eat a lot of our meals together. Once I have to prepare for buying a house and kids, it’s going to be MUCH harder for me to put away $19.5K in an account that I won’t be able to access penalty-free before age 60.
Saving money in a 401(k) allows me to save on taxes. Money in a 401(k), even if it might dip occasionally due to the stock market, can be counted on to grow given a long time horizon (I’m talking 20+ years) and beats cash sitting in a drawer or under a mattress.
Nerdwallet has an online calculator that shows you how much you’ll need to have saved by the time you retire (you can choose your retirement age) and extrapolate based on how much you have in savings today. It’ll give you a good idea of whether you’ll need $1M saved by the time you’re 65 or $2M by the time you’re 50, based on your expected spending per month during retirement.
What is an IRA?
An IRA, or individual retirement account, is an account set up at a financial institution that allows an individual to save for retirement with tax-free growth OR on a tax-deferred basis. I opened my roth IRA at Schwab. Vanguard and Fidelity are two other popular brokerages. All sites offer fee-free buying/selling of most ETFs, mutual funds, and individual stocks, and it’s free to open an account!
The 3 main types of IRAs each have different advantages:
Traditional IRA - You make contributions with pre-tax money, the money grows tax free, and you get taxed when you withdraw the money during retirement.
You’d want to contribute to a traditional IRA if: 1) your adjusted gross income is less than $64,000 for 2019/ $65,000 for 2020 (single) and 2) want to contribute pre-tax money. You’ll be taxed upon withdrawal, and you are forced to withdraw money from your tradIRA beginning at age 70. More info on withdrawing early from a traditional IRA here.
Roth IRA - You make contributions with money you've already paid taxes on (after-tax), the money grows tax-free, and you DON’T get taxed on withdrawals once you’re 59.5, since you already paid taxes on the money going in.
You’d want to contribute to a Roth IRA if: 1) your adjusted income is above the traditional IRA limit but below $133,000 (single) and 2) you would rather pay taxes now so you don’t have to pay taxes later. You are NOT forced to withdraw money from your roth IRA ever, and can pass down the money to your children, spouse, or charity.
Rollover IRA - This is created when you quit a job and “roll over” the money from that 401(k) or 403(b) into a traditional IRA.
source: Fidelity.com. see a traditional vs Roth IRA chart on IRS.gov. If you’re interested in retiring early, the Mad FIentist compares traditional vs Roth IRA contributions.
Note: If you make above $133k, there are roundabout ways to contribute to a roth IRA. One method is called the backdoor Roth, which will be covered in Part 2 of this series. Another method is the mega backdoor Roth.
Contributions for IRAs follow the tax year, NOT calendar year. So you’ve got until April 15, 2020 to make retroactive contributions for the $6,000 2019 limit, go go go! MARCH EDIT: Since the deadline for submitting your federal tax return has been pushed to July 15, 2020, you’ve now got until July 15 *not April 15* to contribute toward your 2019 IRA limit, since IRA contributions follow the tax year. Yay more time!
Photo by Smart Financial Strategies
Should I go Roth or traditional?
If you think you’ll be in a higher tax bracket when you withdraw from your IRA or 401(k)—usually retirement age—pay your taxes now so you’re not paying more in taxes later. If you think you’ll retire in a lower bracket, you might want to go Traditional and pay the taxes later when you withdraw. None of us have a crystal ball to predict how much money we’re making at 60+ years old though, so it’s a good idea to do a mix of pre-tax and post-tax contributions across your investment vehicles. Personally, I contribute pre-tax money to my 401(k) and post-tax money to a Roth IRA.
How do I choose stocks for my 401(k) or IRA?
Asset allocation, or the process of deciding where you want your money to be invested (e.g. ratio of stocks to bonds that you possess), may sound like a headache, but it’s definitely worth considering. Personally, I plan to invest for the long-term (we’re talking 40-50 years), so I’ve chosen to be more risky with my stock market choices, choosing to invest more of my money in stocks (aka equity) than bonds. Take a look at what options are available to you, as you might want a mix that different from your employer’s default. Here’s the Wall Street Physician’s take on a simple 3-fund portfolio, with stocks, bonds, and international funds.
Can my 401K lose money?
For the first couple months after I started my full-time job, I had no idea that a 401(k) was tied to the stock market. I just assumed money would grow once I put it in until I withdrew it after I turned 59 1/2. The thing is, because your 401K is invested in a mix of stocks and bonds, your 401K balance will dip when the market dips. That’s why during the 2008 recession, people near retirement-age panicked, because their portfolios dropped 30-40%. The important thing to know, is that the stock market will always correct itself, and if you hold tight during a recession and don’t panic-sell at a loss, your portfolio will grow back and rise up higher than it was before. So keep contributing, even during a recession; you’re essentially buying low! It’s also why as people near retirement age, they gradually hold more bonds than stocks, because bonds will dip less than stocks during a recession.
Why is Roth capitalized?
It’s named after William Roth, a Delaware senator who pioneered the creation of this unique retirement plan.
Should I open an IRA?
Yes! IRAs allow you to save on taxes (either on money going in or on money coming out) for contributing toward retirement. The popular platforms to open an IRA are Schwab, Vanguard, and Fidelity. Acorns seems to be growing in popularity too. I went with Schwab because I got a free $100 for depositing $1K into my account using my friend’s referral link. Here’s my Schwab referral link, so you get $100 on your first deposit too. I get $0 out of it—just sharing the love. Once you open your account and deposit a check or make a bank e-transfer, scroll up to check out the answer for “How do I choose stocks for my 401(k) or IRA?”. The deadline to contribute money that counts toward the 2019 limit is April 15, 2020, so open your account asap and add money before the deadline! MARCH EDIT: Since the deadline for submitting your federal tax return has been pushed to July 15, 2020, you’ve now got until July 15 *not April 15* to contribute toward your 2019 IRA limit, since IRA contributions follow the tax year. Yay more time!
You can also open a self-directed brokerage aka taxable brokerage account, to be covered in Part 2. Stay tuned!
Arvabelle covers the differences between Fidelity, Vanguard, and Schwab
Again, you can contribute toward the 2019 $6,000 IRA deadline until April 15, 2020. After that, you can contribute toward the 2020 $6,000 deadline until April, 15, 2021. For 401(k), you can contribute up to $19,500 (not including company match) until your last paycheck of this calendar year (Dec 2020). More info on Forbes
Alright, what should I do now?
If you haven’t yet, open a free Individual Retirement Account at Schwab, Fidelity, and Vanguard. Even though you’re opening the account in 2020, you’re eligible to contribute funds toward the 2019 $6,000 limit until April 15, 2020. So get to it! After April 15, 2020, you’ve got until next April—a full year—to work on contributing toward the 2020 $6,000 limit. MARCH EDIT: Since the deadline for submitting your federal tax return has been pushed to July 15, 2020, you’ve now got until July 15 *not April 15* to contribute toward your 2019 IRA limit, since IRA contributions follow the tax year. Yay more time!
Link your bank account info and deposit some money before April 15. Make sure you choose “2019” and not “2020”! You have the rest of 2020 to contribute to 2020, but until 2 more months until 2019’s period ends.
I get ZERO money for my referral link to Schwab, but you’ll get $100 bonus for the first $1k you deposit! Free money, it’s a no brainer—you could view it as an easy-peasy no-stress-about-the-stock-market 10% return on your $1k.
Log into your employer 401(k)
Check what % of your paycheck is currently earmarked for your 401(k). Some employers default you to 3%. If you can afford to, bump it up to 8% or even 10%! Future you will thank you, and if you bump up 2-5% every year or so, you won’t even miss the money!
Check what type of 401(k) your account is—do you wanna switch it to a Roth 401(k) or Traditional 401(k)? You can maintain funds in both kinds, so if you’re really not sure, you can contribute to one kind and switch to the other type halfway during the year.
Look into your fund mix (aka what bonds and stocks your 401(k) is invested in. Personally, I’m younger than 35, so I’m 100% in stocks, because although stocks are more negatively impacted than bonds during a recession, I have a long enough time horizon (30+ years) to sit tight and wait for the economy & stock market to recover.
Before you bump up your retirement savings contributions, you should work to 1) eliminate any debt (e.g. credit card debt, student loans, car payments) and 2) have an emergency fund of 3-6 months’ worth of expenses kept in a high-yield savings acccount in case you’re ever laid off—enough to cover rent, phone bill, groceries, car, insurance—or have an unplanned medical emergency.
Disclaimer
one last plug to start saving for retirement now so that it has time to grow:
Michael saved $1,000/month from age 25-35. Then he stopped saving but left his money in his investment account where it grew at 7%/year till he retired at age 65.
Jennifer held off and didn’t start saving until age 35. She put away $1,000/month from age 35-45. Like Michael, she left the balance in her investment account, where it grew at 7%/year till she retired at 65.
Sam didn’t get around to investing until age 45. Still, he invested $1,000 per month, from age 45-55. Then he also left his money to accrue at 7%/year until his 65th birthday.
Michael, Jennifer, and Sam each saved the same amount — $120,000 — over a 10 year period. Michael’s money grew the money most (source: moneyunder30.com)