So you read my previous post (“4 reasons to start saving for retirement…now”) and saw the light – you need to get it in gear. Congrats! Making that decision is a big step, and I, for one, am proud of you. However, I’m sure you’re currently sitting there in your pajamas, eating a bowl of Cap’n Crunch, thinking, “Ok, I’ve decided I need to save and how much to save, but now what?” And that, my friends, is a good question…and one for which I have the answer.
The main advice I would give anyone looking to save for retirement is that if the company you work for offers an employer-sponsored retirement plan (ESRP), take them up on the offer. What exactly are these mysterious ESRPs I speak of? Well, they’re the terms you’ve heard people throw around in any retirement conversation, where they take a bunch of numbers and letters and jumble them all together – the 401(k)s and 403(b)s of the world. As confusing as their names may be, these plans are an optimal place to put your initial retirement savings - not only do they make it easy to invest by transferring the money straight out of your paycheck, but companies usually match the money you put into an account, up to a certain extent. That’s an initial 100% return on anything you put in – can’t beat free money!
I’ve listed below some of the more common employer-sponsored retirement plans and explained the main concepts behind each. So read on – it’s information you’ll want to know to best plan for your future.
If you choose to participate in your company’s 401(k) plan (and you should), you will be contributing pre-tax dollars to a tax-deferred account*. What does this mean? Well, while you get to avoid paying tax now, you must pay taxes on both your contributions and any earnings you make whenever you take the money out of your account. Contributions are limited each year, and the 2014 limit is $17,500 (don’t worry, I’m nowhere near that limit, either). And please note, you are not allowed to take money out of your account until age 59 ½; otherwise, you are not only taxed, but charged penalties on the distribution as well.
The best part about a 401(k) is that employers usually match up to a certain percentage of contributions. For instance, if your company has a 3% match and you make $50,000 a year, your employer will match you dollar for dollar in contributions up to $1,500 ($50,000 x 3%). That’s easy money, people.
Let’s make this simple: 403(b)s are basically the same as 401(k)s except they are for businesses that are considered tax-exempt in the government’s eyes. So if you work for a school system, nonprofit hospital, or religious organization, this is what you will be offered.
The downside to these is that a) the businesses that offer these usually have smaller budgets, meaning they normally forgo making matching contributions and b) investment options under these plans aren’t as varied as a 401(k). The upside? If you’ve been with one of the qualified tax-exempt companies for 15 years, you can contribute an additional $3,000 per year up to $15,000 (meaning that you would be able to contribute that $3,000 for 5 years until you reach that limit).
3) SIMPLE IRA
SIMPLE (Savings Incentive Match Plans for Employees) IRAs are for companies that have less than 100 employees. Best thing about these? Companies offering this type of plan are required by law to either match employee contributions up to 3% of the employee’s salary OR contribute 2% of pay for all eligible participants.
Another great aspect of this is that all contributions are immediately 100% vested. I know, you’re probably wondering, “What the H-E-Double Hockey Sticks does that mean?” Trust me, it’s a simple concept. When you are immediately vested, the money you and your employer put into your account are instantly yours. With 401(k)s, the money you individually put in will always be yours, but many times the money contributed by your employer won’t all be yours until you hit a certain anniversary with the company. So, for instance, a company with a 401(k) may have a policy that states if you leave after one year, you only receive 25% of the employer match, after two years only 50%,etc. With SIMPLE IRAs, you immediately are entitled to 100% of whatever your employer contributes.
SEPs (Simplified Employee Pension Plans) are a little bit different in that you, as the employee, cannot contribute to the plan. Your employer has the option to contribute to the plan on your behalf, but these contributions are discretionary, meaning they are not entitled to make them if they so choose. Note, however, that if they do, they can contribute up to 25% of the employee’s pay. Many small businesses choose this plan because they can weather ‘down’ years by scaling back on these contributions without incurring penalties (and the administrative fees are much lower).
These are also tax-deferred accounts (both contributions and earnings are taxed when you take the money out of the fund) and are 100% immediately vested.
Hopefully this gives you a good starting point to intelligently approach your retirement savings, but as always, if you have questions, feel free to ask. We’ll continue the retirement topic further in my next post, where we get into the wonderful world of IRAs. And ladies (and gents), even though it may sound boring, you definitely want to be in the know regarding them.
BB Bit (of Advice): Enroll in your company's retirement plan today, and contribute up to what they will match. If you don't, you're throwing money down the toilet.
*Note: Tax-deferred 401(k)s make up a majority of the 401(k)s offered by companies; however, Roth 401(k)s, which have the initial contributions taxed and the earnings grow tax-free, have gained some popularity in recent years.