You’ve graduated and landed your first job. If you start investing early, that $5 you’re about to spend on coffee could grow to $100 by the time you retire. Thanks to compound interest, which means you’ll be earning interest on your interest, the younger you start, the bigger and faster your nest egg will grow. But before you invest your hard-earned money, there are some things to know about 401ks and IRA plans.
Free Money… seriously
If your employer offers you a 401(k) or a plan that has a matching program, consider it free money. It could mean thousands of dollars per year. Let’s say you’re making $45,000 and your employer offers you a 50-percent match of 6-percent of your salary. That would likely be $1350 in free money by the end of the year. Some 401(k)s also allow you to take loans against them. Cons: You might not have as many investment choices as an IRA, administrative costs may be higher and your money is generally on lockdown until you’re 59½.
The annual contribution limit is $18,000.
If there’s no sponsored plan, start a Roth IRA or traditional IRA as soon as possible.
What’s better, a Roth or Traditional IRA?
It’s not as confusing as it sounds. People under 50 can contribute $5,500 per year to either one. The big difference them is when you’ll pay taxes.
Traditional IRA like a traditional 401(k), it offers tax-deferred growth.
Pros? You don’t have to pay taxes on your money until it’s withdrawn and, if you don’t have a 401(k), some contributions reduce your taxable income. If you follow the rules, the tax refund could help you to reinvest into your retirement. Cons? You may be in a higher tax bracket when you retire, and, as your money grows, the more tax money you’ll have to pay. Living expenses usually move in one direction: a gallon of gas in 1996 was $1.06…
Roth IRAs: allow you to pay taxes when you make your contributions, but generally not when you withdraw your money in your retirement.
Pros: because of compound interest, (hopefully compounded often), your money will grow faster the longer it compounds, accruing more money than you put in – which means, years later, after it has grown incrementally, you’ll get your fortune back tax-free if the rules still apply. Cons: Roth contributions are not tax deductable and if the tax rate reduces later, a traditional IRA might have been a better choice.
Early Withdrawal Fees
This is your retirement nest egg. Try not to raid the nest of your 90-year-old self if you don’t absolutely need to. You’ll be hit with a federal tax of 10 percent for IRA withdrawals before age 59½, plus income tax on the amount withdrawn. So let’s say you borrow $5,000, and the withdrawal puts you into the 25-percent tax bracket: you’ll pay $1,750 in taxes and penalties. Exceptions: $10,000 for your first home down payment, medical expenses over 7.5 percent of adjusted gross income, post secondary education, health insurance while unemployed, disability, death and IRS payments.
Where do I set up an account?
Set up your 401(k) through your employer, but shop around for where to set up an IRA. Brokerage firms can charge an annual maintenance fee, but many don’t. Some charge on a percentage basis, others a transaction basis. Transaction-based fees to set it up might be the way to go, as long as there aren’t a lot of transactions afterward. Make sure the bulk of your contributions go toward your retirement account, not trading commissions. Consider lower cost index funds. Ask how much you’ll need to start and maintain the account and what investment options are available (real estate, funds or stocks)?
How do I evaluate 401(k) funds?
You can learn about funds by comparison, rate them and analyze long-term performance. Check out free membership from Morningstar, which allows you to see and compare how funds measure up and check performance. The XRay tool helps you to check on your inventory. Brightscope can be a useful rating directory. Try not get too many funds with similar investment holdings, and remember, the more expensive the fund, the more those fees will impact your retirement.
Christine Giordano is a freelance writer, based in New York.