How To Invest For Retirement – 401(k) and Roth IRA

Recently I had a conversation with my friend Julie about investing for retirement. She just started working for a new employer that offers a 401(k) plan. Since Julie had never had an employer with this benefit before and was unfamiliar with retirement investments in general, she didn’t bother signing up.

This reminded me of myself when I landed my first big job but had no clue about personal finances or investments. I missed out on years of contributions (you can read more about my story here). Naturally, I felt an instant urge to tell her about my experience and how not to repeat my mistakes. I recommended to her that she should research 401(k) and Roth IRA and reach out to her HR department to find out how she could begin contributing, right away.

Retirement investments could help you sail into the sunset on your own sailboat one day
Retirement savings play a very important role in building wealth.

I wanted to give Julie a proper step by step guide to follow (see below) so she could start investing for retirement and improve her personal finances in the process. This prompted me to read up more myself on the pros and cons for each option. All sorts of questions started popping up in my head. What are the differences between a 401(k) and a Roth IRA? What are the limits? Which one should you max out first? Can you withdraw the money whenever you want? What happens to your investments if you leave the company?

In this post I’ll try to provide a simple and hopefully helpful how-to guide for getting started with retirement investments.

Do you really need to invest for retirement?

Retirement savings play a very important role in building wealth. According to a 2019 study conducted by Ramsey Solutions, 80% of the millionaires they surveyed contributed to their company’s 401(k) plan. To understand the reasons behind that metric we need to examine what a 401(k) plan is, but we’ll get into this a bit later. For the sake of keeping this simple, I would just keep it short and answer “Yes, you need retirement investments.”

If you are not convinced, though, take a look at this 2017 CNN article titled “How to become a millionaire on $56,000 a year”. You can also use this 401(k) calculator to figure out how much you would have by the time you retire based on how much you contribute and whether your employer offers a contribution match.

To give you an example, let’s say that you can contribute just $5,000 per year into a 401(k) account starting at age 25, with an employer match of 4%. By age 65 your 401(k) would be worth $1,011,262! By the way $169,125 of that would’ve come from your employer’s contributions (this is in addition to your salary, and it’s crazy not to take advantage of it).

401(k) balance chart showing your contributions, employer contributions and interest gained over time
How 401(k) investments grow over time. This chart was built using the 401(k) calculator at smartasset.com

Keep in mind that this is JUST from your 401(k) account. Hopefully by increasing your salary and saving and investing more over time you could do a lot better than this.

Retirement investments through 401(k) and Roth IRA

When should one start saving for retirement? The simple answer is “As soon as possible!” I sometimes wonder what my net worth would be today if at the age of 18 I knew what I know now about investing and compound interest. I’d probably be one of those millionaires from the study mentioned above.

Let’s look at the two most common retirement investment options: 401(k) and Roth IRA.

401(k)

A 401(k) plan is a retirement investment account that many companies offer as a benefit for their employees. What makes it a “retirement” account is the fact that you agree not to withdraw your money until you reach the age of 59½. You let the money accumulate and grow over time and technically you don’t have to initiate any withdrawals until you’re 72 years old.

Once you sign up for a 401(k) (your Human Resources department at work should be able to help), you can choose the contribution amount per paycheck that will be automatically sent to your retirement account. You can decide and you are in control of how much is sent with each paycheck. It’s important to know that the money goes straight from your employer to your 401(k), and your paycheck will be smaller. This essentially means that the contributions are tax-deductible, i.e. you lower your effective taxable income by the amount you contribute to the 401(k).

When you open the 401(k) account, you can choose among some simple investment options. Oftentimes you would simply choose a target retirement date and leave it at that, rather than managing your own portfolio. That said, if you wanted to, you absolutely could pick and choose which funds to put your savings into. However, keep in mind that 401(k) accounts usually have a limited number of funds available to choose from.

In 2021, the maximum you can contribute to a 401(k) plan is $19,500 per year.

401(k) Q & A

Once I sign up, do I have to always contribute something with each paycheck?

No. You can change the contributions to 0% or $0 per paycheck if you wish.

What if I withdraw the money before 59½ years of age?

I would not recommend it, but if you absolutely must, then you would have to pay a 10% penalty and have to pay income tax on the amount withdrawn.

Do I have to pay taxes when I withdraw the money in retirement?

Yes. A 401(k) is a tax-deferred account, meaning you don’t pay taxes while you work and contribute to the account, but you pay income tax later when you withdraw the money.

What if I switch jobs?

Usually you would either move the money into your new employer’s 401(k) or into an IRA account. You can also leave it where it is. Just make sure you’re not paying extra fees compared to your new employer’s 401(k). No rush however, as you can roll it over at a later point, as well.

What companies offer the best 401(k) plans?

Bloomberg has created a list just for this. Now you know where to apply during your next job search. You’re welcome!

A man and a woman living a stress-free life knowing their financial future is secure thanks to having retirement savings
Having retirement savings and watching your investments grow lets you live a stress-free life knowing your financial future is secure

Roth IRA

A Roth IRA is another long-term retirement investment account which you should not withdraw earnings from before you’re 59½ years old. Unlike the tax-deferred 401(k), though, a Roth IRA is funded with after-tax dollars. Therefore, the contributions are not tax-deductible. But once you start withdrawing funds in retirement, the money is tax-free.

You can also withdraw the amount you actually invested from your pocket, at any time, and with no tax or penalty. There are also special exceptions for withdrawing early and penalty-free such as buying your first home, or paying for college expenses.

As far as limits go, in 2021, the maximum you’re allowed to invest in your Roth IRA is $6,000 a year. Another important thing to know is that if you earn more than $140,000 per year for singles (or $208,000 for married couples), you’re not eligible to contribute to a Roth IRA. Note that these limits change every year. When opening your Roth IRA or before investing for the year, first check what the current limits are.

You can open a Roth IRA account at any time by yourself. Almost all investment companies offer Roth IRA accounts. I personally like Vanguard for their generally smaller fees.

Check out Investopedia if you’d like to learn more about 401(k) and Roth IRA accounts.

Retirement investments guideline

So do you need both a 401(k) and a Roth IRA? If you can save enough to invest for retirement and you are eligible to invest – then yes, you should probably get both. That said, some employers don’t offer a 401(k) plan to their employees, in which case you don’t have that option. Although, if you are self-employed there is a solo 401(k) or a SEP 401(k) option you may be able to take advantage of.

Here are the four simple steps to invest for retirement:

  1. If your employer offers a 401(k) match, invest just enough to get the full match. The match is basically free money that your employer is giving you for your retirement.
  2. Pay off your credit cards and any other debt you may have. This is really important if you want to be able to save, invest and build wealth.
  3. Contribute as much as possible to a Roth IRA. Again, check if you are eligible first, and don’t exceed the yearly contribution limit.
  4. If you have money left over, go back to your 401(k) and contribute as much as possible to it.

If you still have money to invest, take a look at the personal income spending flowchart (step 4 and beyond). This flowchart is also a great way to improve your personal finance situation altogether.

Another good read on the topic is Saving and Investing – an excellent resource from the SEC.

This information would’ve been tremendously helpful to my younger self. But since I can’t turn back time, I hope it’s helpful to at least a few of you out there.

— Finance Squirrel

P.S. If you want to go a step further you can even manage your own 401(k) and Roth IRA portfolios by passively investing into low-cost index funds. This could save you hundreds of thousands if not millions in fees over the years.

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