Simple Retirement Investment 101 with Saving For More in 2021
Practically no one wants to work until they die. There might be a few exceptions to that. Most people would like to retire at some point and not have to work to pay the bills. In order to retire and still have income, you either have to have a passive income setup or being able to draw income from retirement savings.
So most financial experts recommend investing in a 401k, IRA, and/or ROTH IRA early and consistently. In my other article, I talked about the power of investing in retirement early and the potential returns. You can find the article here.
“You should start as early as you can so your investment can have more time to grow. The more time it has to grow, the more valuable your assets will become.
For example, if you start investing $100 per month at a rate of 7% return (around the average return in the stock market) per year, you would have $262,481 after 40 years. If you invest $500, it jumps up to $1,312,406 after 40 years.”
401K
What is 401k? 401k is an employer-sponsored retirement account. Pensions used to be a more common payout to the employees for retirement. With 401k, the responsibility of savings for retirement shifts more to the employee with the employers potentially also contributing to the account on behalf of the employee.
Employees who are eligible for 401k can choose to participate or not participate in this benefit. If the employee chooses to participate in the program, the employee will be responsible for deciding which funds to participate in and how much to contribute.
For people that just joined the workforce, some experts would recommend trying to max out your contribution in the first couple of years so you could get a nice jump on the growth that will accrue for years to come.
There is a max limit on how much you can contribute to your 401k based on the year and your age. For example, as of 2020-2021, max employee contributions is $19,500 per year for workers under age 50 and $26,000 for those 50 and up (including the $6,500 catch-up contribution)
If you are making $40,000, contributing $19,500 might leave you with very little else to pay your other bills, so it may not make sense. However, if you are making $70,000 a year, it would be much more manageable to max out your contribution.
If your employer does any type of 401k contributions matching, you will want to be sure to at least max out those contribution amounts. For example, if your employer will contribute 50% for every dollar up to 6% contribution, make sure you contribute at least 6% of your salary to your retirement portfolio; because that is literally FREE money they are giving you.
If your employer offers 401k and Roth IRA, you can split the contributions however you want. But the combination contributions amount cannot exceed the max allowed limit ($19,500) as of 2021.
401K Withdrawals
Since 401K is designed for retirement, if you take money out before hitting 59 ½ years of age, you will incur a penalty for the withdrawals. So this really should be a last resort for emergency funds. It would be advisable to set aside some emergency funds when you are considering how much money to contribute to your 401K.
The earnings and growth of 401k are tax-deferred. Meaning you don’t have to pay taxes while your 401k account balance is growing. You are instead taxed when you make withdraws from the account.
If you withdraw money from 401k before you are 59 ½ years old (or meet other IRS criteria like being permanently and totally disabled), you will incur 10% early withdrawal penalty on top of having to pay normal income tax for the withdrawal amount.
Even if you are able to withdraw the money tax-free and penalty-free, it’s still not a good idea to withdraw from this account unless it’s an absolute emergency because you will be limiting the growth potential of your account if you withdraw early. The more time your 401k has time to grow, the more money it will likely give you for your retirement. Most analysts expect 6-8% return on the stock market on an annual basis.
IRA Rollover and Changing Jobs
If you decide to change jobs, your 401k account will still be with your old employer. You can have the option of opening an IRA account with a brokerage firm and roll it over with no penalty or taxation. Some companies will also allow you to roll over your old 401k into their account and you can combine that too. That is usually penalty-free as well.
You also have the option of leaving the 401k with your old employer if it’s managed well and growing well. Just make sure you keep track of all the 401k accounts you have at each job if you decide not to consolidate them into one account.
You will want to carefully consult with the brokerage firm or your new companies to make sure you don’t incur any penalty for the rollover process.
ROTH IRA
What is the difference between ROTH IRA and 401k? ROTH IRA is another option that many employers offers. One difference is that for 401K, your contributions are pre-taxed and you are not taxed until you withdraw from your 401K account when you hit 59 and ½ years old. For ROTH IRA, your contributions are post-tax, meaning you make contributions to ROTH IRA account after your income has already been taxed.
The good thing about ROTH IRA is, you will not be taxed again when you make a withdraw from your account. The first five-year rule states that you have to wait five years after your first contribution to a Roth IRA to withdraw your earnings tax-free.
So this really comes down to if you’d rather get taxed before the contribution or get taxed first than make the contribution, and it really comes down to when you are retiring and how much you will be withdrawing when you are ready to retire.
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Practically no one wants to…