In the last Millennial Moment blog, we talked about tips for when you’re starting a new job. Now, let’s fast forward a few decades to the end of our careers when we are older, (hopefully) wiser, and about to retire. While retirement might feel forever away, now is actually the time to start planning and saving for it. Before you invest in your future, it is important to understand how retirement funds work so that you can take advantage of the various options available.
Depending on your background, retirement may or may not already be a common subject for you. I had a bit of a head start learning about retirement funds. I’m the daughter of a CPA, so the topic was brought up every so often over dinner while growing up. (In case you are wondering – it pairs well with spaghetti.) However, retirement funds may be a completely foreign world for you. 401(k)s and IRAs sound like intimidating, technical terms at first, but don’t worry, today we are breaking down the basics so that you can feel comfortable preparing for your retirement.
Types of Retirement Plans
Traditional 401(k)
- A 401(k) is a retirement account only available through your employer.
- Maximum contribution you can make in 2017: $18,000
- Contributions are made using pre-tax dollars. This means you don’t have to pay taxes when you contribute the funds, but you will pay taxes later when you withdraw the funds.
- Your contributions reduce your taxable wages on your W-2.
- Employers can match your contribution.
- For example: Assume an employer chooses to match your contributions up to 4%. If you contribute 4% to your 401k, your employer would double your contributions by also contributing 4% to your account. This match isn’t taxable to you when you employer makes the contribution, but it is taxable when the funds are withdrawn.
- There is a Roth option available as well.
Traditional IRA
- A traditional IRA is an individual retirement account that is not connected to your employer.
- Maximum contribution you can make in 2017: $5,500
- Contributions are made using pre-tax dollars. (Similar to 401(k) contributions. See above)
- Contributions are generally fully deductible on your tax return.
- You can make a contribution to BOTH a 401(k) and a traditional IRA if you are so inclined.
Roth IRA
- A Roth IRA is different from a Traditional IRA in that you pay taxes on contributions, but you don’t pay taxes on the distributions.
- Contributions are made using after-tax dollars.
- Let me explain: Say you contribute $1,000 to your Roth IRA and pay the associated taxes in 2017. Over time, let’s say the $1,000 grows to be $7,000. When you retire, you can withdraw the $7,000 tax-free. The advantage of a Roth IRA is that you only paid taxes on the $1,000 instead of the $7,000.
- Maximum contribution you can make in 2017: $5,500
- Your contributions are not tax deductible.
Note: This is a very high level overview because retirement funds can be very complicated. So if you’re reading this while thinking “but what about 403(b) plans and SEP plans, etc.,” you’re right. There are several other types of plans, but we’re going to stick to the main ones for now. Keep in mind that other factors like catch-up contributions and distribution rules are not mentioned, but will also come to play when retirement planning.
How do I know how much I should contribute to my retirement?
Short answer: it depends. Every situation is different, so it is always best to consult a trusted financial advisor to determine what action is best for you. (If you don’t have a financial advisor, some companies offer access to advisers to help get you started, so consider asking your employer.) If your employer is offering a match, it is generally recommended to contribute at least up to your employer’s match, and more if you can.
I’m still paying off my car, student loans, etc. I’ll start contributing in my 30’s and worry about it later.
Trust me, I hear ya! But don’t forget about the power of compound interest. Even if your contributions are just a small amount for now, an extra 5-10 years to let those contributions grow can make a sizable difference when it is time for you to retire. The younger you are when you start contributing to your retirement fund, the better the opportunity for earnings growth.
How much money do I need in order to retire?
Again, it’s best to consult a financial advisor. So many factors affect the calculation. How long have you been making retirement contributions? What age do you want to retire? What kind of lifestyle do you anticipate having during retirement? What will your spending habits be?
If you want a quick, rough estimator, here is a link that one of the managers at ATKG shared with us. And if your retirement estimate made you have a minor heart attack – you’re not alone. I did the same thing.
Now that you have some of the basics down, hopefully you are a little more prepared and motivated to begin retirement planning. While retirement planning may not be the most exciting task on your to-do list, one day you will thank yourself for taking the time to prepare for your future.
Happy planning,
Amy