If you truly want to put the gold in those golden years you need to have a retirement account. If you don’t have one, you need to start one. This is true whether you’re in your 20s or your 40s, as it’s never too early or too late to harness the power of compound interest.
How compound interest works
According to the online encyclopedia Wikipedia, compound interest “arises when interest is added to the principal of a deposit or loan, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding.” To put this another way it’s how just about anyone can accumulate enough money to have a nice requirement.
An example of the power of compounding
Here’s an example of the power of compounding. Let’s suppose you have $1000 to invest and that you’re willing to add $100 a month to it for a period of 20 years. If you were to earn 5% a year, which is fairly modest, you would have $42,330 at the end of those 20 years. In comparison, if you were to save $100 a month without compounding, you would have only about $25,000.
The three basic types of retirement accounts
There are a number of different kinds of retirement accounts but if you’re an employee the three most popular are a traditional IRA, a Roth IRA and a 401(k) plan. If you work for a nonprofit organization there is the 403(b) and if you’re self-employed there is the SEP or Simplified Employee Pension.
Here is how they differ.
Anyone can have a traditional IRA (Individual Retirement Arrangement) whether you’re employed or not and whether or not you participate in some other retirement plan. An IRA can be set up with just about any financial institution but is most often with a brokerage firm. With a traditional IRA, you can contribute up to $5500 a year (for now) tax-free. In other words, you can deduct whatever amount you contribute to your IRA from your income taxes. You can begin taking withdrawals from an IRA when you
- Turn 65 (or the plan’s normal retirement age, if earlier);
- Participate in the plan for 10 years; or
- Your employer terminates your services
One of the best things about a traditional IRA is that you fund it using before tax money. The downside is that when you begin withdrawing the money it will be taxed as ordinary income at your normal tax rate, which will probably be 25%. Plus, you must begin withdrawing the money when you reach the age of 70 1/2 whether you want to or not. This will be in the form of what’s called a Required Minimum Distribution and will be calculated based on how much you have in your IRA and your age. Of course, you can withdraw more than your Required Minimum Distribution if you wish.
Many of the things that are true for a traditional IRA are the same for a Roth IRA. For example, you can deposit up to $5500 a year in a Roth IRA just as you could with a traditional IRA. You can also withdraw money the same way as with a traditional IRA – when you turn 65, have been in the plan for 10 years or your services are terminated by your employer. However, in terms of taxes a Roth IRA is the exact opposite of a traditional IRA. You fund it with after-tax dollars but then when you withdraw the money it is not taxable. Again, you will have to begin withdrawing the money when you turn 70 1/2 and there will be a Required Minimum Distribution (RMD). You can take more than your RMD but if you take less you will be fined by the IRS.
Many people call a 401(k) the workingman’s best friend. With a 401(k) plan, you can choose to “defer” some of your salary. Instead of getting that amount in your paycheck, the deferred money would go into the 401(k) plan sponsored by your employer. This deferred money generally is not taxed until it is distributed. But the real beauty of a 401(k) is that in many cases your employer matches your contributions up to a certain level. While this will vary from employer to employer, a typical situation is that the employer matches 50% of your contributions for the first 6% of your salary you contribute, which means it won’t match more than 3% of your total salary. Other companies might elect to provide a straight match to a certain point. In this case, the employer matches 100% of your contribution up to a set percentage of your income.
A 401(k) is more generous in that you can contribute up to $12,000 in a year. The money you contribute is 100% vested because after all it’s your money. However, your employer’s contribution may vest over some period of time.
You can borrow from a 401(k) account with certain limitations. If you do elect to borrow from your account you will be required to pay it back within six months or the money will be treated as ordinary income and you will be taxed accordingly. Since the money is yours you can take it with you if you leave your employer and then roll it over into another 401(k) plan or into the IRA of your choice.
The same restrictions apply to a 401(k) as a traditional IRA or Roth IRA. You must start withdrawing your funds when you reach age 70 1/2, as there will be a Required Minimum Distribution.
This plan is pretty identical to a 401(k) except it’s for people who work for nonprofit organizations. This includes employees of public schools; some colleges and universities; churches; or charitable organizations that are tax-exempt under section 501(c)(3) of the IRS code. You can defer up to $16,500 of your annual salary into a 403(b) plan and you must begin taking your Required Minimum Distributions when you reach age 70 1/2.
You manage your money
Regardless of which type of retirement account you choose, you will be in charge of managing it. This means you will decide how to invest the money. If you have an IRA you can invest in just about anything you choose up to and including real estate. However, with most 401(k) s your choices will be limited. As an example of this, if your employer has Fidelity Investments as its fund manager you might be limited to choosing from among a group of the mutual funds it offers. But the important thing is to be conservative in your investing. Stocks, bonds, mutual funds and most other investments go up and down in value. It’s much better to find investments that return a safe 3% or 5% than to gamble on some high-flying stock that’s skyrocketing in value but that could crash and burn next year – wiping out all your hard-earned savings.
In the event you don’t have a retirement account, run do not walk to your HR department or your local brokerage and get one set up. Make regular contributions, let the power of compounding work for you and you might even be able to retire at age 65, move to that island paradise and spend your golden years basking in the sun. If not, you might find your golden years are not so golden and you could end up literally working until you drop.