You aced your interview and are now working in your first job after graduating college. Your human resources manager just handed you a packet of information about benefits, including vacation and sick time, the work lunch program and oh yes, your 401k or IRA plans. Where do you start? Retirement is the furthest thing from your mind but you know you’ll to fill out the paperwork, so might as well do it right.
Let’s start by explaining a 401k plan. These plans, referred to as a defined contribution or qualified profit sharing plans allow you to contribute part of your wages into funds comprised of mutual funds, variable annuities or life insurance that allow your money to grow due investment growth and compounding interest. Compounding interest is the act of adding interest to the principal of a deposit or loan so it can earn even more interest. This is a great strategy that will help your money grow at a quicker pace.
401k’s are not taxed while gaining investment earning. Your employer will make contributions to your account based on your salary level and investment earnings accumulate tax-deferred. You become vested in your plan between 3 to 6 years depending on your employer and if you leave before becoming fully vested, you forfeit all or part of your plan’s accumulated value. Distributions are only taxed after you reach retirement age or terminate employment. Be careful, if you take money out of your plan before age 59 1/2 it is subject to a 10 percent penalty. However, this tax does not apply if you withdraw due to a qualifying disability. Annual contribution limit for a 401k is $18,000.
There is the traditional 401k, a safe harbor 401k and a Simple 401k plan. The most flexible is the traditional 401k. In this plan, the employer can make contributions on behalf of employees, to match what the employees contribute or do both. Participants make pre-tax contributions through payroll deductions.
The safe harbor plan unlike the traditional 401k is not subject to annual nondiscrimination testing which is the annual ADP or ACP nondiscrimination test. In a safe harbor plan, employees must adhere to certain contribution and vesting requirements.
A simple 401k plan is used by small businesses with 100 or less employees who received at least $5,000 in compensation from their employer in the preceding year. It enables employers to offer cost effective retirement plans to their employees.
There are two types of Individual Retirement Plans (IRAs), a traditional IRA and a Roth IRA. You can contribute $5,500 to a traditional IRA up to the age of 70 1/2 and deduct it from your salary if you and your spouse, if married are not covered by a retirement plan at work. If you have a retirement plan at work, your deduction may be limited. You can withdraw money anytime but know that earnings you withdraw are taxable. If you take out money before turning 59 1/2, you may have to pay an additional 10% tax penalty. However, you must start withdrawing from your account by April 1 following the year in which you turn age 70 1/2 and by December 31 of later years.
A Roth is different in that you can contribute at any age if you have taxable compensation and your modified adjusted gross income is below a certain limit. You contribute after tax money that you’ve earned so it is not tax deductible to an annual limit of $5,500. Unlike the traditional IRA, you are not required to start taking distributions at a certain age. You do however pay a 10% tax penalty if you withdraw before 59 1/2.
How to choose a fund
When analyzing which fund to put money into, don’t just go by the name of the fund, this could be misleading. Find out what is the objective and strategy of the fund. Look at Morningstar and Yahoo Finance to help you with your research. Also, check out long term returns to give you an idea of how the fund has behaved throughout the years. Consider if you want your investments automated such as in a target fund, asset allocation fund or life cycle fund or if you would rather actively manage your investments. It all depends on how comfortable you feel.
Remember, check out fees, invest in the long term and diversify your portfolio but take some time to decide.