IRA stands for Individual Retirement Account. It’s an account that you open on your own, unlike a 401k. There are several different types of IRAs to consider, including:
Traditional IRAs – You pay the taxes when you withdraw the money in retire- ment.
Roth IRAs – You pay the taxes on the front end, when you earn the money, but not when you withdraw
SEP IRAs – For self-employed
SIMPLE IRAs – For small business owners and self-employed individuals.
Each type of IRA has eligibility requirements including income requirements, and they have caps. Let’s take a quick look at the difference between Roth IRAs and Traditional IRAs because they’re the two most common.
We’ve already mentioned that there’s a tax difference between the two. With a Roth IRA, you pay taxes on your earnings, but you don’t pay taxes when you withdraw.
Traditional IRA plans tax your withdrawals in retirement.
Roth IRAs do allow you to withdraw your contributions without paying a penalty, un- like traditional IRAs. However, with a Roth, you’ll be penalized for withdrawing any investment earnings before age 59 ½, unless it’s for a qualifying reason. The qualify- ing reasons are important because they’re often reasons that finances can become derailed. Being able to borrow from your IRA without a penalty is a protection that many can’t resist. The qualifying reasons include paying for:
- College expenses for you, your spouse, your children or even your
- Medical expenses greater than 7.5% of your adjusted gross
- A first-time home purchase. You can borrow up to $10,000 without
- The costs of a sudden
Note: If you convert money from a traditional IRA to a Roth IRA, you can’t take it out penalty free until at least five years after the conversion.
Most people don’t know that Traditional IRAs require you to start making withdraw- als called “required minimum distributions” after you reach age 70 ½. Roth IRAs don’t have this requirement. Additionally, you can’t make contributions to a traditional IRA after you have turned 70 ½. A Roth IRA lets you contribute as long as you’d like.
Look into your options and compare. Even if your company offers a 401k, an IRA account is a good idea to save for retirement. Next, let’s look at the basics of 401k plans.
Understanding 401k Plans
A 401k plan is a retirement plan that your employer provides. You decide how much you want to contribute to the plan, and your employer takes that amount out of your salary, before taxes, and puts it into the account.
You also get to decide how you want your money invested, within limits. Your employer’s plan will have a selection of investments for you to choose from. You decide how you want to spread your investments and risk. You might wonder, in this age of job hopping, what happens to your account when you leave.
The answer is that you keep the money and the account. You might roll it over into your new employer’s plan, or you can roll it into your IRA. There may be some fees and penalties depending on how you choose to transfer the money. The most important thing you can remember and a mistake to absolutely avoid is cashing out the account.
Don’t simply close the account and pocket the cash. First, you’ll pay penalties on the money. You’ll also set your retirement savings back by much more than you imagine. Remember, $5000 a year when you’re 25 can turn into a million when you’re 65. Don’t throw away the opportunity of time and compound interest.
Many companies also offer what’s called employer matching or a matching contribution. This means that they contribute a certain percentage of your salary or your contributions to your account. For example, if they offer 50% matching then they might put in 50 cents for every dollar you contribute up to a predetermined limit.
This is free money; please take advantage of it. If your employer offers a 401k plan, use it. If they offer matching, maximize it. Contribute as much as you need to get the full employer matching contribution. Don’t let this free money go to waste.
Other Employer Plans
There are other employer plans that work much like the 401k. The only difference is that the organization of the company is different. For example, a 403(b) plan is for employees of public education and most non-profit organizations, and 457s are for state and municipal employees.
You don’t have to choose one. You can, and probably should, have both an IRA and a 401k unless you’re self-employed. Having the accounts is the first step. You then have to decide how to invest your money. The first consideration is how much risk you want to take with your money.
Let’s take a look at the concept of investment risk next. There are some general rules of thumb that make it much less confusing than you might imagine.
401k Cash Outs versus 401k Loans
If you need money and have been saving for retirement with a 401k plan, you may turn to that plan. You may want to use the money to weather your current financial storm. If you are relatively unfamiliar with the ins and outs of 401k plans, you may be confused. Many individuals know they are saving for retirement and that is it. Do you have to repay the money you take out? Are you charged fees? It all depends because you have a couple options.
So, what are your options to access the money in your 401k account?
Your options include cashing out your 401k and taking a loan from it. What is your best option?
When cashing out your 401k, you don’t take a percentage of it. You take it all. This may seem like a good option if you want to buy a new car and pay for it in full. With that said, you are charged penalties. This penalty is 10%. You are not charged this fee when accessing your retirement at the age of 60. Moreover, 401k contributions are tax sheltered at first. You are taxed when you access the money, such as with an early withdrawal.
Having your retirement savings in your hand to use at your disposal may seem like a good idea. Yes, it will at the time. It is important to think long-term. Say, you have $20,000 in retirement savings. After the 10% fee, federal and state taxes, you are left with an average total of $16,000. For starters, you lose money. Next, you no longer have that money for retirement. How do you intend to survive financially without it? You better have a backup plan in place. If not, you could be homeless or working until you are 70 to make ends meet.
Not all employers have the option of early cash outs. Most advise against it. One of the few cases in which an employer will opt for an early cash out is with extreme financial distress or terminal medical conditions. The other case is with a job switch. If switching jobs, you can leave your 401k as is and pay management fees or you can rollover to an IRA or your new company’s 401k plan. There is, however, the option to cash out early. If you are in your early 20s and do not have a lot of money invested, you don’t have much to lose.
As shown, cashing out your 401k early has many downsides. It is risky and you lose money for retirement. If you need cash and you need it now, apply for a 401k loan. Most employers allow them. These are loans, so they must be repaid. Although 401k loans are optional, most employers will give them if you show need. Fill out a loan application and speak to someone in your company’s financial department.
The only significant downside to borrowing from your 401k is double taxation. As with cash outs, you are taxed when you get the money. Next, you repay that loan. When repaying, you are taxed. This money is not legally considered a 401k contribution, but a loan payback. So, you are double taxed. Still, it is usually less than the fee charged with a 401k early cash out. There may also be a handling fee, usu- ally around $75 or less.
The only dangers of a 401k loan come from changing jobs and not making repay- ment. If you do not repay your loan, your account may go to collections. If you change jobs, your employer may shorten the term of your loan and request payment within 90 days. If you anticipate switching jobs soon, hold off on a loan or consider waiting to make the switch.
As you can see, both 401k loans and early cash outs have their pros and cons. If you are in financial distress, take a minute to think about the situation. Have you considered the alternatives, such as getting a bank loan, borrowing money from family, reducing expenses, or getting a second job? Dipping into your 401k account, even as a loan, should only be used as a last resort.
401k Plans and Stocks: The Importance of Diversification
If you have a 401k plan, chances are your money is invested in stocks. Unless nearing retirement, investment experts recommended dabbling in the stock market. For those who are able to wait and survive the market ups and downs, the stock market is a great way to invest, save, and make money for retirement.
If you just created a 401k account or if you are now realizing the importance of get- ting the most from your 401k, you may wonder how to increase profits and reduce losses. When the stock market is involved, there is one word you need to know; diversification. Diversification is key to maximizing your savings and reducing losses.
Most importantly, never invest too much money in your company stock. For most, company stock seems like the best choice. You work for the company, so why not support it by being a stockholder. This is a good theory, but it can backfire. What if your company collapses and goes under? You not only lose money from your stock, but you lose your job too. Don’t suffer a double hit.
Always review your employer contributions. Many employers contribute to their employees’ 401k plans. This usually involves matching a percentage of employee contributions. Some employer contributions come with restrictions. For example, the money may only be used for company stock. Your hands are tied in this aspect, but use the rules and restrictions to diversify your own contributions. For instance, if your employer contributions buy you stock in your company, use your own money to invest in others.
Always think outside of the box. For example, in 2007 and 2008, the auto industry took a significant hit. Automakers were left to layoff workers, close plants, and ask for government assistance. There were signs these companies were starting to go under. If you had stock in the automakers, you may have had an opportunity to get out before the stocks dipped too low. With that said, it wasn’t just the auto makers that saw a decrease in stock, most wholesale auto parts suppliers, auto stores, and car dealerships saw a decrease too. This is because they are all directly related to each other. When diversifying your stocks, always consider this relation. Never invest only in stock related to the auto industry and so forth. Diversify your portfolio.
One of the best ways to diversify is to consider the economy. It always has its ups and downs. For example, when the economy is good, consumers spend more money. When it is bad, they spend less. This is evident with restaurants. Dominos Pizza shares were around $32.25 in April 2007. In January 2009, they were about $6.13 a share. Now, the economy is bad. Consumers are watching and limiting their purchases. For years, McDonalds shares were consistently below $45 a share. In 2007, they started to increase. In January 2009, shares were worth about $60.07 each. If you invest in retail stores or restaurants, be sure to have a mixture of high end and discount companies. That way you are protected if the market changes direction.
The above mentioned tips in this section focused on diversification for 401k stocks. It is also a good idea to diversify in other aspects. Don’t invest all your money in the stock market. Every so often, the market experiences twists and turns. Don’t get caught in the rough patch when ready to retire. As you near retirement, start making the switch to bonds. They do have a smaller payoff, but the risks are much less. If in your early 20s or 30s, diversify and create your portfolio with a mixture of stocks and bonds, and as you age you need to keep rebalancing your portfolio’s risk profile to accommodate your changing situation.