Retirement Funds: Nuts and Bolts

vanguardMillions of students across the country spend tens of thousands of dollars and years of their life in pursuit of a formal education. They do this in hopes of increasing their personal ability to make money. Ironically, most do not invest time to learn how to utilize that money efficiently. Instead they go with the pack, learning how to consume to the maximum extent their incomes will allow. These people deserve some slack, however. Our educational system does not provide organized instruction on how to manage money, only how to spend it.

When college graduates land their first job, they are given the daunting task of choosing a retirement plan. What makes this task so intimidating is not that it is an advanced topic, but rather we never learned anything about it.

Since YOU are here and going out of your way to invest in your future, I won’t let you go without picking up some information about these retirement plans. I mean, retirement is kinda the theme of this blog, how could I not have at least one post about retirement planning? When your friends eventually notice you sliding ahead of them, you can refer them to this blog and together we can wake the rest of the world up.

I won’t get too technical here, we’ll just cover some basic functionalities of tax advantaged accounts for long term investing. Consider what you put away into these investment vehicles as your old man/woman money, as there are penalties for early withdrawal (before age 59.5). This of course means you will also be saving a separate pile for your pre 59.5 years. This part of the planning is unique to an early retiree, but since you know how to manage your own investing, you will have no problems here.

If you already have a firm grasp of tax advantaged accounts, feel free to skip around to other posts. I aim to clarify the concept for any younger readers out there who may not be in the loop. Many young people face enough fear of make the wrong choice in retirement plans that they opt out of the choice altogether.

Below is an excerpt from a TED talk by Barry Shwartz, where he outlines the surprising findings of a Vanguard study.

for every 10 mutual funds the employer offered, rate of participation went down two percent. You offer 50 funds — 10 percent fewer employees participate than if you only offer five. Why? Because with 50 funds to choose from, it’s so damn hard to decide which fund to choose, that you’ll just put it off until tomorrow. And then tomorrow, and tomorrow, and tomorrow, and of course tomorrow never comes. Understand that not only does this mean that people are going to have to eat dog food when they retire because they don’t have enough money put away, it also means that making the decision is so hard that they pass up significant matching money from the employer.”

This excellent talk was titled The Paradox of Choice, I encourage you to check it out.

There is no reason to be struck by such paralysis when picking a plan. The single worst decision is indecision. If you really are having that much trouble, at least put your choices on a dartboard to decide, it will be way better than not participating.

For long term retirement investing, these are the three common types of investment vehicles if you live in the United States.

Roth IRA’s

A Roth is an account run by the individual, this means you. As of 2015, you can contribute up to $5500 each year or $6500 if you are older than 55 (an age I believe you should be done saving and living off a sustainable income for sure). Your contribution limits may be lowered depending on your income.

For early withdrawals (before 59.5), there is a federal tax of 10% on all EARNINGS. You will not pay a penalty on any principle than you withdrawal.

You pay income tax on your contributions as they go in, your withdrawals later will then be tax free. This is nice when we are talking about a compound snowball of earnings working in your favor for 30+ years, all coming at you tax free.

Traditional IRA’s

Another individual retirement account. Contributions cannot be restricted by income amount and you can no longer contribute once you reach age 70.5. Unlike the Roth, contributions are tax deductible.

Taxes work a bit differently, your contributions go in tax free and you pay taxes on the withdrawals later.

Although there is a never ending battle between which of these above two choices are better. I believe it depends on the individual. If you have an unusually high income and don’t qualify for the Roth, then obviously the Traditional is the way to go. Also, the taxes you pay on the traditional later on will depend on your tax bracket. If you are leading a life of happy efficiency and living on $30,000 or less a year, the traditional  is looking tempting to you.

401ks

These plans are offered by your employer and often come with a wonderful thing called employer matching. This is when your employer will contribute as much money as you do to the fund up until you are saving a certain percentage of your income. Employer matching is free money, yet LESS THAN 10% OF EMPLOYEES TAKE FULL ADVANTAGE OF IT! WTF?!

Taxes in a 401k work similarly to a traditional IRA in that they are deferred until you withdrawal from the account later in life. The limit for tax deferred contributions as of 2015 is $18,000. At this point you are considered to be ‘maxed out’.

A bit about risk adjustment.

Technology has allowed a great amount of automation to be implemented into long term investing. It is becoming more common to see companies that will perform routine rebalancing for their customers, along with automatic risk adjustment as they age. Risk adjustment is typically associated with LIFE plans. As time rolls on and you accounts inflate to ever increasing towers of cash. The riskiness of the portfolio is decreased so as to protect you from temporary market fluctuations as you near retirement.

These short term fluctuations don’t matter when you are young. If fact, they should be welcomed with open arms. Dips and drops will help your account in the long run as you stay relaxed and keep investing on a regular schedule. The long term behavior of the economy will keep it’s word of trending upward. The reason for risk adjustment later in life is to buffer against temporary downs so you can transition to retirement during any time, even during the crash of 2008.