So you’ve got some money tucked away for a rainy day in the near future, but what should you do about the savings you’ll need for the long term? Remember back in April when I talked about the magic of compound interest, and how it would give us the ability to live a rich life, if only we would hurry up and get to investing? I hope you were picturing yourself, because you’re here, and that time is now.
Most people think of today’s topic – where to put your long-term savings – as the crux of personal finance. And in many ways it is: You’ll certainly have a harder time getting to your worry-free golden years without a 401(k). But you can only do this if you do it right, by first living below your means (something I’ve struggled with), saving cash for an emergency (something I’m still doing), and thinking through your needs.
Got it? Scout’s honor? Okay then, let’s get to it.
When investing for the long term, there are three rules:
Rule #1: Don’t invest money you’d like to see any time soon. By “soon” I mean 5 years minimum, but ideally 10, 20, 30, or 40 years down the road, depending on how old you are. You’re investing for the long term, and you’ll be penalized if you withdraw this money early. If you need cash in the short-term, stick it somewhere else.
Rule #2: Don’t turn down free money (read: employer match). Your employer matches the first six percent of your salary? Then I expect you to be stowing at least six percent of your salary in that plan.
Rule #3: Max out tax-favored accounts before investing in taxed accounts. Long-term savings can be stowed in a tax-favored account, like an IRA or 401(k), or in a brokerage account, which is subject to taxes. Needless to say, take advantage of the tax breaks the government offers in the first two types of accounts before moving onto the third.
There are a few typical places for your long-term savings: namely, a 401(k) or IRA, each coming in both a “Roth” and “traditional” version.
A traditional 401(k) is a retirement account offered only through employers. This is a type of investment account in which you, as the investor, elect to contribute a portion of your paycheck to the account, which (at your discretion) is then invested – either by you or a brokerage firm.* A major perk of 401(k)s is that many employers match all or part of their employees’ contributions. This is free money and it is not to be turned down!
There are two special tax advantages to the traditional 401(k): First, your contributions are made pre-tax, meaning any money you put into the account is deducted from your paycheck before your income is taxed, saving you immediate dough. Second, money within this account can grow tax-free (meaning you can buy and sell stocks to your heart’s content without paying any capital gains tax) until you withdraw it without penalty at age 59 ½. At that point, you would pay income taxes on the distributions you receive as if they were ordinary income. The government sets limits on how much you can contribute to your 401(k), and in 2013 this limit was $17,500.
A less common Roth 401(k) is similar to a traditional 401(k), but the tax incentives are switched. Under a Roth 401(k), rather than using pre-tax money to fund your account, you put in post-tax funds (meaning you had to pay taxes on that income). However, at retirement you’re free to take your distributions tax-free.
Choosing whether to go with a traditional or Roth 401(k) depends on your view of your income tax rate now versus when you plan to withdraw the funds. If you believe your income tax rate will increase as you get older – due either to a bump in your income bracket or legislators raising tax rates – then a Roth is the way to go. If you want to save the tax impact now and believe your tax rate will stay stable or decrease in the future, then a traditional is right for you.
If you don’t have an employer who provides you a 401(k) (or even if you do – you can and should get both types of accounts if possible), you can open an Individual Retirement Account, or IRA, which can be opened through any ordinary brokerage account. I opened one for myself my senior year of college through Charles Schwab.
The IRA – both traditional and Roth – functions exactly like a 401(k), with a few key differences. The tax incentives of an IRA mirror that of a 401(k) – the traditional saving you money now and the Roth saving you money later. Unlike a 401(k), however, anyone with income can contribute to this type of account, making it the most accessible retirement account. Unfortunately, the contribution limit is just $5,500 per year – much lower than the 401(k)’s $17,500 limit. Finally, the Roth IRA is actually restricted based on income – those making over $129k cannot contribute to a Roth IRA.
Finally – and only after you’ve maxed out both of these accounts – you can put as much money as you please into your own brokerage account to invest how you want. Gains on these accounts are subject to hefty capital gains taxes, so only do this as a last option.
*For example, my 401(k) funds are invested under a Fidelity plan I’ve elected out of a few different options based on my risk tolerance. Since I’m young (and have many years ahead of me to recoup losses in the market), I have a high risk tolerance: The plan I elected invests mostly in stocks, rather than “safer” assets like bonds, CDs, etc. Alternatively, I could have elected to manage my savings myself, in which case I would make all the decisions about exactly which stocks to buy, sell, etc. on my own. We’ll get more into investing later.