One of the most important benefits that an employer can offer you is to help you save for your retirement when you are in your early twenties, but the money you put aside in your first five years of retirement will become the greatest part of your retirement fund. While retirement is a long time off, it’s critical that you understand this process.
This topic is going to focus primarily on investment/retirement concepts you need to know.
- Defined benefit plan- this is a retirement plan option that has virtually disappeared. In this plan, you contribute to your retirement out of each pay check, as does your employer. The amount you contribute is fixed and you must make this contribution. Your employer invests this money for your retirement. Then when you retire, you receive a guaranteed retirement for the rest of your life.
- Defined contribution plan- this is a retirement plan where you decide the amount you want to invest out of each pay check. Your employer will in most cases match your investment up to a given amount. You make a decision on how to invest. You will have choices among different investment options. When you retire, you then decide how to receive your money from your investment.
- Vesting period- this is how long you need to work for your employer before the employer’s contribution becomes yours. For example if the vesting period is 3 years and you leave in 4 years, then the amount of the money your employer contributed to your account is yours. You will need to transfer this into another retirement account. If you leave in 2 years, the money the employer put into your account will be kept by your employer. You will still be able to keep your own contributions to your retirement account.
- 401(k) or 403(b)- these are retirement options. The numbers refer to portions of the IRS code which describes how these plans are taxed. In both of these cases, the money you put into your retirement account is not subject to income tax when you earn it. Thus if your salary is $50,000 and you put $5,000 into one of these accounts, then your taxable income is $45,000. You will need to pay income tax on the funds when you take them out of the account. There is a cap on the amount you can put into these accounts each year. For more information on these investment options, see the topic entitled: Understanding How a 401(k) Plan Works.
- ROTH IRA’s- this retirement option works almost opposite to the 401(k)/403(b) plans. The money you put into the account has already had income taxes taken out. Then when you take money out of the account, you pay no income tax. Suppose that you have a salary of $50,000 into a ROTH IRA. Your taxable income will be $50,000. Now suppose the $5000 you invested is worth $17,000 when you retire. You will not owe any taxes on this amount. See the topic: Understanding How a ROTH IRA Works.
Investment options – when you have money taken out of your paycheck, it will be placed into a small number of investment options. Your employer will offer you more than 20 options to choose from. These options will be funds that invest in a collection of companies or other investment vehicles. You will not be picking a specific company but a group of companies that have similar financial characteristics. These investment options will be managed by a professional investor.
A lot of this sounds scary, but you will be given a lot of advice. There are general rules that you can use to guide you:
- Start investing early
- Invest continuously
- Be wary of investments that sound too good to be true
- Keep a balance to your investment options
There are a number of additional topics in this section that can help you think about your financial decisions.