As a former pension actuary, retirement saving is one of my favorite personal finance topics. I’ve written several posts on 401(k) vs IRA, and today I’ll be talking about the history of these retirement saving plans and making some observations about how the history affects the current retirement saving pictures.
Hopefully I have given you enough tease to get you curious about the tax advantages of a retirement savings account. I recommend you peruse these introductory posts to gain a basic understanding of retirement saving before reading this number-heavy post.
Chances are you have heard about the tax advantages of a 401(k) or IRA somewhere before. Let me sum up and illustrate in an easy-to-understand way, and as always, I’m available to answer questions.
Let’s clarify this first: retirement savings accounts have tax advantages over what?
Like a 401(k), an IRA is a retirement savings account. You put money in it, and use that money to invest. But unlike a 401(k), an IRA does not have an employment requirement. IRA stands for Individual Retirement Account; anyone, even if he is not employed, can contribute to an IRA unless his income is too high. This works perfectly for freelancers such as my friends that are dancers and do not work for any particular company.
This post has 3 parts. Part 1, I explain what a 401(k) is. Part 2, I explain how you contribute to a 401(k). Part 3, I explain why you should contribute to a 401(k).
Part 1. What the heck is a 401(k)
A 401(k) is a retirement savings account sponsored by employers. In order to contribute to a 401(k), you need to be employed.
I’m sure you have heard of these terms before. They probably appear on the media more frequently than the Kardashians. Traditional 401(k), Roth 401(k), Traditional IRA, and Roth IRA are 4 types of retirement savings accounts.
“Saving” is a funny word in this context. It may not mean what you think it does.
In my previous post, I hinted at why putting your money away in a checking account may not be a good way to save for retirement. Let’s compare this strategy with investing the money saved away. Consider this graph which I used for another post (“The power of compound interest”) a while ago:
After 40 years, by investing your money, you will end up with 4 times the amount you contributed. 4 times. In other words, investing your retirement saving basically cuts the amount you need to save by 75%. Instead of saving 40k per year, now you only need to put away 10k per year.
OK, let’s face this. I am in my 20’s. If you are reading my blog, you are probably in your mid-20’s as well. What’s up, retirement? Geez, why care about anything 40 years out?
Well, I’m an actuary, so I speak in terms of probability. What if I’m one of the (un)lucky few bastards that make it past 65 years old? Well, first off, I will most likely be out of jobs. And secondly, my health will not be cheap. Think more doctor visits, more ways to exercise, healthier food, higher health insurance premiums. And I may want to give something to my grandchildren if they choose to attend Harvard….
Where does the money come from?