So What the EFF is a 401k? And 8 Other Retirement Questions, Answered

Figuring out how to be an adult is hard enough and now they want me to save for retirement?

For most young adults, the moment the words retirement or 401k come up we start zoning out. It’s way too far in the future to think about (like 40 years if your are in your early to mid 20s). But here’s the thing, if you don’t save enough for retirement then you will be monumentally screwed. So just suck it up. Plus on the upside this stuff is not that hard.

Here are the answers to 9 of your questions about retirement investing:

What is a 401k?

A 401k is a retirement savings plan available through employers that allows employees invest a portion of their pre-tax paycheck for retirement. 401k savings can grow tax free until retirement. But once you start withdrawing money, the withdrawals will be taxed as ordinary income. Employers often match their employee’s contribution, so make sure you are maxing out your employers match.

What is an IRA?

IRA stands for Individual Retirement Account. An IRA allows individuals to save money for retirement. You can have an IRA regardless of whether you already have a 401k at work. If you don’t have a 401k at work, then an IRA is your only option for tax advantaged retirements savings. There are two main kinds of IRAs: a traditional IRA and a Roth IRA. A traditional IRA functions very similarly to a 401k. Your contributions to the account are pre-tax and the withdrawals at retirement are taxed as normal income tax. With a Roth IRA, your contributions are made after-tax. However when you retire, you can withdraw the money tax-free.

When should I start saving for retirement?

Right now, probably. If you have a lot of student loan debt at a high interest rate you may want to pay that down first. You should also look into refinancing at a lower rate. And if you don’t have an emergency fund, you should create one of those first. But the main point here is that if you haven’t started saving for retirement yet, then you should start as early as possible to give your money time to grow. And thanks to the magic of compound interest starting early can make a six-figure plus difference in retirement.

What is an employer match?

Well it’s basically free money so you should get it. The employer match is the money your employer puts in your 401k for you. For example, your employer may match every dollar you put into your 401k up to 3% of your salary. Pretty awesome right? Free money is certainly better than non-free money you should remember that your employer’s match may not line up with your retirement savings goals. Many experts suggest you should save between 10% and 15% of your income for retirement. If that is the case, maxing out a 3% employer match wont get you enough money for retirement.

What if my employer doesn’t offer a 401k match?

If your employer does not offer a match then you will need to work a little harder to meet your retirement goals. It’s up to you whether you want to save for retirement in an IRA rather than a 401k or vice versa. Here are some things to keep in mind. The annual savings limits for an IRA ($5,500) is much lower than a 401k ($18,000). So you can contribute a lot more pre-tax money to your 401k each year. However, for various, reasons including cost and liability employers limit the number and types of investments that are available in a 401k. Another potential draw back to 401k is cost. Some 401k plans have expensive fees which will eat into your retirement savings. If that is the case you may want to max out your IRA each year before you put money into your 401k.

What is an expense ratio?

The expense ration is what you pay the person or company that invests your money in the market. Your expense ratio comes out of your annualized return. For example, if the expense ration is 1% and you investments grew 7% then your actual return after fees will be 6%. Mutual funds generally have much higher expense ratios. Index funds and etfs tend to have very low expense ratios. If you are wondering why someone would invest in a mutual fund when index funds are so much less expensive, well so are finical researchers. Because in addition to being more expensive than index funds, mutual funds also tend to underperform the market over the long-term.

What does asset allocation mean?

Asset allocation is pretty simple, it’s just the mix of stocks, bonds, real estate, commodities, etc. that you are investing in.

How do I determine my risk tolerance?

The basic idea behind risk tolerance is pretty simple. It’s simply, how much risk can you accept to meet your retirement goal? Stocks have higher risk and potentially higher returns than cash. That risk is especially true in the short term. There is no guarantee about where the market will be in the next few months or even next few years. If you will be retiring relatively soon, then you will want to limit your risk. However if you have a three or four decades before retirement then you can and should accept much more risk.

So how much do I need to save for retirement anyway?

Well, this is the million dollar (or multimillion dollar) question. The way to answer this question is to start by asking yourself how much money you will need or want to each year during retirement to live off of. Generally financial advisers say you can withdraw 4% of your retirement savings without risking running out of money. So, for example, if you want to live off of $100,000 a year during retirement, you will first need to figure out how much you will be getting for social security (assuming it still exists). Let’s assume you will be getting $20,000 a year from social security. That means you will need to withdraw $80,000 per year. $80,000 is 4% of $2,000,000. Which means that you will need to have a retirement nest egg of $2,000,000. Sounds simple right? If you want to do some scenario planning to figure out how much money you can expect to have with different savings rates, you can try this retirement calculator