You may hear these four terms often, but do you understand what they mean to your retirement?
401(k)
The most common type of workplace retirement plan is a 401(k) plan that allows employees to defer up to $22,500 of their annual salary on a pre-tax basis. Some employers will match your contributions up to a certain percentage. This is a good thing and everyone (younger people included) should be enrolled at least to the point of taking advantage of the company match. Some plans stipulate that the match is only available to those that contribute to the plan, while other plans have a guaranteed safe harbor amount that is paid to all employees by the company without employee contributions. You heard me right, free money!
401(k) plans are generally invested in pool of mutual funds, which are subject to market volatility. So when the market is doing well your 401(k) plan is growing. And the other side of the story…well you know what happens when the market is in the crapper. Distributions are made during retirement and taxed as ordinary income. There are also 403(b) plans, which are similar to a 401(k) plan, but for employees of tax-exempt, nonprofit institutions — such as schools and hospitals. The contribution limit and other rules are the same as with a 401(k) plan.
Asset Allocation
This is the strategy of dividing your investments among different assets and asset classes such as stocks, real estate, bonds, LLC’s, etc. The aim is to find the sweet spot for your money so that risk and reward are balanced. Asset allocation will vary based on age. Typically more risk in a portfolio is seen in the younger generation that likely have 90 percent in higher risk investment like stocks and 10 percent in lower risks investments like bonds. As we age our tolerance for risk becomes less and less due to the time allotted for recovery if things go south. In many popular mutual funds, the asset allocation adjusts itself automatically based on the risk tolerance and age of the participant. But since no two people are the same or have identical goals, it’s always good to initiate an annual review with an investment professional.
Compounding
The investments in your retirement account earn interest — and that interest earns interest. The longer your money compounds, the faster it grows. Let’s say you own stocks growing at 6 percent per year; the value of that investment will double in about 12 years, but will be worth four times as much in 24 years. The earlier you start saving, the more you benefit from compounding. If saving is delayed, the power of compounding is lost and savers will need to defer a greater percentage of their salary to catch up.
IRA
An Individual Retirement Account is often used to supplement workplace plans. It has similar tax advantages (contributions are deductible from your gross income) for most people, but the annual contribution limit is much lower ($6,500 under 50 and $7,500 over 50). If you leave your job, you can “roll over” the balance from your workplace retirement plan into an IRA; that way you get to continue enjoying tax-deferred growth on your assets. If you prefer a more hands-on approach to investing, there are Self-Directed IRAs, which enable you to call the shots and have complete control over your investment choices. Most retirement plans offer varying degrees of self-directed investing. There are also Roth IRAs, which allow you to make contributions on an after-tax basis, and withdrawals in retirement are nontaxable; however, there are income limits for contributing to a Roth IRA, so they aren’t an option for higher earners.
