Importance of a retirement account: Fourth in a series of financial tools to master
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| Money growing over time! |
Welcome back! This is the fourth installment of ‘financial tools to master’ series. In this post, I would like to discuss the importance of retirement accounts and how they can help in your path to early retirement.
My first encounter with a retirement account was at my first job selling Toyotas/Pontiacs. ***For benefit of those who don’t know what a Pontiac is, it was a brand of cars that General Motors sold. It was discontinued around 2009. My supervisor at the time mentioned it, but frankly I had no idea what it was. Not knowing much about the 401k, I declined to open an account.
After I changed my job from selling Toyotas/Pontiacs to Acuras, I opened up a 401k account. My colleagues at the Acura dealership were instrumental in getting me interested in a retirement account like the 401k. They would show me how much they were putting away each pay check. They were showing me how it worked.
Just because I opened an account didn’t mean I understood much about which investments to choose and why. It was literally Greek to me at the time. My colleagues recommended me investments I should select, so off it went.
I put away 10% of my paycheck initially then raised it to 15% the next year. It was exciting to see your account go up in value. This was back in 1996 to 1999. Stock market was doing exceptionally well. If you bought something around that time, you would’ve done well.
In the summer of 1999, my wife and I decided to buy our first home. We didn’t have much money, so we settled on a ‘co-op’, which is very popular in New York City. Co-op or cooperative is buying shares of an apartment building rather than buying and owning your place like a house or a condo. Condos and houses were beyond our means...
The advantage of a co-op is lower cost to buy, but there were too many disadvantages, including way too much paperwork to get accepted into the co-op when buying and selling, too much maintenance fees (we paid $1200 maintenance whereas our mortgage was $350!), and association raising our maintenance fees when it couldn’t balance its budget.
In order for us to buy this co-op, I had to borrow money against my 401k. I borrowed $7500, which was about half of my account balance at the time. I knew I was forgoing future compounding earnings to do this, but we didn’t see any other way at the time...
Long story short, after taking out the loan against my 401k, we ended up closing that 401k account for good that same year. We were making typical rookie mistakes. We were house poor and we knew it. We had like $38 sitting in our checking account once we closed on our co-op! We needed to pay maintenance and mortgage...
I had briefly changed jobs that summer to try my hands at selling Mercedes Benz, but after 3 months, I ended up back at the same Acura dealership. This meant I didn’t earn much money for those 3 months...We were ill prepared as home owners...No emergency fund, and no clue...We were just winging it best we could.
I knew closing my 401k account was a big no-no. My colleagues talked to me about compounding effects I would be missing out by closing the account. But, I had to put out the fire first. Lesson learned...
The moral of this story is to have an emergency fund ready so you don’t make the same mistake I made. If I had one, then perhaps my 401k would still be intact. I know it wasn’t much money, but the compounding effects of it would’ve amounted to a decent pot by now...
Well, enough of me lamenting the past! Let’s jump right into retirement accounts.
Let’s first define what a retirement account is. Retirement account is a tool for putting away money that often has tax advantages, that will be available at retirement. Most defer tax until your retirement age of 59 1/2. Some, like Roth IRA is not tax deferred, but you won’t pay taxes when taking your money out at retirement age of 59 1/2.
Most popular types of Retirement Accounts:
- IRA (Individual Retirement Account): This is an account you open yourself through a financial institution/broker like Fidelity, Charles Schwab, TD Ameritrade, etc., and not through your employer. Tax is deferred until your retirement age. At this writing (January 2021), the maximum allowed contribution is $6000 for someone below the age of 50, or $7000 for someone over the age of 50.
- Roth IRA: No tax advantages, but you can take money out at retirement tax free. Maximum contribution is same as above.
- 401k: Employer sponsored retirement account. Maximum contribution is $19500 or $26000 if over 50 years of age. Money is taken out of your paycheck by the employer. Tax is deferred until you take money out at retirement age.
- SEP Plans (Simplified Employee Pension): Usually set up by a small business owner for employees or for self employed owner. Maximum contribution is $57000 or 25% of earned income.
Most people will use a 401k or an IRA as retirement accounts. Here’s how to open different accounts.
Roth IRA / IRA:
- Make sure you first have a checking account. (You should if you read the post about ‘Importance of a checking account’. If you missed it, click here.). You’ll need this to transfer money into the retirement account. You can open up an account online. Simply pick a financial institution that you’re comfortable with, then open an account. I recommend ones that do not have any fees to open and maintain. Fidelity, Charles Schwab, TD Ameritrade, etc., do not have fees. *Google ‘no fee ira’ to find one.
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| Google ‘no fee Ira’ |
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| From Fidelity site |
- Above screenshots are from the Fidelity website for informational purposes. Remember to pick the one you like!
- Once you open an IRA, you’ll need to select types of investments. Without going into too much detail at this time, here are my tips on initially choosing the investments.
- Buy mostly stock mutual funds that mimic the S&P 500 (top 500 publicly traded companies in the US). Example of this would be something like ‘Fidelity 500 Index Fund (FXAIX)’ or ‘Schwab S&P 500 Index Fund (SWPPX)’. Both of these funds offer low expenses. Research on Google ‘s&p 500 index funds’ to come up with options.
- Aim to buy around 75-85% into this investment. As you get more knowledgeable about investments, you can always change it later on.
- Aim to buy some bond mutual funds to offset stocks, like ‘Western Asset Core Plus Bond (WACPX)’ or ‘Vanguard Total Bond Index (VBTLX)’. Aim about 10%.
- If you’re extra aggressive, then invest the remaining 5-15% into small capitalization index fund like ‘Vanguard Small Cap Index Fund (VSMAX)’ or ‘Fidelity Small Cap Index (FSSNX)’. Both offer low expenses.
- Your company will in most cases, automatically enroll you in one. It’s important to CHOOSE your investments though. Most companies will select either money market funds or select ‘target date funds’ (fund picks out the year closest to your retirement at age 65; it then automatically balances mix of stocks/bonds to go safer as you get older; returns are not impressive in many cases; they may also have higher expenses), unless you select investments yourself.
- Follow similar rules above. Most 401k plans will offer similar investment choices we mentioned. In your 401k investment options, choose an index fund with a low expense rate as possible. In my company’s 401k, there were several index fund options. Pick ‘S&P500’ index fund for the most part (75-85% like discussed above), and two others (bonds and small cap index fund). Every 401k is different. You may need to seek help from your company’s 401k administrator if you have questions about an investment...
- Remember, as you get more knowledgeable with finances, you can always tweak them later on! I usually tweaked mine once or twice a year. If I saw an investment was doing well, then I would increase my percentage to buy more shares. Conversely, if an investment was not doing well, I would reduce my percentage to buy less shares. Don’t think what you select on day one is what you’ll end up with on retirement! Rebalancing the amount going into different investments is an important part of the process!
- Stock: a fractional ownership of a company; when buying a stock or a share of a stock, you’re betting on future of that company to do well
- Bond: instrument of debt; common ones are corporate bonds and municipal bonds; company or a municipality pays you interest usually monthly, for borrowing your money
- Mutual fund: managed investment that buys stocks of many companies, reducing risk
- Large cap or large capitalization companies: companies that have market capitalization of $10 billion or more; companies like Visa, Apple, Amazon are examples
- Mid cap or middle capitalization companies: companies that have market capitalization of between $2 billion and $10 billion; companies like American Eagle Outfitters, Dunkin Brands, Avis are examples
- Small cap or small capitalization companies: companies that have market capitalization of under $1 billion; companies like Papa John’s, Redfin, AMC Entertainment, are examples
- Index fund: designed to follow an index; index would include things like S&P 500’, ‘Dow Jones Industrial, NASDAQ, Russell 2000; typically has less expense versus a regular mutual fund
- Diversification: selecting multiple investments to minimize risk; buying one company’s share is risky, but buying mutual funds or index funds will mitigate the risks
- Asset allocation: idea of selecting the different investment types for your portfolio to reduce risk depending on investor’s risk tolerance, goals, and time frame
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