Investing 101 Pre-Tax Retirement Accounts

A few of my friends who are beginning to work now asked me if I could post how to approach investing once they start work. I happen to be a very savvy investor in my young investing experience and offered to post a few articles pertaining to this area. Before I begin though, I want to just let all my readers know that I am not a financial adviser and have not taken a single exam that would give me any qualifying credence in this area. That being said, I have invested and done very well over the past 5 years and wanted to share some of the basics of where/how to invest before discussing specifics (i.e. what to invest in?).

401(k)/403(b)/IRA

For recent graduates entering the job market, if you get hired by a company, whether it is a profit/nonprofit, your company will offer you the ability to invest in a fund for your retirement. Nonprofits/government agencies usually offer employees 403(b) opportunities, while private/public companies offer their employees a 401(k).

Employees can also contribute money into an Individual Retirement Account (IRA) which serves as the same purpose as both a 403(b) /401(k), if your company does not offer a 401(k).

How Do these Retirement Accounts Work?

Both a 401(k) and a 403(b) are retirement accounts in which employees can contribute money without incurring any tax penalties. As of 2013, the IRS increased the maximum contribution from $17,000 to $17,500 for employees under 50. For those above 50, the IRS allows an additional $5,000 to be saved tax free.

What this means in simple terms is if you make $50,000 a year and are under 50, $17,500 of your salary can be declared as “tax free” and invested without incurring any immediate tax liabilities. If you were above 50 making the same salary, you could stash $22,500 in your retirement account.

If for instance, your company offers a 401(k) and you have your own IRA, you cannot contribute more than the maximum pre-tax deduction to both accounts. This means that if you are under 50, you can only contribute $17,500 but the money can be split into both accounts as you please.

If your employer offers a match for your 401(k), then you should take advantage of the match and not try to invest in your IRA; however, if there is no incentive for you to invest in the 401(k) option your company is offering, and you gain more value from your own IRA, don’t waste your time with your company’s 401(k).

If you work for 40 years and consistently contribute the maximum every single year; assuming you started working at 25, you would contribute $17,500 for 25 years and $22,500 for 15. Ignoring all capital gains on your investments, you would have a total of $775,000 in your 401(k) by the time you hit retirement.

The flipside of a 401(k) is once you start withdrawing money from the account, you incur taxes based on how much money you are withdrawing. For instance, if I withdraw $200,000 from my 401(k) when I am 65 and I am still making a salary of $150,000, I would be taxed for incurring income of $350,000 and would pay a hefty penalty for withdrawing so much money. It’s important to be keep track of your current tax rate and withdraw from your 401(k) accordingly when the time is correct.

Withdrawal Exceptions for an IRA

If you withdraw money prior to 59.5 from your IRA, you may be subject to a 10% additional penalty not withstanding your current tax rate. It is very important to know the following exceptions may help you avoid any penalties for early withdrawal.

1. Buying a house
2. Paid for college for yourself or a dependent
3. You had a direct transfer from one retirement account to another
4. You were disabled
5. You were unemployed and had to pay for health insurance/medical expenses.
6. You had medical expenses that cost more than 8% of your income
7. You received a bonus/lump sum of money and transferred into a retirement account within 60 days of receiving the money

Withdrawal Exceptions for a 401(k)

Slightly different from the exceptions for an IRA.

1. If you left your job after you turned 55
2. If you had medical expenses of 8% more than your income
3. You got divourced and need to split the money
4. Home Buying only applies up to $10,000