Most of us have the option of saving for retirement in a 401K plan (Wikipedia) which is usually, but not always, the best way to save for retirement.
Pros
- Tax-Deferred: Save on taxes now. You will need to pay for it later though. Your tax rate now will most likely be higher than during retirement. If this is true, you’ll end up paying less in taxes and have more for retirement.
- Automated Savings: The savings come out of your paycheck so you never see it and it actually gets saved rather than spent.
- You Can Save A Lot: The amount you can save is decent. In 2009 it is $16,500 and it tends to rise.
- Free Money (Sometimes): Your employer may match your contribution. In this case, it is free money until you hit the contribution limit. ie. If you employer has a 50% match up to $5,000, and you contribute $5,000, they will add another $2,500 for a total of $7,500. You should aim to get the maximum employer match whenever possible.
Cons
- You Do Pay Taxes Eventually: In some situations, your tax rate now will likely be lower than during retirement. This is more likely to be true if you are…
- Early in your Career: Your income is likely to grow by 2-3 times in the next 20-30 years.
- Lots of Income Tax Deductions: If you claim lots of income tax deductions due to a house or other reason that you don’t expect to have during retirement, your tax rate now may be lower than in retirement.
- Fees: Some plans charge an administrative fee of 0.5% on to of mutual fund expenses of 0.7%. This can drag down your long term returns substantially.
- Investment Choices: Most plans offer 10-12 investment options. The choices may not match your investment preferences or they may charge higher than normal expenses fees.
- Mandatory Distributions: When you are retired, you will be required to withdraw funds whether you need them or not and regardless of your tax situation.
Your Alternatives
So you might ask where else can you save that might be better based on the circumstances? If you think you’re in a low tax rate now as compared to when you retire, here are some options.
- Roth IRA: So you can pay your taxes later with a 401K or pay them now with a Roth IRA (Wikipedia). You need to earn less than $95,000 if you are single and $150,000 if you are married. Otherwise, anyone can open this account at a brokerage and contribute up to $5,000 per year.
- Roth 401K: (Wikipedia) This works similar to a 401K except you put funds in after you’ve paid taxes on them. Then you never pay taxes again.
If you self-employed or your employer doesn’t offer a 401k, you do have some other options such as a traditional, SIMPLE or SEP IRA (Wikipedia).
