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Investing Guide => Personal Finance => Topic started by: z28dreams on April 12, 2008, 10:39:37 AM

Title: 401k and IRA basics
Post by: z28dreams on April 12, 2008, 10:39:37 AM
This guide will help you understand how 401k's and IRA's work, and why they should be the first places you invest your money in.

401k (and 403b)

For those of you employed, this is a great option for retirement.  It basically works like this:

Your employer lets you deduct a certain percentage of your paycheck each week to invest.  The company usually gives you a choice of investments to pick from, including mutual funds, bonds, money market accounts, etc.  There are 2 major advantages to doing this vs. investing by yourself.

1.  Tax benefits - At the end of the year, any money invested into a 401k is deducted from your income, so you don't have to pay taxes on it.  This means that for every dollar you invest, you save around 25-30% right back in taxes!

2.  Matching - many companies offer to match a % of your money. This is essentially free money.  A typical employer might let you deduct 15% of your paycheck, and will match up to 50% of the first 8% you put in (read:  4% of your salary ).  This varies from employer to employer.

Example:  You are fresh out of college and working a job paying $55,000.  Your employer lets you deduct up to 15% of your salary and matches 50% up to 8%.

How much you will save:
If you max out your 401k, that means you invest 15% of 55k.  ($8250).
So, now your taxable income is only 55,000-8250 = $46,750

Right there, you saved roughly .25 * 8250 = $2062 in taxes that would have just been taken by the government

Next, your employer matches 50% up to the first 8% (4% total).  So, they give you a free .04 * 55000 = $2200

Overall, you are $2062 + $2200 = $4262 richer than if you had not used your 401k.  That's like getting an 8% salary increase.

Moral of the story:  USE your 401k !!


Every year, the government allows you to invest a set amount of money for retirement.  An IRA is sort of the opposite of a 401k - that is, you are taxed NOW on the income, but at retirement you can take it out tax free.  Since most of us will be in a higher tax bracket when we are older, this typically makes the most sense.

In the past, $4000 was the limit, but it has been increased to $5000 a year for 2008.

Roth IRA's are setup just like normal mutual funds.  You can use Vanguard or Fidelity do to this quite easily.

I do not believe there are any limitations to what securities you can invest in, so you can continue to invest in mutual funds as described in my other guides.

How do I get started?

You can always go through a broker like Vanguard or Fidelity to manage it yourself.  For many people with large incomes though, it sometimes makes sense to get a financial planner.

This is perfectly acceptable, and as you get older they can help you plan your investments around life decisions.  Just be sure to insist on no-load index type funds and you'll be fine.

You can talk to an adviser / financial planner for free advice here: http://www.handcrawler.com/financial.php (http://www.handcrawler.com/financial.php).  Just let them know your plans, and see if they are a right fit for you.