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What is 401k or an IRA anyway?

It used to be a mystery whenever I heard of the term 401k or IRA. As far as I know, many shy away from it mostly due to ignorance. I went from shying away to blindly investing to understanding the investment. Not that I am an expert in 401k or IRA, but, I think I do know the fundamentals of its operation. Thought of sharing it with you folks and hearing back your perspectives.

Well, the fundamental premise on which 401k and IRA is built is retirement planning. Assuming a meagre 2% inflation, your expenses at retirement will be roughly twice that of what you spend today. Remember, when you retire, you wont be earning any money. The standard amount that you would earn through social security will be a pittance and not guaranteed (as you are probably aware, social security would go negative in 2042 or earlier). This means that you will have to save money. No other way…:(.. How much does one need to save? It is a tough question to answer. It depends on the kind of lifestyle that you want to lead. For example, if you own a house at the time of retirement, you could probably shave off a big chunk of your expense that you spend today. Health care will be a killer. Now, for most of us, we get it covered through our company insurance policies. At the time of retirement, you have to pay for it yourself.

Anyway, the point is, there are several ways to save money towards retirement. Two of the popular schemes are the 401k and IRA. What is special about these schemes is that is the type of benefits that you reap. 401k allows you to contribute upto $15500 per year (pre-taxed income). The contribution is also tax exempted. You pay the tax only when you take the money out. One could invest the 401k contributions in different mutual funds arranged by the companies. The interest or earnings that you get out of these investments are also tax-deferred, meaning you dont pay the tax till the retirement. So, money grows tax-free throughout. When you withdraw the money at retirement, you pay tax based on your then income (which will hopefully be less and hence lower tax bracket). In many cases, the company matches the 401k contributions upto a maximum of around $2500-$5000. In such cases, it is a no brainer to invest in 401k since you get 100% return on your money. Based on the seminars and studies, the consensus seems to suggest that maxing out (contributing the maximum possible, $15500) is the best choice since the interest compounding can have significant impact over many years.

What is an IRA then? It is Individual Retirement Account and can be setup by an individual in fidelity or charles schwab or any of the major investment firms. One can contribute a maximum of $4000 (between Jan to Apr of the new year, you can still contribute upto $2000 for the previous year quota, in case you missed it) in this account. Here, the investment is under your control. This means that you can choose to invest this money in Stocks or Mutual Funds or Bonds. Upon resigning from a company where you held your 401k account, the entire amount can be transferred to an IRA so that you can get control over it (this is called a Roll-Over and there is no limit to how much you can roll over). Here, the tax-deferral benefits are not as straightforward as 401k since IRA is based on income. There are 2 common types and they are (i) Roth and (ii) Traditional. Most of us may not qualify for a Roth IRA if both husband and wife are married and filing jointly. If your individual income is less than $95000 or joint income is less than $150000, you qualify. Otherwise, you dont. The advantage of Roth IRA is that, you contribute after tax money and when you get back the money at retirement, you dont have to pay tax on the contribution. But, you do pay tax on the earnings generated. In the Traditional IRA case, you wont qualify for a tax deduction either. Your single income should be less than $55000 or joint income should be less than $100000 in order to get tax exemption. Otherwise, you dont qualify. The above rules give only one option, which is, you can invest upto $4000 of your after-tax money and have the earnings grow tax-deferred. At the time of retirement, you will get your contribution back without tax and earnings taxed based on the tax-bracket at the time of retirement. I think it is still better since this investment is under your control.

One of the prime question that people often ask is, if can this money be withdrawn at any time… The answer is yes. You will have to pay tax and also pay a penalty of upto 10% for the money withdrawn. But then, this is retirement money and even if you return to India, the money can be withdrawn from there and you will be subjected to corresponding taxes. If you really need to, you could take a loan of upto $50000 from the 401k account. The cool thing is that, when you take the loan, the interest that you pay goes to your account since you are the lender… Irrespective of what dimension you look at, I strongly think that everyone should contribute the maximum towards your 401k account. It is a great investment scheme and has tremendous impact over time. One of the commonly held perception among humans is that, most of us think we wont get old…:) Not that we dont know that we are going to get old, but, we seldom think about it or plan for it. Unfortunately, time doesnt stop ticking..:)

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Posted by on January 3, 2007 in From AM-KICKING blog

 

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