At Clark's Consumer Action Center, we get a lot of calls about investing, saving for retirement and how to get started. Below are the answers to your most frequently asked questions and resources for you to learn more.
What is a retirement account?
A retirement account is a tax-friendly way to save money for your future. You can open an account at any time, and then, ideally, you put money into it on a regular basis. That money is then invested in a variety of ways – stocks, bonds, mutual funds etc. – allowing your savings to grow over time and earn you more money for your retirement.
Read more: Clark's investment guide
What is an IRA?
A traditional individual retirement account (IRA) is a personal savings plan, set up outside of the workplace by an individual at a bank or other financial institution, that allows you to take money out of your paycheck before it gets taxed and invest it for retirement, allowing your savings to grow over time.
Once you turn 59 ½, you can withdraw any amount. If you withdraw money before that time, you will pay a 10% penalty (there are exceptions to this rule). After age 59 ½, you should be able to take money out penalty-free, but you will still owe income tax on each withdrawal. Distributions from an IRA aren’t required until age 70 ½. A traditional IRA is just one type of retirement account. When it comes to saving for your future, you have several options.
What is a 401(k)?
A 401(k) is a retirement savings plan at a workplace that allows an employee to take money out of his or her paycheck before it gets taxed and invest it for retirement. There are two types.
The most common, a traditional 401(k), reduces your overall taxable income. But the tax hit comes later in life, when you want to withdraw your contributions and earnings at the time of retirement. Contributing to a 401(k) works like an IRA – money is taken out of your paycheck automatically (whatever amount you decide) and is then invested in your account. The traditional 401(k) is the most common kind of retirement saving plan in America.
The newer kind is a Roth 401(k), which is offered by most employers these days. It doesn't give you a tax break now, but you can withdraw your contributions and earnings tax-free at the time of retirement.
Some 401(k) plans include an employer match to make your money grow faster. This is when your employer will match your contributions (typically up to a certain percentage of your salary), allowing you to save more for your future. The employer match is essentially free money – an incentive for you to save – so if you have this option, you should try to contribute enough to your 401(k) in order to get your employer’s match. If you can’t contribute that much at first, just start by contributing 1% of your paycheck to your 401(k) and increase that amount by 1% every six months until you reach the employer match.
What is a 403(b) and a TSP (Thrift Savings Plan)?
These are also retirement accounts you typically open with your employer. While 401(k) plans are offered by private companies, 403(b) plans are offered to public education and non-profit employees. TSPs are offered to federal government employees.
What is a Roth IRA?
A Roth IRA is a modified individual retirement account in which a person takes money that's already been taxed and invests it for retirement. Like a traditional IRA, this type of plan is set up by an individual, outside of the workplace, through a bank or other financial institution.
Annual contribution limits are $5,500 per year ($6,500 for those age 50 or older), and income limitations do apply. Typically that means individuals with $110,000 in taxable income, or married couples with $173,000 in taxable income, face restrictions on how much they can contribute each year to a Roth account.
Unlike both a traditional 401(k) and a traditional IRA, you don't get any current year tax benefit for contributing to a Roth IRA. But the money grows tax-free and can be withdrawn tax-free after age 591/2.
What are the types of investments found in retirement accounts?
IRAs, Roth IRAs and even 401(k)s are like an empty shell or a vacant house. You’ve got to put some furniture in the house. That gets to the heart of how you invest the money you put into a retirement account. Examples of investments include stocks, bonds, mutual funds and more. Here are some examples of individual investment options at Fidelity.
Read more: 5 fixes for investment mistakes
What are the penalties for early withdrawal from a 401(k)?
If you withdraw money before you reach age 59 ½, you will pay a 10% penalty in addition to any normal income taxes. So let’s say you are only 40 years old and you decide to withdraw $10,000 from your 401(k) – you will have to pay a penalty of $1,000 plus income taxes on that $10,000. Bottom line: Don’t withdraw money early if you can avoid it.
Can I borrow from my 401(k)?
There is a way to get early access to the money in your 401(k) that doesn’t come with a penalty. You can actually take out a loan from your 401(k). How much you can borrow from your fund will depend on your company. You usually have five years to pay the loan back. If you don’t repay the loan on schedule, the loan with after tax dollars converts to a withdrawal, and you’ll have to pay the 10% penalty, plus any income taxes. Borrowing from your 401(k) should be a last resort.
Read more: The dangers of taking out a 401(k) loan
What options are available for my 401(k) if I leave my company and what is a rollover?
Whenever you leave a company, you have a few options for what you can do with your 401(k). You can just leave the money where it is and let it keep growing within that company’s 401(k) plan. You can take the money in your 401(k) with you by rolling it over tax-free into a rollover IRA account at a mutual fund company, brokerage firm or bank. You can keep your money in that rollover IRA where it will continue to grow tax-free until you retire.
When doing a rollover, always be sure it’s being done as what’s called a “trustee to trustee transfer.” That means the money goes from your current plan administrator to your new plan administrator and never enters your hands. You never want to receive a check for it yourself unless you want to be eaten alive on taxes and penalties.
What is a mutual fund?
A mutual fund is a way for individual people like you to pool your money together with other investors and purchase stocks, bonds and other securities that may be difficult for one single investor to do alone.
Most mutual funds hold more than 100 securities, a big bucket of companies that would be difficult for an individual investor to keep up with. But with a mutual fund, you can invest money across a broad spectrum of capitalism without having to put in a huge amount. Plus, you don’t have to manage it. Many mutual funds allow you to buy shares for as little as $2,000 and invest as little as $50 per month, and then the fund is managed by a professional. And instead of owning the actual stocks (or whatever the fund is invested in), each investor owns shares in the fund itself – sharing in the fund’s total gains – or losses.