How Retirement Works

For most people, it’s like this: you reach a certain age and start thinking about spending your days on the golf course or on a beach. Then you look at your bank statement and freak out and think about taking on a second job instead. You should be doing less and less work as you are getting older. Retirement accounts let you do less work. All you have to do is start a retirement account NOW, which I’ll show you exactly how to do.

How do retirement accounts work:

Many people mistakenly think that retirement accounts are just places for you to save money until you’re 65. Actually, they offer you humungous benefits if you agree to save for a long-term horizon. Let’s compare regular (taxable) investing accounts with how retirement accounts work.

Regular Investing Accounts vs. Retirement Accounts:

Regular Investing Accounts: When you open up an account at ETrade or whatever, you’re generally opening p a regular investing account, which is also called a taxable account. This means that when you sell your stocks, you’ll pay taxes on your gains-and if you sell your stocks in less than a year, you’ll pay a huge amount (regular income-tax rates, like 15% or 30%).

Retirement Accounts: Retirement accounts, quite simply, give you huge tax/growth advantages in exchange for your promise to save and invest for the long term. Now, this doesn’t mean that you have to hold the same stock for 30 years. You can buy and sell shares of almost anything as often as you want. But with a few exceptions, you have to leave the money in your account until you get near retirement age.

Here’s how retirement accounts work, and where the magical benefits kick in. In a retirement account, you get big tax benefits. While 10% or 20% may not seem like much in a year, when you compound that over 30 years, it becomes a gigantic amount. In fact, start a retirement account next week and two things will happen: (1) You will be more financially prepared than 99% of your peers, and (2) you will be rich. If you start a retirement account in your early 20’s and you fund it regularly, you will be rich.

Understanding Your 401(k):

A 401(k) is a type of retirement account. If you work for a company, chances are you already have one offered to you. Here’s how it works: You put pre-tax money into the account, meaning you haven’t paid taxes on it yet. In regular, taxable investing accounts, you pay taxes on your income and then invest it. So for every $100 you make, you might actually only be able to invest $85 of it. 15% (or whatever, depending on your tax rate) goes to the tax man. There’s an extra benefit, too: Your company might offer a 401(k) match. For example, a 1:1 match up to $2,000 means that your company will match every dollar you invest up to $2,000, therefore, investing $2,000/year really means you’re investing $4,000/year. Basically, your money goes into an investing account where a professional investing company manages it. You can choose from a bunch of different investing options, like aggressive, mixed, international, etc. Don’t worry about switching jobs; if you leave your company later, you can take your 401(k) with you. And be aggressive with how much you contribute to your 401(k) because every dollar you invest now is worth many more times that in the future. The hardest part is making the first phone call to HR to get it set up.

401(k) Restrictions:

            The 401(k) isn’t tax-free. The government has to get its tax revenue sometime, so you’ll pay ordinary income tax on the money you withdraw around retirement age. You’re currently limited to putting $19,000/year in your 401(k). You’ll be charged a big penalty of 10% if you withdraw your money before you’re 59.5 years old.

401(k) Summary:

  • $19,000 annual limit
  • Pre-tax money
  • Company matches supercharge growth even more-this is free money you must take

Understanding your Roth IRA:

            A Roth IRA is another type of retirement account. Every person in their 20’s should have a Roth IRA. It’s simply the best deal I’ve found for long-term investing. A Roth IRA is different than a 401(k). A Roth uses after-tax dollars to give you an even better deal. With a Roth, you put in already taxed income into stocks, bonds, index funds-whatever- and you don’t pay when you withdraw it. Here’s how it works: When you make money every year, you have to pay taxes on it. With a Roth, you take this after-tax money, invest it, and pay no taxes when you withdraw it. If Roth IRA’s had been around in 1970 and you’d invested $10,000 in Southwest Airlines, you’d only have had to pay taxes on the initial $10,000 income. When you withdrew the money 30 years later, you wouldn’t have had to pay any taxes on it. Oh, and by the way, your $10,000 would have turned into $10 million. You pay taxes on the initial amount, but not the earnings. And over 30 years, that’s a stunningly good deal. The maximum you can contribute into your Roth IRA is $6,000 per year.

Roth IRA Restrictions:

You are penalized if you withdraw your earnings before you’re 59.5 years old. (Exception: You can withdraw your principal, or the amount you actually invested from your pocket, at any time, penalty free.) There are other exceptions for example, buying a home or for emergencies. There’s a maximum income of $137,000 to make full contributions to a Roth.

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