This article describes different types of retirement accounts that are available in general and my personal approach to investing in them.
- tax-advantaged retirement account
- offered by company/employer
- the retirement plan differs between companies
- typically employees contribute some part of the salary prior to taxation on a monthly basis to the retirement account. When an employee is enrolled in the program, the contribution happens automatically.
- on top of personal employee contribution, the employer might offer some percentage of employee salary (“free money”) to be contributed as well. Depending on the company, there are various rules tight to this process. For example, some employers provide a certain percentage of the employee salary without a need for employees to contribute their own money to the program. In some cases, the employee is expected to contribute a certain amount of money on a monthly basis in order to retrieve the employer’s contribution match.
Regardless of what the rules are, I strongly recommend for any employee to take advantage of the “free money” offered by the company.
Let’s have a closer look into why I have personally started investing in retirement accounts, when, what are my contribution values and what is my reasoning behind the decisions taken.
Disclaimer: I am not a financial advisor, this blog describes my personal opinion and approach I have decided to use. Feel free to share your opinion below in the comments.
My 401(k) story: I have started contributing to the 401(k) retirement program at the age of 31. I got a “wake up” call at the time when the company, where I am employed, was changing the retirement plan based on newly introduced law in the country where I live. Basically, the new law required auto-enrolment into a government pension plan with a mandatory 2% employee contribution and 1.5% of employer contribution. The decision within the company was to opt-in into the third pillar pension plan instead that is fully sponsored by an employer. With those law changes, I was given an option to enroll in a company-sponsored retirement account, however, it was not mandatory. I have hesitated and postponed my decision by one year upon the announced pension program changes, as I was caught in the work too much and with the big purchase plan (I was about to buy my first own and new apartment). However, after purchasing, owning and living in the flat for a while, which was paid at full price without a mortgage, I have started thinking on how to leverage any new savings, and that was the time when I start looking into investing in general in both tax-advantaged accounts and non-tax advantaged accounts. I felt like I missed the train since I was reading on the internet that plenty of the folks started in their twenties, hence I got fully on-board and started planning to max out retirement accounts to not miss on more opportunities.
At this point in time, my employer sponsors 3.5% of my salary into the 401(k) plan, which is great and as my salary will be growing, the employer contribution will as well. In addition to that, I have added around 2-3% of my salary to this plan.
I am happy with the decision, however this specific account I am not fully maxing out to the limits. I might later, however my priority is actually to be enrolled in 401(k) in order to get at least employer benefit, adding my own money is just plus. The most important for me is to max out other retirement vehicles that are traditional IRA and Roth IRA.
- individual retirement account
- can grow tax-deferred
- no need to pay taxes on capital gains or dividend income until the beneficiary makes a withdrawal
Outside of 401(k), my very first goal was to max out Traditional IRA, even though many experts suggest doing so with Roth IRA. Here was my thinking:
- annual contribution limit was smaller than for Roth IRA – this was more of a psychological aspect, as it kept me motivated when I saw the account to be closer and closer to contribution limits
- the biggest motivation to max out this account first was because if I do so and I reach the higher tax bracket with my salary, I can deduct paid money into this account from income and therefore pay a lower tax.
- my first year of investing in this account was focused on maxing it out. I wanted to do it faster and not via dollar-cost averaging strategy, keep in mind that when I started I had a good reason to do it in this way. At that moment market was significantly down and I wanted to use this to my advantage. I have invested in dividend based packages offered in my pension account. Unfortunately, I do not have an option in my country to do self-directed IRA (hoping that will change in the near future). The dividend investment approach for this account was chosen in order to grow money as a result of the compounding effect.
- individual retirement account
- offers tax-free growth
- tax-free withdrawals in retirement after certain conditions are met
- funded with after-tax money
- contributions are not tax-deductible
- no need for regular payment – I am the boss when the payments will be done, which allows me to contribute more when the market is down and less when I feel that the market is overpriced. However, I am still doing dollar-cost-averaging and contributing to the account on a monthly basis. Contributed value is just enough that will allow me to max out the account within a year. When market offers significant “discounts” then sometimes I decide to contribute some extra money after which I will again calculate the sum of the allowed money that can be contributed in the year and then lower the monthly payment to assure that I do not cross the contribution limit as that can come with consequences.
My goal was to max out the accounts in the first year of investing in pension programs. And I can gladly say that I have managed to do so! I felt so great, when I just opened 401(k), later when I maxed out traditional IRA account, and afterward, I was just passionate to do the same with Roth IRA. I was so motivated after each milestone. Since I maxed out accounts within a half a year, the next half year I can continue to live frugally and save for the retirement accounts that I will contribute to in the upcoming year. Also, now after maxing out retirement accounts, I can be focused for the next half year on personal non-tax advantaged accounts. I do have 2 non-tax advantaged accounts, where one is for short-term and other is used for long-term investing (future purchases, goals).