Basics of Retirement Investing

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Seated Stock TradersFive years, on the first day of my first “real” job, the HR administrator of my company handed me a folder labeled XYZ Company Pension & Retirement Plan. Inside the folder was a description of the company’s pension and 401(k) package, two “things” that meant almost nothing to me. I knew what a pension was but had no clue was a 401(k) was, but the folder seemed to have enough information in it to help me start my own 401(k) company if I wanted to. I made some good decisions about my 401(k), mostly by luck (I put 40% of my money into emerging markets, which was a good choice but I did it for a bad reason – I had no reason!), but you shouldn’t have to.

Retirement investing is not rocket science, it’s just confusing with all the acronyms and the taxability and everything else. The basics, which we’ll cover in this Foundation series article, once you unravel the confusion, are fairly straightforward.

Tax Advantaged, Tax Deferred, Tax Free

Tax advantaged means any account that has some sort of tax benefit, which includes accounts that are tax deferred and tax free.

Tax deferred means that contributions you make to an account and the earnings of those accounts will not be subjected to a tax until you begin taking disbursements or making withdrawals. Your 401(k) is a tax deferred retirement account, your contributions are tax deductible (you don’t pay income tax on your contributions), your growth is not subjected to capital gains tax, and you’re disbursements are treated as income and taxed then.

Tax free accounts are those accounts whose earnings and appreciation are not subject to taxation. A Roth IRA account is a tax free retirement account (I believe it’s the only tax free account).

Defined Benefit, Defined Contribution Plans

You may see these two terms thrown around as well and they refer to the type of retirement plans your company may provide. A defined benefit plan is an employer-sponsored retirement plan where the benefits are based on an equation using various employee factors such as salary, period of employment, seniority, etc. With defined benefit plans, the employer manages the portfolio and thus takes on the risks. Pensions are a type of defined benefit plan.

Defined contribution plans are employer-sponsored retirement plans where the employer sets aside a set contribution to the plan on behalf of the employee. A 401(k) is a type of defined benefit plan.

Major Retirement Account Types

The 401(k), and it’s sibling in the non profit world, the 403(b); is one of the most popular and well-known retirement investing accounts because it is accessible to so many people. Your contributions to a 401(k) are tax deductible (they are usually taken directly from your paycheck) and your account grows tax free. Your contribution limit is $16,500 a year in 2009, $22,000 if you are over the age of 50, and your employer may offer some sort of matching contribution (free money!), one of the great appeals of this plan.

  • The Roth 401(k) was recently introduced and becoming more widely available. A Roth 401(k) works much like Roth IRA, explained below, except it shares the same limits as the 401(k). Think of it as a Roth-version of the 401(k). You cannot deduct your contributions from your income for tax purposes but the assets grow tax free and disbursements are tax free. This is only available if your employer offers it.

The Individual Retirement Arrangement (IRA) is a retirement account that lives outside of your employment, so anyone with income can open an IRA. IRA’s come in many flavors but the two major types are the Traditional IRA and the Roth IRA.

  • The Traditional IRA is similar to the 401(k) in that your contributions are usually tax deductible and your growth is tax free, you pay income taxes only when you start taking disbursements from the account. The contribution limit for the Traditional IRA is $5,000, or $6,000 if you are 50 or older. There are cases when your Traditional IRA contribution isn’t tax deductible and one of them is if you are an active participant in an employer-sponsored retirement plan. If you cannot deduct your contribution to a Traditional IRA, it’s far more appealing to go with the Roth IRA account;
  • The Roth IRA is like the Traditional IRA with one notable and important difference – your contributions are not tax deductible but your growth is tax free and your withdrawals are tax free. With the Traditional IRA, you pay taxes later; with the Roth IRA, you pay taxes now. The contribution limit for the Roth IRA is $5,000, or $6,000, if you are 50 or older but there are limit restrictions based on your income. Review this article on Traditional and Roth IRA contribution limits to get an understanding of how your contribution is limited by your income.

One important fact to take note of, Traditional and Roth IRAs share contribution limits, meaning you can contribute a total of $5,000 between the two. If you contribute $2,000 to a Traditional, then you may only contribute $3,000 to the Roth IRA (assuming your contribution isn’t otherwise limited by your income). The same rule applies for 401(k)s and Roth 401(k)s, except the total limit is $16,500.

Tax Diversification

You’ve probably heard of asset diversification but tax diversification is something you should be cognizant of. If you’re just starting your first job, retirement is probably forty years away. We won’t know what the tax rates will be like in ten years, let along forty. Will they be higher? Will they be lower? Will the income tax be replaced by a consumption tax? Since we don’t know, it’s important that don’t put all of our eggs in one type of tax advantaged account. If taxes go up, then the Roth IRA is the best choice because you pay taxes today and get the earnings tax-free tomorrow. If taxes go down, the Traditional IRA and 401(k) are better choices because you don’t pay taxes today, you pay them tomorrow when they’re lower. Since we don’t know where taxes will go, it’s best to spread your money around to both.

Standard Contribution Strategy

If you’re wondering where you should contribute and with how much, this is the standard contribution strategy published almost everywhere.

  1. 401(k) if matching funds: If your employer offers you a match on your contribution, contribute as much as you can to maximize the matching funds.
  2. Roth IRA: Once you’ve maximized the 401(k) matching funds, you’ll want to contribute to your Roth, if you’re able, to help diversify your tax profile.
  3. 401(k): If you are able to contribute more, the experts often advise that you take the balance of your tax free benefits and contribute to the limit of the 401(k).

If you are able to fulfill all three, you’ve put away $21,500 towards your retirement. If you still want to contribute more, you’ll have to do it in a taxable brokerage (and receive no tax benefits for it) or consider a tax-deferred annuity, which is a topic outside the scope of this article.


Brokers keep the lights on by charging you fees. Your 401(k) will likely give you the option of selecting from some mutual funds to invest in. I won’t go into asset diversification, that’s is a bear of a topic that could be its own Foundation article, but the single most important determinant of a mutual fund’s performance is the fee is charges its investors. When you’re reviewing the fund’s prospectus, the pamphlet that explains every last detail about the fund, look for the expense ratio. The expense ratio is how much of the fund’s assets the broker will take each year to cover costs. You can’t control the performance of the fund, but you can control how much you’re paying in fees. All funds charge an expense ratio.

When you are buying mutual funds outside of a 401(k), say in your IRAs, you need to also be aware of a mutual fund’s load. Load is just another word for sales charge or sales commission. You will probably want a no load fund, meaning it doesn’t charge you a sales commission, but there are some good loaded funds out there. Here’s a good discussion about mutual fund loads that should give you enough information to make you dangerous.

Another fee you might see yourself paying is an administrative fee charged by the broker managing your 401(k) or IRA (that broker is known as the trustee). With your 401(k) you won’t have a choice, your employer picks the administrator. However, with an IRA, it’s best to pick a broker that won’t charge you that fee (TradeKing doesn’t charge an annual IRA fee).

Finally, if you’re investing in stocks, be aware that you will often have to pay a commission on the purchase and sale of various securities.

Selecting A Broker

My advice is that you should select a broker based on the fees and what you intend to invest in. If you want mutual funds, I’d go straight to the mutual fund companies themselves. I mentioned TradeKing before, because they charged no administrative fees for IRAs, but they do charge you a commission on mutual fund transactions. If you just plan on buying Vanguard funds, you should go to Vanguard directly (if you go electronic, the fees are waived). So the short answer is, the best broker is the one that will charge you the lowest amount in fees to invest in the securities you are interested in.

Social Security

Social Security is officially called OASDI – Old age, survivors, and disability insurance. Social Security, one of the payroll deductions on your paycheck, was created with The Social Security Act of 1934, signed by President Roosevelt, and was part of the new Deal. It’s since been amended but the basics are fairly straightforward, you make payments while you work and you get payments once you retire (or reach retirement age). The Social Security Administration will send you your Social Security Statement (example) each year, I believe a few months before your birthday, that outlines how much you’ve contributed and what your benefits are projected to be. For all intents and purposes, this isn’t something you should worry about until you are nearing retirement.

That should about cover all the basics! If you think of a topic that you think I should include, please let me know.

(Photo: rednuht)

{ 15 comments, please add your thoughts now! }

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15 Responses to “Basics of Retirement Investing”

  1. Excellent overview and very helpful. Thanks!

  2. You mention that maxing out your 401(k) contributions and then putting your money in a Roth IRA, would you recommend maxing out your standard 401(k) matching and then put money into a Roth 401(k) if your employer offers it? It seems that may be pretty good way to go as well.

    • Jim says:

      It’s not a bad idea, I don’t list it as the “safe path” because not every employer offers a Roth 401(k).

  3. Mr. GoTo says:

    Jim – Some of the larger 401(k) plans offer a self-directed brokerage account option which allows participants to use a broker to select from all available stocks and mutual funds, instead of just the few offered by the plan itself. Investors who are willing to do some research on their own should look into this option because it can lower costs and provide opportunities to create more diversity in asset allocation.

  4. Wow, I’ve never read a better comprehensive look at retirement planning.

    I always advise people to maximize their tax free contributions because it is very likely you’ll be paying more in taxes when you’re older than you do now. I max the 401(k) to get the company match, and then focus on the Roth IRA. My Roth offers better investment options as well.

    • saladdin says:

      How do you figure you will pay more in taxes when you retire?


    • Jessica says:

      I disagree. You may pay higher taxes when you’re older BEFORE you retire but if you’re planning right, you won’t be in a higher tax bracket when you retire, which is all the more reason to max out your 401(k) first. What you’ll actually need to survive on in retirement will be much, much less than what you’re bringing in from your job right now (adjusting for inflation, of course, because remember that the tax brackets also go up every year with inflation). You won’t have a mortgage (hopefully it’s paid off by then), car payment, kids living at home, etc to cover, just the basics. Or do most people plan their retirement differently?

      • Steven says:

        You are wrong. Taxes in 30 years when I retire will be much higher. Taxes at the moment are at almost an all time low. With this defecit we are going into with all this money going to bailouts, we are going to have to pay for it eventually. Taxes will be much higher in maybe even the near future. On another note, Whole life insurance is not a bad way of growing and withdrawing some of that money tax deferred. Plus you have a death benefit. Usually what I recommend is putting into your 401k up to what the company matches the “free money” and then putting the rest in other investment vehicles.

  5. Tarah says:

    If you’re going to go back to the 401(k) after maxing out your Roth and you still have money left over that you want to invest, would it make more sense to go 401(k)-Roth-Traditional IRA-401(k)? That way you have more choice with more of your money.

    • Jim says:

      The Roth IRA and Traditional IRA share the same limits, so when you max out your Roth contribution, you can’t contribute to a Traditional IRA.

  6. Sun says:

    Brokers usually charge a much higher fee to buy mutual funds than stocks. So it’s better to go with mutual fund companies directly if you want to dollar-cost averaging mutual funds in your retirement accounts.

  7. TTFK says:

    I have the less common SIMPLE-IRA. This small-business option has several advantages for employees:

    1. The employer must either contribute up to 3% matching to participating employees, or 2% of gross to ALL employees regardless of whether they are contributing themselves or not.

    2. All employer contributions are 100% vested the moment they enter your account.

  8. frugalCPA says:

    I agree with Steve that taxes will probably go up, though it’s hard to predict to what level they’ll rise and how long they’ll stay high. My plan is to always have a good mix of 401k and Roth IRA.

  9. thomas says:

    Lots of information in one post! Good job.

  10. Ronnie says:

    i don’t understand why you reference 2006 tax breaks, did i miss something here?

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