Since the 1980s, it's been the definitive American retirement plan, named after the corresponding section of the Internal Revenue Code: the 401(k). The setup is simple. With a 401(k), you contribute money from your paycheck every month. The money is automatically deducted from your check and invested in a particular fund. You get the proceeds when you retire.
The upside, at least most people see it as one, is that a 401(k) can run on autopilot once you've got it moving. You contribute a fixed amount monthly, your employer matches it, and as long as your salary never changes (and you keep your job), the theory goes that you'll wake up one day with enough money to get you through retirement.
What Are the Downsides?
The downsides are plenty, one major one being that you can't really set and forget a 401(k). If your salary doubles from x to 2x, and you're still contributing y every month, you're putting yourself at a disadvantage. But the fundamental shortcoming of the 401(k) is that the government's administrators forbid you from contributing more than $17,000 per year ($22,500 if you're at least 50.)
So, what else is out there for a forlorn employee? Plenty. If your employer doesn't offer 401(k)s, that might actually be a blessing. Employees who can't build 401(k)s can join the self-employed and small business owners in the magical realm of the individual retirement account.
IRAs are similar to 401(k)s, but there are some key differences. With an IRA, the most you can contribute is $5,000 a year ($6,000 if you're at least 50). On the other hand, you can withdraw from an IRA without penalty if you get disabled or have to pay out-of-pocket medical expenses.
With an IRA, the world is your investment oyster. You can invest in just about any security or financial instrument whose value can be measured precisely and daily. What it doesn't include is things like collectibles. Your mint-condition Inverted Jenny 24¢ stamp might be worth $925,000, but that's only an estimate based on the price the most recent profligate rich person paid. It could take years to find a comparable rich person. One hundred shares of a stock, however, carry a value that you can calculate to the penny.
Just as most 401(k)s are self-directed, meaning you can choose from a handful of funds, the same goes for most IRAs. You can loan money in your self-directed IRA to anyone except immediate family (nice try), your financial advisor, your lawyer and any company that you own at least half of.
Like 401(k)s, IRAs come in both traditional and Roth versions. Do you want to pay taxes now, or later? With a traditional IRA, you deduct the contributions from your taxes today, and pay income taxes when you start withdrawing decades down the road.
With a Roth IRA, you don't get to deduct the contributions from your annual tax bills, but once you start withdrawing, it's all tax-free. Any growth is tax-free too, so if you're under 50 it's almost always going to be a better deal to go with a Roth IRA over a traditional one. You do have to ask yourself if you're going to be in a higher tax bracket once you retire, and if the tax brackets in the future will bear any resemblance to today's. Twenty-three years ago, the highest marginal tax rate in the United States was 28%. Twenty-four years before that, it was 91%. If you can accurately predict where Congress and the president will set the limits 24 years from now, hopefully your clairvoyance extends to picking stocks, too.
Finally, there are regular old investment accounts. You go to a broker with a cashier's check in hand, open an account and "contribute" as much as you want, or can. Any profit, whether from appreciation or dividends, will likely be taxed as long-term capital gains, which likely means you'll pay a lower rate than you'd pay on ordinary income. On the other hand, this is your investment and nobody else's. Its care and feeding are your responsibility.
The Bottom Line
If you're disciplined enough to ride out the inevitable lows, breathe deeply during the highs, and treat irrationality and panic like the leeches they are, a standard investment account might be the way to go. But they take a lot of effort to maintain. Which isn't to say that you should check your portfolio value every day, but rather that you should constantly be on the lookout for undervalued investments and, of course, determine if you're inadvertently carrying any overvalued ones. Most people find it far easier to let someone else do the work.
More From Investopedia
- Ways To Budget For A New Year's Party
- How To Manage And Consolidate Your Own Debt
- The Pitfalls Of Borrowing From Your 401(k)