The world of retirement accounts can be very confusing...let me restate that: the world of retirement account IS very confusing. We've got 401(k), 457(b), IRA, 403(b), Roth and so on. So I'd like to remove some of the confusion about retirement accounts here.
Types of Retirement Accounts
The first wave of confusion is usually around the names of the accounts. It doesn't have to be confusing; the types of accounts with numbers and letters are named for specific sections of the tax code that allow these kinds of accounts to exist. That's it. An IRA stands for Individual Retirement Account, and a Roth is a type of IRA (although more recently there are Roth 401(k)s...just to keep things confusing).
Another common point of confusion is that these retirement accounts are just that - accounts. They are not investments. Once you have one of these accounts open, you put cash into the account, then buy investments with the cash. The reason for so many different kinds of accounts mostly comes down to the tax treatment and contribution limits (meaning, the amount of cash you can put into the account each year). With most of the accounts (Roth being the only one that is different), you get a tax break on the money you put into the account. That means you have to pay taxes when you withdraw money. With Roth accounts, you don't get any tax break when you put the money in, but you never have to pay taxes on that account again.
All retirement accounts have similar rules about when you can take your money out. Since these accounts get favorable tax treatment and since they are meant to be retirement savings, generally you have to wait until you are almost 60 in order to take out your money. You can get access to the money before that but there are penalties associated with doing that.
How Do I Use a 401(k)?
The most common retirement account is the 401(k). Most of us have access to a 401(k) account at work. The way these generally work is that you are able to set aside money before any taxes come out (saving you some money). The limits for these accounts are high; most of us aren't able to fully maximize the amount (it's currently $18,000 per year that you can put into the account, even more, if you are over 50 years old). On top of that, most employers will at least partially match our contributions. That is free money. Each employer decides how much that will be. For example, my last employer-matched half of my contribution up to 6% of my salary. That means that if I contributed 6%, they contributed 3% on my behalf. If I contributed 4%, they contributed 2% for me. Some companies match dollar for dollar up to 5%. You should talk to your HR department to find out what your company's rules are. Generally speaking, you want to contribute at least enough to get the full match from your employer.
Within the account you'll have access to different investments. These will be mutual funds. A mutual fund is nothing more than an investment that invests in something else. For example, there are mutual funds that invest in companies in the US, or mutual funds that invest in bonds. The word mutual fund can be scary but it simply means that the mutual fund company takes your money, and the money from many other investors, and invests that money for you.
Each company will have a list of mutual funds from which you can choose. This is another thing that varies from company to company. Hopefully your company has inexpensive options for you. I'll talk more about this in later articles, but you want to look for mutual funds that have low expense ratios - the cost the mutual fund charges to invest for you. This should be easy to find in your company's literature. If your company has bad options (which, unfortunately is pretty common), then you have to decide whether to save into your 401(k) or open an IRA - which is a retirement account that you can open at many brokerage firms and they give you access to virtually any investment you want. If you can't get inexpensive options with your employer, you can get them with an IRA. Just remember to weigh the fact that you might get a match from your employer.
Special Considerations for Teachers
A cousin of the 401(k) is the 403(b). 403(b)s work in much the same way but are offered to employees of nonprofit organizations, such as teachers and nurses. As I mentioned above, it is common for 401(k) providers to offer really bad mutual funds to their employees. Unfortunately for teachers, 403(b)s are often times worse, because not only do they offer bad mutual funds, but they offer annuities, as well. An annuity is an insurance contract that is protection against living too long. In short, for a plain vanilla annuity, you pay a lump sum in exchange for monthly payments for the rest of your life. These make sense for a limited number of people outside of a retirement account. They make almost no sense inside of a retirement account. There are even worse flavors of annuities, including variable annuities and equity-indexed annuities. I won't get into why these are bad for you here, but just remember that these kinds of products combine the worst elements of investments with the worst elements of life insurance. Stay away from them.