Long-term savings and investing

401 (K)

What is a 401(K)?

A 401K is an employer sponsored savings plan. As an employee, you decide how much you want to contribute to your retirement plan each month and your employer automatically deducts this amount from your paycheck. The employer then puts this money in the 401(K) where it can generate returns. The money can be invested in a variety of ways including mutual funds of stocks and bonds. Although the employer is the one that puts the money in the account, you as the holder of the plan determine how you want the money to be allocated among different assets.

What are the benefits of a 401(K)?

One benefit of a 401K is that you are not taxed on the money you contribute to the plan when you make the contribution. Even though it is technically income coming out of your paycheck, this money is contributed to the 401K tax free. Another advantage of a 401K is that many employers have a matching contribution plan. This means that the employer specifies some set amount that they will contribute to your retirement plan. For example, they might add 50 cents for every dollar you contribute, up to a limit.

How much can you contribute to a 401(K)?

If you are under the age of 50, you can contribute up to $17,500 (2013) a year. If you are 50 and older, you are allowed $up to 23,000(2013) a year to catch up. The more you contribute each year the better. Try to contribute the maximum amount if you can. You at least want to make sure you contribute enough to meet the requirements for your employer’s matching contribution.


With a 401(K), you cannot make any withdrawals until the age of 59 1/2 years. If you choose to take money out of the account before then, there is a 10% early withdrawal fee. Once you turn 70 1/2 years old, you are required to start making withdrawals and there is usually a minimum amount you have to withdraw each year. When you make withdrawals is when you are taxed on the money. This money is included in your taxable income and it is taxed as ordinary income.

Roth IRA

What is a Roth IRA?

IRA stands for individual retirement account and it is another means to save money for retirement. You make contributions to your account but in contrast to a 401(K), these contributions are taxed at the time of the contribution. However, the money is not taxed when you make withdrawals.

A Roth IRA is different from a traditional IRA and provides many benefits for young people.

What are the benefits?

A Roth IRA can be beneficial to younger people. Although you are taxed on the contributions you make up front, chances are that you are in a lower tax bracket while making these contributions that what you will be in when you start making withdrawals in retirement. So in the long run, it is likely to save you money.

How much can you contribute to a Roth IRA?

If you are under the age of 50, you can contribute $5,500 (2013) a year. If you are over the age of 50, you are allowed to contribute $6,500 (2013) a year to catch up. There is no minimum amount required to contribute by federal law although the financial institution is likely to have a minimum amount to open the account. However, the more you can give the better.


The rules for withdrawals from a Roth IRA are more flexible than those of a 401(K). First of all, withdrawals are not taxed since you were already taxed on the money when you first contributed it. The only stipulations are that you must be at least age 59 1/2 (or dead or disabled) to make withdrawals and the account has to have been open for at least five years. Another advantage of Roth IRA’s is that you are not required to withdraw money like you are with a 401(K). No matter how old you are, you can keep your money in the account and let it grow. For a young person who is concerned about locking up their money for decades, the Roth IRA offers more flexibility than other retirement accounts.

Distributions are deemed to come first from contributions. So if you needed to, you could withdraw all your contributions without any taxes or penalties, at any time. If you withdraw more than your contributions and tap into the earnings in the account, then you will owe taxes and perhaps an early withdrawal penalty if you don’t meet the age and 5-year requirement.

Here is a summary of the differences between a 401(K) and a Roth IRA in 2013:

401 (K)

  • Contributions Taxed? No
  • Withdrawals Taxed? Yes
  • Maximum Annual Contribution: 17,500 (or 23,000 if over age 50)
  • Withdrawal age without penalty: 59.5
  • Mandatory Withdrawals: 70.5

Roth IRA

  • Contributions Taxed? Yes
  •  Withdrawals Taxed? No
  •  Maximum Annual Contribution: $5,500 (or 6,500 if over age 50)
  •  Withdrawal age without penalty: 59.5
  •  Mandatory Withdrawals: Never

Written by Katie Leginsky, Peer Educator, Financial Wellness Program, University of Illinois Extension, 2012

I want to invest my money in either stocks or mutual funds. What’s the difference?

The first thing that someone like yourself should know before you invest your money is what you want your money to do.  What is mean by this is are you looking to make a quick buck or are you thinking about the long haul?  This choice will determine the types of investments you will find attractive.

There  is a plethora of different investment instruments that are available for someone who’s looking to invest.  This can be advantageous but daunting to the investing newcomer.  What’s an ETF?  What are financial derivatives?  What are blue chip stocks?  These might be some questions that a novice investor may have when looking at different avenues of investment.  Often, financial jargon tends to get in the way of understanding the various forms of investment.

Stocks are a type of security that designates ownership in a publicly traded company.  By owning a share of a company’s stock, you have a claim to their assets and earnings.  In essence, you become an owner of a company.  By purchasing common stock, you have a right to vote at shareholders’ meeting and are entitled to receive a dividend, which is a portion of a company’s profits paid out to its owners.  By purchasing preferred stock, you do not have the right to vote at shareholders’ meetings but can still receive a dividend.  The reason why this type of stock is classified as ‘preferred’ is that in the event of liquidation (when a company goes out of business). Preferred stockholders have priority over common stockholders in the company’s assets and earnings.  That is to say, the residual assets and earnings are divvied amongst preferred stockholders first and then to common stockholders.  In the event of liquidation, common stockholders may not get their investment back!  This, however, does not mean that common stock is a poor choice of investment.  Thanks to the United States’ accounting system, the financial information of publicly traded companies must be publicly reported so that anyone can see it.

In the same vein, mutual funds are a collection of various financial instruments managed by a mutual fund company such as Vanguard and T. Rowe Price.  A mutual fund pools money from its investors and invests that lump sum of money in various securities.  This basket of securities can include stocks but is not limited to them.  A mutual fund can be comprised of bonds, money market securities, other mutual funds and commodities, to name a few.  A mutual fund manager will then invest that money in accordance to what type of mutual fund it is.  One that focuses on long term financial stability will buy and sell securities that are not very risky.  Relatively small risk investments offer relatively low returns but will continue in the foreseeable future.  Higher risk investments offer higher returns, but there is a chance that the company offering that security will not perform well.  This is called the risk-return tradeoff.  Higher risk investments must offer a higher return because there is a high level of uncertainty of success and life of a company in the future—which translates to a higher risk of you not getting your money back.  With mutual funds, you’ll also have to be aware of the various fees and commissions that you’ll have to pay.

The type of investing that you want to do depends on how risk averse you are.  If you like taking risks, you’ll probably want to invest in stocks or mutual funds that offer the potential for higher than the market average returns. If you do not like taking risks but want to see constant returns on your investment, you’ll probably want to invest in blue chip stocks or large cap mutual funds.  Blue chip stocks are the stocks of companies like General Electric—companies that are well established and very stable.  Large cap mutual funds are like blue chip stocks in that they are comprised of large corporations that are well established and financially stable.

Apart from the basic mechanics of these types of investments, one  thing you must know is what you want to do with your money and what you want your money to do for you. Make sure you ask yourself the following questions before you do any investments:

Do you want to invest your money?  If so, which to do you prefer—high returns and high risk or low returns and low risk?

Written by Eric Pinter, Peer Educator, Financial Wellness Program, University of Illinois Extension