Retirement accounts aren't investments, but "special boxes" for your investments. They have special powers, like x-ray vision and wasabi resistance, that help you earn more money over time than mere mortal investments.
Retirement accounts go by a bunch of different names, like IRA, 403(b), and 401(k). Why the funny names? The government likes names that are vague and uninformative, yet still difficult to remember.
An individual retirement account. This is set up by an individual. (You don't need a company to sponsor this, as you would with a 401(k) account.)
This is like a 401(k), but it's set up for what we like to call "nice poor people": teachers and non-profit employees.
A company-sponsored plan that allows you to save your money (just like you normally would) with a bunch of added perks.
Don't think of these ugly names as a "retirement accounts." Think of them as birthday presents to yourself for turning 60. Then you'll be able to say, "Look what I got you. It's enough money to live on for the rest of your life. Wasn't that thoughtful of me?!"
How Retirement Accounts Work
These accounts aren't investments themselves. They're more like special boxes where your investments get all sorts of special powers, like growing tax-free until you're old and gray.
What's so great about that? You are earning more interest on your interest (compound interest) because Uncle Sam isn't getting his hands on it every year. It adds up quickly. See the story at bottom for an illustration of compound interest.
You can only contribute up to a certain dollar amount per year into an IRA. Company-sponsored plans, like a 401(k), usually allow you to contribute more money per year than an IRA.
For most retirement accounts, the money you contribute isn't taxed by Uncle Sam. He won't get his sticky little fingers on it until you withdraw it years later when you're living in your second home on the beach.
You normally can't get money from your retirement account until you're 59 1/2 (some exceptions: paying for college or buying your first home). You'll be charged a 10% penalty and get kicked in the shins if you take it out early.
If your company offers a 401(k) match, your employer will match a certain percentage of your salary and put it into your "special box." Cha-ching! So, if they match 2%, make sure you contribute at least 2% of your salary to receive this free money.
To get an IRA, go online (or visit your local bank or financial institution). Pick virtually any online broker or mutual fund. Click on "Open an IRA account." (Oooh, it's getting tricky.) Select a mutual fund (or stocks) to invest in. These are now in your "special box."
To get a 401(k) or 403(b), it will need to be offered to you by your employer. You'll need to select (a) the percentage taken from your paycheck and (b) how your money will be invested in your new "special box."
Bert had a friend named Dunce. He would insist that his name was pronounced "Doon-say," but everyone knew better.
When Bert started working (after eight years of college), he put $2,000 into his retirement account. He started at age 25, did it again at 26, and continued this every year until age 35. At this point he stopped investing and left his money in the account to earn interest.
Dunce, on the other hand, didn't start saving until age 35. To make up for lost time, he planned to add $2,000 every year for 30 years.
Now imagine that each earns 10% interest every year. Yes, 10% is high, but it helps illustrate this point.
Who is going to have more money at age 65: Bert and his 10 years or the Dunceman and his 30?
See the above graph. Bert wins by a landslide. Why? Compound interest. His early investment grows on itself so quickly that Dunce never has a chance to catch up.
(Mathlete Fact of the Day: Bert and Dunce would "tie" at age 65 if the interest rate were 6.25% instead of 10%. Still surprising.)