5.6 Retirement Planning

Why Start Early

Retirement planning relies on compound interest — earning returns on both your principal and prior earnings. Starting early gives money more time value, so even small contributions can grow significantly. Delaying contributions means needing much larger amounts later to reach the same goal, making time the most powerful retirement-savings tool.

Employer-Sponsored Plans

A 401(k) is an employer-sponsored retirement plan funded with pre-tax payroll deductions, lowering current taxable income; withdrawals are taxed in retirement. Many employers offer employer matching, contributing additional funds based on employee contributions — essentially free money. Contribution limits and rules are set by the IRS, and early withdrawals often trigger penalties.

Individual Retirement Accounts (IRAs)

A Traditional IRA allows pre-tax contributions that grow tax-deferred, taxed upon withdrawal. A Roth IRA uses after-tax contributions, but qualified withdrawals in retirement are tax-free. Choosing between them depends on expected tax bracket now versus in retirement. Both have annual contribution limits and penalties for early withdrawal before age 59½.

Key terms

401(k)

Employer-sponsored retirement account funded with pre-tax payroll deductions; withdrawals taxed in retirement.

Traditional IRA

Individual retirement account with pre-tax contributions that grow tax-deferred until withdrawal.

Roth IRA

Individual retirement account funded with after-tax dollars; qualified withdrawals are tax-free.

Employer Matching

When an employer contributes additional funds to a retirement account based on employee contributions.

Compound Interest

Interest earned on both the principal and previously accumulated interest, accelerating growth over time.

Try an AP-style question

A 401(k) is…

1. a government pension for all
2. an employer-sponsored retirement plan
3. a type of savings bond
4. a short-term loan