Monday, March 2, 2009

Know What Is Available To Save For Retirement - Part 1

Tip #80 - Know What Is Available To Save For Retirement – Part 1. In the past we have discussed different kinds of savings and investment accounts. But today let’s talk specifically about how to put the money away toward retirement – that is what type of investment vehicles you can use to save for retirement.

In the US, these are the 3 main retirement vehicles for saving:
1. A 401(k) at work (or 403(b) if you work for a non-profit)
2. An Individual Retirement Account (IRA) that you set up on your own (or a SEP IRA if you are self-employed).
3. Traditional pension plan

Let’s talk about number 3 first. A traditional pension plan is a defined dollar amount that a company provides for its employees’ retirements after they have worked there for a certain number of years. This type of plan has started to disappear from the corporate scene in the US. And because it’s not something an employee actively participates in, rather it’s money the company provides automatically to its employees, we will not discuss it any further. If you know your company will provide a pension for you when you retire, then make sure you consider that source of funds when figuring out any additional amount you need to save to retire. Otherwise, let’s concentrate on the other two main retirement vehicles in which individuals take an active role.

The two main retirement vehicles in the US for individuals to save are the 401(k) and the IRA. By putting money “in an IRA” or “in a 401(k)”, you are actually earmarking the money for retirement. But within this vehicle, the money can be saved in a CD, a mutual fund, or other account of your choosing that we discussed earlier. However, better than putting retirement money in a CD or mutual fund on your own, by saving it through a 401(k) or an IRA you can take advantage of tax incentives that the US government gives us for saving toward retirement. Today we will talk about the 401(k).

Many places of employment offer its employees retirement savings plan called a 401(k). (A 403(b) is a similar plan for non-profit companies so if that is what you have at work, this information is essentially the same). By saving for retirement “in a 401(k)” you are taking advantage of saving the money pre-tax. For example, if you get paid $50,000 per year and want to save 10% of it for retirement in the 401(k) that your company offers, you will be putting away $5,000. And you do not pay taxes on that $5,000 until you take it out at retirement. Instead you pay taxes only on $45,000 ($50,000 total income -$5000 401(k) contribution). How you invest this money in a 401(k) is up to you within the parameters set up your company. Your company might offer you 8 mutual funds and a money market account through a private investment firm as options to invest your money “in a 401(k).”

As I just mentioned, one of the benefits of the 401(k) is that the taxes are deferred on the money that you invest. So as I said in my example the $5,000 comes out of your gross salary and you don’t pay taxes on it (until you pull it out at retirement) and can invest the full amount. Whereas, if you want to save $5,000 for retirement on your own, you would first be paying taxes on that $5,000, effectively reducing the amount you can invest. Or, another way of looking at it is if you are in the 15% tax bracket, you would need to earn about $5,883 ($5,883-$883 [$,5883*15% taxes]=$5000) in order to invest $5,000.

Also another benefit of the 401(k) is that the earnings on your investment grow tax-free until you take them out at retirement. That means if you invest $5,000 in a money market fund within a 401(k) plan and earn 3% ($150) the first year, then you do not have to pay taxes on that $150 until you retire. If you were to invest $5,000 on your own in a money market fund and make $150, then you would have to pay taxes on those earnings each year you made them. If you expect to be in a lower tax bracket when you retire this can be a huge benefit.

Another benefit of the 401(k) is that many companies “match” what you invest. That is, they may put in the exact amount into your 401(k) account that you put in. Or they may partially match what you put in. For example, many companies will match dollar for dollar the first 3% of your salary that you put in to your 401(k). Back to our example, if you make $50,000 and put in $5000, then the company would match dollar for dollar the first 3% of your salary that you put in (or $1500). So by putting in $5,000 you will automatically have $6,500. (There may be rules about how long you have to stay employed at the company to keep their “match”). Some companies may match 50% of all of your contributions. So if you make a $5000 contribution then they will put in $2,500 into your account. These types of benefits cannot be beat. The company is essentially paying you to invest.

The negatives of the 401(k) plans are that you are limited to where you can invest your money. You have to put the money in one of the choices that your company provides. Some companies have many choices and/or better choices than other companies. The other drawback is that you are limited in the amount that you can invest. Federal law puts a dollar amount limit ($16,500 in 2009) that you can put into a 401(k) each year, but your company may make stricter limits such as only 15% of your salary as the maximum you can put in. In that case, someone making $50,000 would only be allowed to invest $7,500 per year.

If you are going to invest in your retirement (and it is one of the most important savings you can do), then I highly recommend checking out your company’s 401(k) or 403(b) plan. And at the minimum, invest the full percentage needed to take advantage of the company’s match

A few years ago a variant of the 401(k) was introduced called the Roth 401(k), although I don’t believe it is offered as many places as the regular 401(k). The difference with the Roth 401(k) is that you pay taxes up front on the money you invest. Also, earnings on the money you invest are completely tax-free instead of tax deferred. This option is appealing to people who are in a low tax bracket now but expect to be in a high tax bracket when they retire.

In Real Life (IRL) – I started investing in my company’s 401(k) one year after I started working at my first job out of college, which is when I became eligible. I was about 22 years old. I only put in 3% of my salary since retirement was “so far away”, but I wanted to take full advantage of the company match, which was dollar for dollar on the first 3%. The following year I wised up after talking to one of my co-workers who was older and more experienced in investing. He suggested putting the maximum that I could into my 401(k). I took his advice and invested 13% of my salary, which was the most that my company would allow. I don’t remember what type of allocation I did, other than it was a mix of mutual funds and probably some stable money market account.

Since only one of my real life friends know about this blog, I feel pretty comfortable sharing the worth of that 401(k) to show you how quickly this money can build. I worked at that company for exactly 9 years. The first year I worked there I made $19,500. I made no contributions to the 401(k). The second year I worked there I made about $20,500 and I contributed 3% of my salary. The following years (years 3-9) I contributed the full 13% that my company allowed me to contribute. When I left that company I was making about $40,000. This means I invested $600 the first year I contributed the 401(k) and between $3000 and $5,000 per year for the following 7 years that I contributed. I left that company about 10 years ago and today that 401(k) is now worth $66,000, The money was taken out of my paycheck along with my taxes and health insurance contribution so I did not even see the few hundred dollars per month that I contributed for 8 years. And because I never saw the money, I didn’t miss it.

If your company offers a 401(k), be sure to look into it as a means for your retirement investing. If nothing else, at least try to put in as much as the company will match.***

***As is always the case with posts I write on this blog, I am not a financial advisor of any sort. I am just a person who has invested money over the course of 20 years. Any investments you make should be discussed with a competent investment professional.


nankie said...

I, too, have always been a saver and have watched my money grow seemingly effortlessly, over the years, by contributing to my 403B (among other things). But now I've been thinking of curtailing my contribution because the interest rate is down to 1% and it is not even guaranteed. I think I might be better off putting it in a FDIC insured CD. I recently saw one advertised for 4%, for 5 years. Even with after tax money I think this might be better, but I'm hesitant to change.

Michele said...

It's probably best to get advice from a fee-only financial planner (one who does not have a vested interest in which investments you choose).