Retirement Planning: Part 2
Well, since you are reading this, I have to believe that no one suffered adverse consequences from last week’s homework: Calculating how much money you will need for retirement!
Congratulations on taking this first step! You are now well on your way to setting up a – hopefully – happy and healthy path to your golden years.
Last week, we covered the reasons why most folks will require more savings for retirement than the estimates forecast by typical retirement calculators. And I gave you several web sites to visit to calculate your personal retirement needs, using the new Monte Carlo mathematical simulations.
Now that you have a good idea of the size of the stockpile you will need, let’s review the types of accounts that will assist you in growing your retirement monies.
A lucky few of you will have pension plans from employers – usually, a defined benefit plan – to which your company has provided the funds that are growing and awaiting your collection when you reach the end of your work life. But the majority of us must create our own retirement funds, usually in the form of 1) a defined contribution plan, in which we contribute some monies and our employers match our contributions, utilizing a stipulated formula, or 2) an Individual Retirement Account (IRA), in which we are the sole contributors.
The two most popular of the defined contribution plans are 401(k)s and 403(b)s. 403(b) plans are similar to 401(k)s, except they are for teachers, hospital workers, and employees of not-for-profit organizations. The investment strategies are the same, so we’ll just refer to 401(k)s as a substitute for both plans in this section.)
With a 401(k), you contribute a portion of your paycheck to your retirement plan – on a pre-tax basis. That means you are not taxed on your contributions until such time as you begin to withdraw them – hopefully, upon retirement, when your tax rate will be smaller than during your working years.
And because your contributions are deducted from your paycheck, contributing becomes automatic, and avoids the temptation to spend the money on something else; a wonderful forced-savings plan. The 2006 contribution limit for these plans is $15,000. But if you are age 50 or older, you may make an additional $5,000 per year "catch-up" contribution.
Now, you need to know that contribution limits and "catch-up" contributions are subject to change, and after 2008, the limit will be adjusted for inflation in $500 increments.
Sounds simple enough. And it really can be. But unfortunately, many folks don’t fully take advantage of them. Here’s why:
Most contributions to 401(k) plans, sadly, are not maximized. I’ve heard most of the excuses: I don’t make enough money; I need every penny I make for living expenses, saving for college, etc. Yet, you would be surprised at how much you don’t miss those pre-tax dollars coming out of your paycheck. I’ve always made it a policy to put one-half of any raises and bonuses I received into my 401(k). Hey, how can you miss it if you never had it?
And what many participants forget: Your boss is most likely matching at least part of your contributions and that’s free money! I know you don’t need me to tell you about the beauty of compounding; you know that the earlier you begin saving, the more time your money has to make more money for you.
If you can’t afford much, start with just 1% or 2% of your income. Then make a commitment to increase that rate every year until you hit the maximum amount.
Participants generally have an opportunity to choose among a variety of investments in their plans, and this is where trouble often begins. Most investment strategies are made with little or no thought. That’s not really your fault. Most employees are not given enough information or time to make wise decisions, so they just do what I call the "dartboard" method of selection – close your eyes and pick one! But don’t despair; we can help you with that. Just refer back to Financially Fit issues #7 (Making the Most of Your 401(k)) & 8 (Evaluating Your Mutual Funds), for in-depth information on maximizing your 401(k) investments.
Now, compounding those problems of not putting enough money into the best investment vehicles are two momentous mistakes commonly made by investors in their 401(k) plans:
- Not rolling the funds over when you change jobs. Unfortunately, many people, when they change jobs, instruct their previous employer to give them the cash in their 401(k). Not a good idea! That money in your hand is way too tempting. Before you know it, it will be gone and you’ll have to pay penalties and income tax, not even taking into consideration the opportunity cost of losing the ability to compound the returns on that money you just withdrew. A better idea: Roll the money over into your new employer’s plan or into an individual IRA that you can set up easily at your bank or brokerage firm.
- Borrowing money from your 401(k). Oh, all that money can, as my dad used to say, "burn a hole in your pocket". But unless it’s a dire emergency, do not borrow money from your 401(k). The reasons are twofold: 1) You’ll have less in the account compounding for your future; and 2) You may find it hard to pay back the loan and keep contributing at your current rate. If you absolutely need money, look for other loan alternatives. But tell yourself that your retirement funds are not to be touched!
If your company offers a 401(k) plan, our advice is to contribute as much as you can to it, consistently. You’ll be amazed at how quickly the funds can build up over time.
Almost everyone is familiar with traditional Individual Retirement Accounts. Like 401(k) plans, IRAs let you put money away, with certain tax advantages. The concept is simple: If you meet income guidelines, you contribute pre-tax dollars, yearly, to an account, and the money compounds over time.
Here are the adjusted gross income phase-out limits (the tax deductibility declines to zero as income advances) for deductible traditional IRA contributions:
Year Single Filer Joint Filer
2006 $50,000-$60,000 $75,000-$85,000
2007+ $50,000-$60,000 $80,000-$100,000
If you don’t meet the income cut-offs, you may still contribute to a traditional IRA; the contributions just won’t be in pre-tax dollars.
Like 401(k)s, earnings and deductible contributions are not taxed until you withdraw the money. For non-deductible contributions, just part of the withdrawal will be subject to taxation. Another big advantage: Taxes are assessed at ordinary income tax rates, which should be lower in your retirement years than they are when you are working.
When you reach age 59-1/2, you can begin taking distributions without penalties. At age 70-1/2 you must start withdrawing the required minimum distributions from your IRA.
IRAs have two important advantages over 401(k)s:
- Not all companies offer 401(k) plans. But nearly everyone is eligible to have an IRA.
- You have a wider choice of investment options. You’re not limited only to the choices offered in your company’s 401(k) plan offers.
Like 401(k)s, IRA contribution limits are constantly raised. For 2006, a maximum of $4,000 may be contributed to an IRA. And if you are 50 or older, you may make an additional "catch up" contribution of $500 in 2006.
The primary disadvantage to an IRA is the maximum annual contribution limits. Here are the limits for the next few years:
Year Contribution Limit
2006 $4,000
2007 $4,000
2008 $5,000
After 2008, the limit will be adjusted for inflation in $500 increments. In addition to these contribution limits, workers age 50 and older (as of the end of the year) will be able to make "catch-up" annual contributions of $1,000 per year, through 2008.
In contrast, 401(k)s let you contribute up to 15% of your income — which can add up to a lot more than $4,000. Bottom line: IRAs are an essential supplement to your 401(k). Once you have maximized your 401(k) contributions each year, we suggest that you fully utilize your IRA contributions. Just check with your financial advisor to find out which IRA is right for your situation.
Roth IRAs offer a twist on the traditional IRA. Introduced for the 1998 tax year, they have some distinct advantages over traditional IRAs.
- While the contribution limits are the same (but reduced by any contributions you make to traditional IRAs), you fund the Roth IRA with after-tax dollars rather than pre-tax dollars. But because of this, you owe no taxes on your withdrawals (including earnings), as long as the withdrawals are qualified. So while you forfeit any tax advantages in the current year, you should more than make up for it by avoiding taxes on your principal and earnings when you withdraw them.
- Secondly, there are a few instances – such as the first-time purchase of a home or in case of disability – that allows you to make withdrawals from a Roth IRA — tax-free and penalty-free. This makes the Roth IRA an attractive investment vehicle for many other uses in addition to retirement and savings.
- Thirdly, the annual income levels used for determining your ability to make contributions are much higher for a Roth IRA. Individuals making less than $110,000 and married taxpayers filing jointly who make less than $160,000, can make at least a partial contribution to a Roth.
- Finally, unlike a regular IRA, the Roth IRA doesn’t require minimum withdrawals when you reach age 70-1/2.
For self-employed folks, additional retirement accounts are available. And we will cover those in a future Financially Fit issue.
I’ll leave you with this thought: time is of the essence. You need to begin to maximize your retirement savings NOW. Chances are, although you may contribute the maximum to your 401(k) plans and your IRAs, you will, undoubtedly, need to supplement those funds to meet all of your retirement needs. But combined, those two vehicles should at least give you a very good start.
About the Author
Nancy Zambell, Contributing Editor to BrokerAdviser.com's Financially Fit, has enjoyed a diversified career in the financial services industry.
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