Time to Max Out Those Retirement Plans

My parents and many of their contemporaries didn’t have to worry too much about saving for their retirement years, since many of them were covered by defined benefit plans funded by their employers.

My, how times have changed! Fewer and fewer employees are that lucky today. Instead, most of us are solely responsible for funding our golden years. Fortunately, Uncle Sam has provided a couple of vehicles that make it easy to save and come with significant tax advantages.

The first is a defined contribution plan – the 401(k), a savings and investing plan that Congress created via the Revenue Act of 1978. In this plan, the individual makes contributions, deducted from your paycheck on a pre-tax basis according to a stipulated formula. And then your employer may elect to match part or all of your contributions, in essence, giving you free money.

Right now, you can contribute up to 15% of your income to your 401(k) plan, which can over time add up to a lot of cruises, golf games and fancy retirement villas!

Because your contributions are pre-tax basis, that means you are not taxed on them until you begin to withdraw them, hopefully, upon retirement, when your tax rate will be smaller than during your working years.

And since your contributions are deducted from your paycheck, contributing becomes automatic. Think of it as a forced-savings plan, in which you don’t spend it because you don’t see it!

For 2007, the contribution limit is $15,000. But if you are age 50 or older, you may make an additional $5,000 per year “catch-up” contribution. After 2008, the limit will be adjusted for inflation in $500 increments.

Plans such as the 401(k) are tremendous savings vehicles, but unfortunately, they are not often used to their maximum abilities. Here’s why:

Most 401(k) plans are underfunded, usually because folks think they can’t afford to sock money away. However, if you fall into this category, you are making a big mistake. Chances are, you won’t even miss those pre-tax dollars coming out of your paycheck. An easy way to do this is by consistently and immediately increasing your contributions by a portion of any raises and bonuses you receive. Hey, how can you miss it if you never had it?

Additionally, most employers offering 401(k) plans at least partially match your funds, and as I said earlier, that — plain and simple — is free money! Add in the beauty of compounding (making interest on interest) and before you know it, you have a real retirement account.

It’s understandable that when you first open your 401(k), you may be unsure about the level of your contributions. So, if you don’t think you can 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.

Once you’ve decided how much to invest, your next step is to choose among the investments your employer’s plan offers, which is not often easy. Your employer will most likely invite the plan administrator in to give you an overview of the plan, but you will need more assistance than that. To help you with this important decision, just refer back to Financially Fit issues #7 & #8, for in-depth information on maximizing your 401(k) investments.

And don’t forget: your plan need not be stagnant. As you become more used to directing your own retirement funds, you may find that you will want to change your investment strategy from time to time. Fortunately, most 401(k) plans are now set up to accommodate those changes.

Before we leave the subject of 401(k)s, I want to caution you about two common scenarios that will adversely affect your ultimate goal of a sunny retirement:

1. Make sure you roll your funds over when you change jobs. Many folks who change jobs make the mistake of taking the cash out of their 401(k) plans. This is a terrible idea! One, you’ll probably spend it on something you don’t need. But worst of all, when you get the money in your hands, you have just subjected yourself to significant early withdrawal penalties as well as hefty income taxes. And that doesn’t even address 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.

2. Don’t borrow money from your 401(k) unless it’s a dire emergency. Here’s why: 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 keep your retirement out of reach!

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.

The second retirement vehicle that you should utilize after you have maximized your 401(k) contributions is an Individual Retirement Account (IRA).

Almost everyone is familiar with traditional Individual Retirement Accounts. Like 401(k) plans, traditional IRAs let you save 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.

Then, to further sweeten the pot, in 1998, Congress created Roth IRAs, which offer several advantages over traditional IRAs. Here are the current contribution guidelines:

Year Contribution Limit
2007 $4,000
2008 $5,000
2009 (and after) $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.

Roth IRAs are funded with after-tax dollars rather than pre-tax dollars, as in a traditional IRA. But because of this, you owe no taxes on your withdrawals (including earnings), as long as the withdrawals are qualified. (primarily meaning after age 59 ½, and if you have owned the IRA for at least 5 years). 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.

Additionally, special circumstances, such as the first-time purchase of a home, disability, unreimbursed medical expenses more than 7.5% of your adjusted gross income, qualified higher education expenses, and a few others may be allow you to make tax-free and penalty-free withdrawals from a Roth IRA. This makes the Roth IRA an attractive investment vehicle for many other uses in addition to retirement and savings.

And because the annual income levels used for determining your ability to make contributions are much higher for a Roth IRA than in a traditional plan, more folks can participate. Individuals making less than $114,000 and married taxpayers filing jointly who make less than $166,000, can make at least a partial contribution to a Roth for the 2007 tax year. For a full contribution, the income limits are $99,000 and $156,000, for single and married taxpayers filing jointly, respectively.

Lastly, unlike a regular IRA, the Roth IRA doesn’t require minimum withdrawals when you reach age 70.5.

Our advice: if you are eligible for a 401(k) plan, fund it first. Unfortunately, not all employers offer 401(k) plans. But nearly everyone is eligible to have an IRA. And an IRA does have the advantage of offering you a wider choice of investment options than what you will find in your company’s 401(k) plan.

Bottom line, you are in the driver’s seat. If you wish to really make your retirement years “golden,” you must maximize your savings. And a 401(k) plan, as well as an IRA, are the absolute first steps you will need to ensure your goals are fulfilled.

Here are a few websites that offer additional information:

http://www.fairmark.com/rothira/

http://www.irs.gov/faqs/faq17-3.html

http://www.irs.gov/taxtopics/tc424.html

http://www.dol.gov/ebsa/publications/401k_employee.html

The sooner, the better, so get started today!

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