Beating Broke

Personal Finance from the Broke Perspective

Don’t Leave Retirement Savings on the Table

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Retirement can sometimes be like that one cousin at family gatherings.  The one that nobody likes to talk about.  I think that, like that cousin, it’s easier to put our retirements out of our minds simply because, for many of us, it’s still so far away. We’ve still got 10, 20, 30, or even 40+ years before we hit that golden age of 65.5 and start living the good life of retirement.  Naturally, our nearer goals are at the front of our minds and take up most of our thoughts.  After all, which are you more likely to worry about?  Your upcoming performance evaluation next week, or your retirement in 35 years? Retirement never stood a chance. But, like that cousin, you’ve got to think about your retirement sooner or later.  And, the sooner you start thinking about it, and preparing for it, the better off you’ll be when it comes time to face it.

In fact, the sooner you start saving for retirement, the better off you’ll be.  Not only will you have to save less because of the wonders of compounding returns, but you’ll have more to show for it when it comes time to retire.  At an average of 7% return, any money that you save for retirement will double every 10 years.  What does that mean?  If you wait an extra 10 years to start saving for retirement, you’ll have effectively cut your retirement fund in half, and will need to either drastically increase the amount you’re saving each month, or learn to live on less in retirement.

Retirement © by 401K 2012

Saving for your retirement doesn’t have to be complicated either. Sometimes, it’s downright easy!  How do you make the most of your early retirement saving?  Stop leaving it on the table.  Get active with your savings.  Go beyond being active, and be pro-active.  Start with your employer.  If you’ve got a 401(k) through your employer, take advantage of it.  Contribute up to the full amount that your employer will match.  Your HR department will help you get it set up, and give you the information on the match so that you can do that.  Most 401(k) programs will have a set of target date funds that can be used to effectively set your 401(k) on autopilot.  If you don’t want to be involved in the choosing of funds for the money to go into, the target date funds can be a great choice.

Once you’ve gotten the full match from your employer in your 401(k), you might want to look into a private pension plan or an IRA as well.  For most, the Roth IRA, with it’s tax free growth and withdrawals is probably the right choice.  If you’re under 50, you can contribute up to $5,000 every year into an IRA.  Use your tax refund, if you get one, to give yourself a boost each year on meeting that $5,000 limit.  If you’ve still got more retirement saving to do after you’ve met the contribution limit, you can up your deduction into your 401(k).

If you need more help with your retirement, or help figuring out what, how much, and when to save, find yourself a retirement expert.  Your CPA or a certified financial planner should be able to give you a detailed plan for your retirement savings. The most important thing you have to remember with all this retirement talk is that if you don’t save, you won’t have any retirement funds to worry about.  Unless you want to count on Social Security to fund your retirement.  I’ve seen people who have done that.  You don’t want to be in their shoes.  Get your retirement saving started today.  It really is important.  Even more than that performance evaluation.

What is the Roth IRA?

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Retirement.  Have you thought about that yet?  Still think you’re too young to deal with that?  Or, just assume that your company 401(k) is enough, so why even worry about anything else?  Let me introduce you to the Roth IRA.

IRA is an acronym that stands for (I)ndividual (R)etirement (A)ccount.  The Roth part is named after the Senator that sponsored the bill that created the Roth IRA.  But, what really matters is that it could be really important to your retirement fund building.  So, pay attention to the next few paragraphs.  Do it for the retired version of yourself!

Source: goodfinancialcents.com via Jeff on Pinterest

Why is the Roth IRA so important?

Unlike the other versions of the IRA (Traditional, SEP, SIMPLE, Self-Directed), the Roth gets some special treatment when taxes come into play.  Instead of being a pre-tax contribution, like a 401(k), or a tax deduction contribution, like other IRAs, the Roth is an after tax contribution.  That means that you’ll be taxed on the income before you contribute it to the Roth IRA.  That sounds terrible, doesn’t it?  It’s not.  And here’s why.  All of the gains on the account are tax free.  What that means is that, if you contribute $5,000 today, and gain $45,000 between now and retirement, you don’t pay any taxes on any of it when you start taking withdrawals.  That’s pretty significant.

If you had your money in any of the other retirement accounts, you’d be taxed on the whole $50,000 as you withdraw it.  At your then current tax rate.  While we can’t know what our current tax rate will be when we retire, we do know that one will exist.  Unless you think that your retirement tax rate will be significantly below your current tax rate, you really should consider adding a Roth IRA to your portfolio of retirement accounts.

How should I use a Roth IRA?

Why did I just say “adding a Roth IRA to your portfolio of retirement accounts”?  There’s a couple of reasons.  The biggest one, though is that the Roth has a contribution limit that is a bit low.  As of right now, that limit is $5,000 if you’re under the age of 50, and $6,000 if you’re over the age of 50.  Unless you really think you’ll be able to build a retirement nest egg that will be sufficient on $5k a year (hint: you won’t be able to), you’ll need to supplement with other retirement accounts. If you’ve got a 401(k) offered at your employer, use it.  At the least, contribute enough to get the maximum match from your company.  Once you’ve met the match, use the next $5,000 and put it into a Roth IRA.  (I’ve got mine at Sharebuilder, but just about every investment house does Roth accounts.)  Once you’ve got the full 5k in your Roth, you and your financial planner can decide what the next best idea is.  If you’re happy with your 401(k) and the investments offered in it, you can continue to contribute any further monies into the 401(k).  If you don’t like the 401(k), you might consider some other form of retirement account.  Maybe a traditional IRA.  The traditional doesn’t have the same tax benefit of the Roth.  Taxes are still taken out before you contribution, in most cases, and you get a tax deduction based on those contributions.  Any withdrawals taken after retirement are also taxed.  The contribution limit is the same, however.

How do I structure my retirement?

How your retirement portfolio and where/when of your contributions is very important.  There are tax codes to take into account, as well as changes to the way that you contribute.  Everyone’s retirement situation is very unique to them.  To really get a good handle on all of this, you really should talk to a financial planner who can get a good idea of what your unique situation is, and make suggestions based on that.  It will likely cost you a little bit up front, but the difference could be life changing when it comes time to retire.  (Check out these great tips on finding a great financial planner)

I’m writing this post as part of the Roth IRA Movement.  It’s a great movement, headed up by Jeff Rose of GoodFinancialCents.  He recently discovered that many of our youth are under-educated on what the Roth IRA is.  He’s gathered well over 100 personal finance bloggers (including Beating Broke) and we’re all posting a Roth IRA post today to try and help with educating on the Roth IRA.  You can read all about the movement as well as see a list of all the posts that are/were written as a part of it at Jeff’s Roth IRA Movement post today.  You can also see a list of the posts over at RothIRA.com.

Reader Question: IRAs, 401(k)s, and Dividends

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Reader David left a comment with the following question in it:

Every other mutual fund I have ever owned has at one time or another paid out dividend distributions.This includes funds that I have held on my own, and some that were held in Traditional and Roth IRA’S. Not so with any funds I have had in two 401k plans over the years. Going all the way back in my annual statements I cannot find a single entry for dividend distributions. Do you have any ideas why this might be so and whether or not I would be better off making contributions to an IRA that go above and beyond the company match??

There are several ways that I’ll attempt to answer this.  Keep in mind, I’m not a financial planner, or a financial adviser, so take what I say with a grain of salt.  Perhaps a few of my adviser readers will have slightly better advice, we’ll see. I think there are really two questions there though (I won’t charge you extra.), so let’s break it down a bit.

Dividend Distributions in 401(k) and IRA accounts

401K
Several things could be happening here, but here are the most likely scenarios.  Because of the difference in how a 401(k) and an IRA are handled for taxes, (401(k) is pre-payroll tax while IRA is post-payroll tax) the tax that you would normally pay on a dividend distribution is deferred in a 401(k).  What that means is that the dividend income in a 401(k) doesn’t have to be reported and is usually automatically reinvested.  Depending on the 401(k) provider, dividend income might just be being shown as a capital gain on the fund since that’s what it becomes in this tax scenario.  Another possibility (although somewhat unlikely) is that, like stocks, not all funds will pay a dividend.  The only way to figure that out is to do some research into the individual funds that you own in your 401(k) and determine if they pay a dividend or not.  I like finance.google.com for quick lookups, but the best place would be the website of the fund, or the prospectus for the fund.

Make Contributions to an IRA that go above and beyond the company match

I wanted to tackle this question separately.  First, you should, absolutely, take advantage of your company match to it’s full extent.  If your company will match x% up to y% of your income, you should contribute y% at a minimum.  It’s free money, and I guarantee you the company looks at it as a part of your compensation package.  You wouldn’t leave a paycheck un-cashed would you?  Once you’ve met that amount, several things come into play.  I think the biggest of these is your personal tax situation.  A 401(k) acts as a deferred tax account.  You don’t pay any taxes on your contributions, and then pay taxes (at your then tax rate), on the withdrawals.  With a Roth IRA, you pay taxes on the contributions, but not on the withdrawals.  Let’s say you make a lot of money now, and your tax rate is 35%.  When you retire, you’re no longer making those fat stacks of cash, and your tax rate drops to 25% or less.  You’ll now pay 10% less in taxes on those withdrawals.  Keep in mind that those withdrawals will include any capital gains that the account has accrued over your working career.  In the Roth IRA, you’ve already paid the taxes on contributions at 35%, and you don’t pay any taxes on the withdrawals.  In this scenario (10% drop in tax rate), you’ll need to have managed gains of 10% above your contributions by the time you retire to realize any significant difference.

Another thing to look at, is whether you are able to contribute to the limits.  In 2012, the 401(k) contribution limit is 17,000.  If you’re 50 or older, you can also make an additional “catch-up” contribution of $5,000, for a total of $22,000.  There’s an additional overall limit of $50,000 for employee plus employer contributions.  So, if you make the max contribution, your employer can only contribute the additional amount to $50,000.  For the IRA, the maximum annual contribution is $5,000 (or $6,000 if you’re 50 or older).  There are also some restrictions on how much of the contribution is tax deductible, and how much can be contributed based on income.

The simple suggestion here is that you should contribute to your 401(k) up to the % that the company will match to take full advantage of that added compensation.  Once you’ve hit that %, contribute to an IRA up to the full amount you’re allowed.  Once you’ve hit that contribution limit, invest any additional contributions into your 401(k).  Obviously, it takes a bit of math to figure all of that out, since you won’t likely know whether you’ve hit the max on the IRA without some pre-planning.  But, if you can manage to sock away the $5,000 (or $6,000 if you’re older than 50) into a savings, you can write one check at the beginning of the year as your current year contribution to your IRA, and then take whatever you’re comfortable with out of your paycheck for your 401(k).  Using a tax refund as a boost to the IRA contribution can be helpful (if you get a refund).

That’s a very high level overview of the IRA vs. 401(k) question though, and you really should consult your accountant or a financial adviser on the subject.  There are lots of factors that go into the the tax ramifications of both, and you really want to know as much as you can so that you can adjust your retirement planning accordingly.

I’m sure many of my personal finance friends who know more about the subject than I do will offer their wisdom in the comments, so be sure to check back and see what nuggets they have to offer. 😉

photo credit: urban_data