How do you wanna retire? On a beach in Tahiti sipping a Mai Tai? Pursuing your dream of becoming a world class sky diver? Maybe quitting the rat race early at age 45 and telling the world to go @#^& itself?
However you envision your retirement, if you want to make those dreams come true, you need to start planning and taking action NOW! Otherwise, you might find yourself filling grocery bags at the local Slaveway well into your eighties. I don’t mean to scare you, but you can’t count on anyone else to provide for your dotage besides yourself. Not your kids, not your girlfriend, and certainly not your employer or the government (although the last two will certainly help you help yourself as you’ll see below.)
First things first
Before we get into retirement saving, you gotta settle your financial house. For that, I got rules!
Pay off any double-digit interest rate debt (read: credit cards), make sure you’re properly insured and have a short-term reserve for emergencies.After you’ve done that, keep spending less than you earn so that you can start to sock away retirement money from each paycheck. And remember, that money is for your retirement! For tax-advantaged retirement vehicles (the best kind!) like the 401k or Roth IRA, you generally can’t take that money out before you’re 59 1/2 without paying some serious taxes and penalties (for Roth IRAs there are some exceptions that The Motley Fool can explain to you.)
However, despite having access to those legal exceptions, I want you to repeat after me: “Retirement savings are for my retirement, retirement savings are for my retirement!” Got it? Good. Let’s move on to where you should put your money to get the most out of each retirement dollar you set aside.
Tax-advantaged retirement savings – the ONLY way to go! (At least I think so.)
As I said earlier, you shouldn’t count on Uncle Sam to fund your retirement. (Even if social security is around when you retire, the pittance you receive will likely be much too small to live off, and certainly not enough to live comfortably with.) However, the government has made several investment vehicles available to the common man (or woman) that incentivize you to save for your own retirement by offering large tax savings.
The most common retirement vehicles are the 401k, 403b and IRA (Roth and Traditional.) The 401k and 403b are only available through your employer, but ANYONE with earned income can invest in a Roth or Traditional IRA.
The 401(k) and 403(b)
The 401k is frequently offered to full-time employees by a private employer while the 403b is offered to some state employees (like public school teachers) and certain non-profit employees (like church employees.) Many aspects of the 401k are similar or identical to those of the 403b. I will discuss the 401k below, but you can assume that the rules and benefits are essentially the same for the 403b. A 401k offers several advantages over a “regular”, taxable account.
Firstly, you don’t have to pay taxes on the money that you contribute to your 401k at the time you invest. This means that if you invest $4000 of your yearly income into a 401k during 2008 and you’re in the 25% tax bracket, you just saved yourself $1000 in 2008 taxes. How did I figure that? Because ordinarily you would have to pay 25% of that $4000 you made to the IRS (25% of $4000 = $1000) and would’ve only been left with $3000 to invest. Instead, you invested that $4000 in a 401k and got to keep it all to yourself! You just increased your savings by 33% because you used your 401k to invest for your retirement instead of a taxable account, that’s big money!
Secondly, every dollar you put into a 401k grows tax-free until you take it out when you need it in retirement. (Generally, you must be 59 1/2 to take money out of your 401k without penalty.) Regular, taxable accounts require you to pay taxes on the dividends and capital gains that your funds produce each year. With a 401k, as long as you leave the money in your account, you don’t have to pay any taxes regardless of how much your fund grows in value!
Lastly, many employers offer “matching” of the dollars that you invest in your 401k. A standard offer is that an employer will match 50 cents on each dollar that you put in, up to 6% of your income. This means that if you make $50,000 per year and put at least 6% ($3000 in a year) of your salary in your 401k each pay period, your company will put in another 3% of each paycheck to boot! (50 cents of 1 dollar up to 6% = 3%.) In the above example, this equals $1500 in FREE money! If you have such a 401k matching deal with your employer, max it out! This is the number one place your retirement dollars should go; no where else can you get anywhere close to this instant, guaranteed return on your money! (Unfortunately, I’ve never heard of a 403b employer offering matching to employees, so this benefit seems to be reserved for those of us lucky enough to have 401ks.)
One other thing to note, the maximum that you can personally contribute in one year to a 401k (or Roth 401k or 403b) is $17,500 in 2013. This number is set to increase with inflation in $500 increments when necessary. (And if you’re close to maxing out that number, my hat’s off to you; nice work!)
The one time that you do have to pay taxes on your 401k account is when you withdraw money from your account (after you turn 59 1/2, otherwise you’ll get hit with nasty penalties! Remember, retirement savings are for your retirement.) At this point, you’re taxed on those withdrawls just like you would be taxed for ordinary income.
However, if you believe that you’re going to be in a higher tax bracket when you retire than the bracket you’re currently in, you might wish that you could just pay the (lower) taxes on your income now, invest it, and then withdraw your money (including all the gains on that money) tax-free at retirement when your tax bracket is higher. Fortunately for you, Uncle Sam has created the Roth IRA (and the Roth 401k) for just that purpose.
The Roth IRA and Roth 401k
The Roth IRA (and Roth 401k) works in a kind of “opposite” way to the 401k (or Traditional IRA, which we’ll discuss briefly later.) Instead of investing money tax-free, you pay that taxes on the income that you invest in a Roth IRA now, but when you pull that money out, your original invested dollars PLUS all the gains on that money aren’t taxed a cent! Also, like a 401k or Traditional IRA, the money you invest grows tax free throughout all those years. Unlike a 401k, virtually anyone with some income can invest in an IRA (Roth or Traditional.) This is subject to certain income requirements which you can check HERE.
This savings vehicle could be a better place for your money than a 401k or Traditional IRA for a few reasons:
1) You expect your future tax bracket to be higher than your current one.
Ex: You currently make $30,000 a year, and are in the 15% marginal tax bracket. However, because you’ve read this blog and have become a prodigous saver, you plan on retiring at 60 with enough money so that you can comfortably withdraw $70,000 a year to live off. This amount of yearly income would put you in the 25% tax bracket. Thus, you’d be better off putting a fair amount of retirement savings into a Roth IRA (paying taxes now at 15%) so that your taxable income when you retire is likely to be within the 15% bracket, and not in the 25% bracket.
2) Your employer doesn’t offer a 401k or 403b and you plan to contribute the maximum to your IRA ($5,000 for 2012/$5,500 for 2013, with the amount set to increase in increments of $500 dependant on inflation.)
The reason you might be able to save more with a Roth IRA is a little more complicated than the last one, but there’s an excellent, clear explanation HERE.
3) You’re not sure how your future tax bracket will differ from your current one, but you just really like the idea of not having to worry about taxes when you retire!
While I completely understand this rationale, I would offer a few things to consider if this is your primary motivation for investing in a Roth IRA or Roth 401k instead of a Traditional IRA or a 401k/403b:
1) As the saying goes, “a bird in hand is worth two in the bush.” By that I mean that while your future tax savings (due to Roth IRA withdrawls) is unknown, it is certain that you will save X % on your taxable income if you were to invest in a 401k or Traditional IRA instead. (Of course, if you’re in the 10 or 15% marginal tax bracket currently, it’s hard to imagine that taxes will be lower when you retire, so a Roth IRA may make sense.)
Keep in mind, also, that some part of your income is never taxed (because everyone has access to a ‘standard deduction’ and ‘personal exemption’ that exempt about $8000 of your income from federal taxation in 2008.) So in retirement, some portion of your “taxable” retirement income (like from a 401k or Traditional IRA) will already be exempt from taxes. Thus, during the course of your working life, you probably want to invest some portion of your retirement savings into a 401k or Traditional IRA (preferably when you’re in a high yearly tax bracket, to reap the greatest tax savings.)
2) Make sure you’ve maxed out your 401k employer matching before you even think about another retirement vehicle.
(If you’d like to know more about taxes and tax brackets, click HERE. 2008 tax bracket information is at the bottom of this article for reference. Keep in mind that the incomes listed are NOT gross income ranges. They are AGI, or Adjusted Gross Income.)
The Traditional IRA
A traditional IRA is like a 401k as far as tax benefits go. However, like a Roth IRA, anyone with some income (and who doesn’t make too much money, generally you need an AGI less than ~$100,000 to qualify.) Also, the maximum allowable contribution is the same as it is for a Roth IRA, $5,000 in 2012, $5,500 in 2013.)
Note that for both Roth and Traditional IRAs, if you’re over 50 you can contribute an additional $1000 for a grand total of $6500 per year (2013) so that you can “catch up” on your retirement savings.
Conclusion and rules of thumb
Now you should have an idea of the valuable tax-advantaged retirement vehicles that are open to you, and why they are such great deals compared to regular, taxable accounts. Lastly, let me break down a few rules of thumb that you can use for your retirement investing.
1) The most important factor in retirement planning is to start investing early. Let’s take two people who are both 30 years old and would like to invest for their retirement. We’ll assume that their investment dollars grow at an annual rate of 8%. Jane decides to begin investing immediately and puts in $5000 per year for 10 years, until she’s 40 years old (a total of $50,000.) Joe doesn’t start investing until he’s 40 years old, BUT, to make up for lost time he invests $5000 for 20 years straight, until he turns 60.
When Jane and Joe turn 60 together, who do you think will have more money? Jane, who started at age 30 and invested for 10 years ends up with $365,000 at age 60. Even though Joe invested twice as much money over the years ($100,000 total), he ends up with only $247,000 at age 60.
Jane ends up with nearly 50% more retirement dollars than Joe, but only had to invest half as much! This clearly demonstrates the importance of acting now with regard to your retirement savings. A 401k (especially with matching) is a really painless way to begin this process. Just start by allocating, say, 10% or whatever you can afford of your paycheck to your retirement fund. You’ll hardly notice the difference in take home pay, but that money will really add up over time (that’s the magic of compound interest!) Try to also increase your percentage savings over time.
2) The first place your retirement dollars should go is towards maxing out a 401k employer matching plan (not everyone’s employer offers these, but be sure to check if your employer does!) This rule prevails regardless of what your tax situation is. Free money is just too sweet to pass up!
3) If you’re in a 25% or above tax bracket, and you don’t already have a large retirement nest egg built up, I would lean towards putting all or most of your retirement savings into a “NO taxes now” retirement account, like a 401k or Traditional IRA. Guaranteed savings of that much are hard to pass up. Also, as stated above, some of this money will likely be tax-free or taxed at a low rate in your retirement.
3) As long as retirement is still 5-10 years off for you, I recommend investing all your retirement savings in stocks (like 100% stock index or mutual funds.) Specifically, I recommend socking the bulk away in a large, safe, low-fee (less than 0.5%) index fund composed entirely of stocks, like Vanguard’s S&P 500 index fund (VFINX.) This also gives you instant diversification by investing you in 500 of America’s greatest businesses. One disadvantage of a 401k plan is that you must choose from the investments offered to you. If you’re lucky, a company like Vanguard, Fidelity or T. Rowe Price that offers low-fee index funds will be available to you.
If you would like to learn more on the subjects discussed above, I invite you to check out the Motley Fool’s (www.fool.com) section on Retirement. Also, if you have questions or comments on certain topics (retirement or otherwise), post a comment and I will try to reply as soon as possible.
Year 2008 income brackets and tax rates
|Marginal Tax Rate||Single||Married Filing Jointly or Qualified Widow(er)||Married Filing Separately||Head of Household|
|10%||$0 – $8,025||$0 – $16,050||$0 – $8,025||$0 – $11,450|
|15%||$8,026 – $32,550||$16,051 – $65,100||$8,026 – $32,550||$11,451 – $43,650|
|25%||$32,551 – $78,850||$65,101 – $131,450||$32,551 – $65,725||$43,651 – $112,650|
|28%||$78,851 – $164,550||$131,451 – $200,300||$65,726 – $100,150||$112,651 – $182,400|
|33%||$164,551 – $357,700||$200,301 – $357,700||$100,151 – $178,850||$182,401 – $357,700|