Planning For Retirement – Part 4 … 401(k)’s

In Part 1 of this series, we briefly discussed how retirement planning had changed from the days when Joe went to work for The Big Company.  Back then, the company provided a pension plan that paid Joe a retirement income based on how many years he’d worked for the company and how much he made while he worked there.  Today, his grandson, Joe3 works for a company that offers a 401(k) plan rather than a pension.  But, how does the 401(k) work?

A 401(k) plan has much in common with an IRA.  Like an IRA, the 401(k) allows Joe3 to reduce his taxable income by contributing money into the plan.  Joe3 directs his employer to deduct a specific amount of money from each paycheck.  These untaxed funds are invested in accordance with instructions that Joe3 provided when he authorized the deductions.  The growth of the investments is not taxed until such time as Joe3 takes money out of the account.

Because this is intended to serve as his retirement plan, Joe3 is expected to leave the money in the account until he is at least 591/2 years old.  If he withdraws money from the account before that age, he will pay ordinary income taxes on the money withdrawn; and, he will pay a 10% penalty for the premature withdrawal.

One of the real advantages of the 401(k) plan is the ability to contribute far more to the plan than is permitted for an IRA.  While the maximum contribution to the IRA in 2012 is $5,000, an individual can contribute up to $17,000 into the 401(k).

Another advantage is that this plan allows an individual to reduce his or her taxable income regardless of annual income.

Moreover, because the 401(k) plan entails regular, consistent, investments, the individual is able to take advantage of the concept of “Dollar Cost Averaging”.  Dollar Cost Averaging simply means that the purchaser buys more shares when prices are low and fewer shares when prices are high.  Consider this example.  Joe3 has decided to invest $100 each month in stock issued by the XYZ Company.

Month Price Per Share Total Shares Purchased
January $10.00 10
February $5.00 20
March $20.00 5
Total $300.00 35

As can be seen, Joe3 has invested a total of $300.  If he decided that he wanted to sell all of his shared in the XYZ Company, how much would he have to sell them for in order to make money; $5, $10, $20, or something else?  If we divide his $300 investment by the 35 shares he owns, we can see that he paid an average of $8.57 per share; thus, he’ll make money if he sells the entire investment for more than $8.57 per share.  Of course, this does not include any fees that he may have to pay when selling the shares.

Now, let’s extend this concept into Joe3’s 401(k) program.  If Joe earns $500 per week and directs his employer to deduct 10% ($50) from each check and place that money into his 401(k).  When prices are high for Joe3’s chosen investment, he will buy fewer shares at the high price.  When prices are low for Joe3’s investment of choice, he’ll get more shares.  At his retirement, Joe3 will have amassed a significant retirement account that he can convert into a regular monthly income to support him in his golden years.

One final potential advantage should be recognized here.  Some companies provide some type of matching contribution to an employee’s 401(k) contribution.  Joe3’s company contributes $0.50 (fifty cents) for every dollar that Joe3 puts into his 401(k).  This represents an immediate 50% return on his investment so longs as Joe3 remains with the company long enough to “vest” that matching contribution.

Companies have a choice in vesting schedules; specifically, that matching contribution becomes the employee’s money when one of two schedules has been met.

  • “Cliff Vesting” – the entire matching contribution becomes the employee’s property after 2 years of employment.
  • “Stair-Step Vesting” – the matching contribution becomes the employee’s money in increments; i.e.,
    • 20% of the matching contribution belongs to the employee after 2 years of employment;
    • 40% of the matching contribution belongs to the employee after 3 years of employment;
    • 60% of the matching contribution belongs to the employee after 4 years of employment;
    • 80% of the matching contribution belongs to the employee after 5 years of employment; and,
    • 100% after 6 years of employment.

Some employers measure the beginning of the vesting period from the initial date of employment while others measure it from the date on which the matching contribution was made by the company.  Of course, the employee’s contributions to the plan always belong to the employee and cannot be taken away (which is not to say that the value is always the same … the value can increase or decrease based on the performance of the investment that the employee has chosen).

Just like the IRA, Joe3 must begin withdrawing money from his 401(k) by the time he turns 701/2.  Failure to make the minimum annual withdrawals will result in the assessment of tax penalties.

401(k) plans offer employees a great way to plan for retirement through the use of payroll deductions (if you don’t see the money, you don’t miss the money) and growth within a tax sheltered environment.  If your employer offers this type of retirement plan, check it out … someday you’ll be very glad you took advantage of the opportunity to plan for your future retired life.

NEXT UP … 403(b)

Planning For Retirement – Part 3 … ROTH IRA’s

The ROTH IRA is perhaps one of the best tax advantaged retirement plans available to the individual taxpayer today.  Created in 1997 by the Taxpayer Relief Act, the ROTH IRA is similar to a traditional IRA in that it allows individuals to save for retirement in a tax sheltered environment; i.e., the earnings and growth within the account is not taxed.  However, there are some significant differences.

  • Contributions are not tax deductible.  All money put into a ROTH IRA is “after tax” money.  You’ve already paid income taxes on it.  While this may initially sound like a disadvantage, it proves to be a real advantage when it comes time to withdraw funds from the account.
  • Withdrawals from the ROTH IRA after age 591/2 are tax free.  That is huge!  Where all withdrawals from a traditional IRA are subject to federal income tax, both the principal and the growth are untouched by the tax man when they are withdrawn from the ROTH IRA.
  • There are no minimum annual withdrawals required from a ROTH IRA after age 701/2.  For someone who does not necessarily “need” the money from their retirement fund and who wants to leave it as a legacy to a family member, this allows the money to continue growing in the tax sheltered environment.
  • Where the traditional IRA prohibits any additional contributions after age 701/2, a person can continue to contribute money into his or her ROTH IRA so long as he or she has income.
  • Earnings can be withdrawn without federal tax penalties when the funds will be used for:
    • expenses for a post-secondary education (i.e., college or accredited trade or technical school
    • health insurance after a long period of unemployment
    • periodic payments such as credit card debt
    • catastrophic medical expenses
    • payment on a levy
    • If the money has been invested for five taxable years, earnings can be withdrawn tax-free if the individual:
      • has reached the age of 591/2
      • has become disabled
      • is using the money for a first-time home purchase
      • has died

One final note regarding withdrawals from a ROTH IRA is in order.  If the ROTH IRA owner dies and the spouse is the beneficiary, the spouse has the right to roll the money into his or her own ROTH IRA or postpone taking payments based on projected life expectancy until the owner would have been 701/2.

The ROTH IRA has the same contribution limits as the traditional IRA discussed in Part 2, including the availability of the “catch-up contributions” if the person is over the age of 50.

Because the ROTH IRA empowers us to accumulate money in a tax-sheltered environment and permits tax-free withdrawals in retirement, this may well be one of the very best retirement planning options available to U.S. taxpayers today.  If you haven’t looked into this great plan, you might want to do so today!

NEXT UP … 401(k)’s

Planning For Retirement – Part 2 … Individual Retirement Accounts (IRA’s)

Basic Information

The creation of Individual Retirement Accounts was included in the Employment Retirement Income Security Act (ERISA) of 1974.  This law empowered individuals to create their own retirement program by contributing money (at that time, the maximum contribution was $1,500) into a special account that would grow on a tax-deferred basis; and, the contribution to this account would reduce the individual’s taxable income for the year in which it was made.  Tax-deferred growth was, and continues to be, one of the greatest advantages offered by an IRA.

Originally, these plans were restricted; meaning, only those people who did not have any type of employer sponsored retirement plan could participate.  But, over the past 37 years, numerous changes have been made to the IRA.  Today’s IRA can be used by any individual; but, there are qualifications that determine how the plan can be used to reduce taxable income.  To see how the plan works, we’ll examine several different scenarios.

Janice works for an employer that provides no retirement plan of any sort to its employees.  Because Janice has no access to a qualified retirement plan, she can contribute up to $5,000 to her IRA and her full contribution can be deducted from her taxable income.  Thus, if Janice makes $40,000 this year and she contributes the maximum amount into her IRA, she will immediately reduce her taxable income to $35,000.

Todd has a qualified retirement plan available to him through his employer.  Because he is eligible to participate in this plan, Todd has some restrictions on tax deductibility of his IRA contributions.  If Todd’s modified adjusted gross income (MAGI) is less than $58,000, any contributions he makes into an IRA will be fully deductible.  If his MAGI is over $68,000, his contributions will not be deductible.  If MAGI is between these two amounts, his contributions will only be partially deductible.

Loren is 60 years old.  Because he is over 50 years of age, the law allows him to contribute up to an additional $1,000 to his IRA under what is referred to as the “catch-up” provision.  The deductibility of this additional contribution is subject to the same standards as both Janice and Todd.

The limits to modified adjusted gross income for married couples are higher; and, the availability of a qualified retirement plan to both or either person will impact the deductibility of the contributions.

The Advantage of Tax-Deferred Growth

Let’s assume that Josh invests $5,000 into his IRA every year, beginning at age 35.  After 30 years, Josh is age 65 and has made a total investment of $150,000.  We’ll also assume that he earns the same 8% return on his investments every year.  Finally, we’ll acknowledge that Josh is in the 25% marginal tax bracket.  Let’s see how his money would grow.

Total Contribution IRA Value Non-IRA Value
$150,000 611,729.34 $314,256.29

Now, let’s assume that, at age 65, Josh takes all of the money from his account in one lump sum.  How will taxes impact his retirement?

Total Contribution IRA Value Non-IRA Value
$150,000 611,729.34 $314,256.29
Taxes Owed on Withdrawn Amount $152,932.34 0
Total Spendable Funds $458,797.01 $314,256.29

Obviously, I think that we will agree that Josh is better off with the after-tax value of his IRA than he would have been had his account been subject to taxation for the entire 30 year period!  You can use a number of different financial calculators that are available on-line to see the advantages of tax deferral in your own specific circumstances.

Withdrawal of Money

As shown above, funds in an IRA are subject to federal income tax when withdrawn from the account at or after age 65.  But, if those funds are withdrawn before age 65, the proceeds are not only subject to income taxation, a 10% penalty will also be collected for a “pre-mature” withdrawal!  While there are some circumstances under which the 10% penalty will be waived, clearly, these accounts are intended to be left untouched until retirement.

Next up … ROTH-IRA’s