Personal Finance Tip #3 - Retirement Accounts

With the increasing uncertainty of Social Security, it is necessary to start planning for retirement as soon as possible. It is important to become financially independent in your "golden years" even if you decide to continue working. Here is an excellent article concerning retirement written specifically for Seemingly Useless by a knowledgeable guest writer.

Perhaps you won’t get a raise anytime soon but that does not mean you cannot boost your take-home pay today! Most people do not realize that by thinking ahead into the future (i.e. retirement) they can actually increase their net worth by bundles today!

The key is to consider tax deferred vehicles such as Investment Retirement Accounts (IRAs) or defined contribution plans from your company, commonly known as 401k plans. By allocating a piece of your paycheck towards these vehicles today, you can lower the amount of money you pay to the IRS each year, which essentially is free money in your pocket!

How is this possible? One way to look at this is through a concrete example. Say you make $100 per week and you are required by federal and state tax laws to pay 50% in taxes. That means you get to take home $50 per paycheck and Uncle Sam takes $50. Yet, Uncle Sam did not work at all!

When you contribute to an IRA, you use before-tax money which means ultimately you pay less taxes to the IRS. So back to our example, say you decide you want to allocate 10% to an IRA account. That means $10 of your $100 paycheck will be transferred to an IRA and you pay 50% of the remaining money ($90) to the IRS. In other words, you pay 50% of $90 to the IRS (or $45) and you get to take home $45.

While your take home pay is lowered from $50 to $45, you also saved $5 in taxes to the government, which you will end up giving away had you not used your IRA. Thus, by simply thinking further ahead, you immediately accumulate free money year after year!

There are a few types of tax deferred vehicles that one should consider. We discuss the three most popular ones here: IRA, IRA Rollover, and 401k.

IRA - This is by far the most traditional of tax deferred vehicles. The idea is you make a contribution using pre-tax money and you won’t get taxed until you decide to withdraw funds at a later age. Most people utilize this vehicle because their tax bracket will be much lower by the time retirement happens so any tax payment then will not be as significant as it will be today. Another reason why people open IRAs is because they do not qualify for ROTH IRAs, which we will talk about later.

ROTH IRA - This is also a popular tax-deferred vehicle and is similar to an IRA with the exception that you use after-tax money to fund the account. Because you’ve already paid a tax on this contribution, you will not get taxed again at the time of withdrawal. If you expect to be in a higher tax bracket at a later age and you qualify in terms of income requirements, this is the right vehicle for you. If you invest $100 today and it grows to $5000 in 40 years, then you will save on a lot of taxes, especially if your tax bracket will be lower. The income limits are as follows: If you make more than $114,000 (or $166,000 as a joint couple), or if you are head of household or married filing separately and did not live with your spouse during the year, then you do not qualify for a ROTH IRA.

401k - Over the past decades, corporations started to provide more and more 401k plans instead of traditional pension plans for their employees. With a 401k plan, you make contributions with before-tax money and all gains are tax deferred until you make withdrawals upon retirement. One of the best things about 401k plans is that most employees will match your contributions up to a certain percent of your annual salary. Again, this is free money! By participating in a 401k plan, not only do you save from Uncle Sam, but you also collect extra money from your firm. Furthermore, you are saving for your retirement so the benefits are three-fold.

Here are a few more tidbits on IRAs/ 401ks that you should know:

1) You must make IRA contributions with earned income. (i.e. you cannot use dividends from stock investments to make your contributions).

2) You can contribute to both an IRA and 401k.

3) There are contribution limits for both IRAs, and 401ks. For IRAs, the limit is $4,000 for 2007 and $5,000 for 2008. For 401k plans, the limit is $15,000 for 2007 and $15,500 for 2008. You can also make “catch up” contributions if over the age of 50. Some companies may also have limits.

4) If you take money out of your IRA or 401k plan prior to retirement (age 59 ½), there could be penalties.

5) Within a 401k plan, your company will generally provide a list of mutual funds that you can invest in. When selecting these investments, make sure you understand all the fees you will pay. Also, it is somewhat risky to participate in employee stock plans, which is often a choice provided. Remember Bear Stearns? Well, many employees that invested in these company stock programs saw their money vanish because the company went out of business.

Final thoughts: While no one will hand you a stack of cash, there are indeed many ways to enhance your wealth. Be sure to familiarize yourself with these tax deferred vehicles and use them to your advantage today!!

If you have any questions or comments on IRAs/401ks or other retirement plans, please leave a comment or send an email to seeminglyuseless@gmail.com

Useful Websites:
Social Security Retirement Site