Retirement

Several times over the last month or two, I have had co-workers tell me one of two things regarding their retirement accounts:

• That they were thinking of moving all of their investments into the cash or money market fund.

Or, even worse,
• That they were thinking of stopping contributions all together.

In my opinion, both of these moves are bad, for multiple reasons. If you think the bottom hasn’t occurred yet, you are still trying to time the market or predict the future if you think it is going lower. You should really be considering long term asset allocation if you are making asset class changes, not trying to predict the future. And if you stopped contributing all together, you are likely missing out on an employer match and tax benefits. I would also guess the same person would miss the boat on when it felt OK to start contributing again.

The increase in the Dow Jones and S & P 500 over the last two days should teach us something. And I really don’t know if or when the stock market will bottom out, or if it already has. It really doesn’t matter. It has risen about 3% or so in two days. If you moved all of your money into cash, when you do get back in, it will most likely take you longer than two days to make 3%.

In order to achieve the average stock market results, or historical returns, you have to be in the stock market the whole time over that time period in question. You cannot move your money in and out and expect to achieve an average result over any period of time. Most people are satisfied with the average stock market returns over a 20+ time period.
You have to be in to win.

The Roth IRA gets talked about quite frequently these days, as a great tool for reaching your retirement goals and building wealth. While many people are well-versed and may be experts on the Roth, for those of us just beginning our saving and investing journey, I thought it would be a good idea to touch on the basics and a few details of the Roth IRA.

What is a Roth IRA and how does it work ?

A Roth IRA (individual retirement account) is a retirement savings account which allows a person to save money for retirement which can be withdrawn tax -free during retirement, after reaching a minimum age of 59 1/2. Investments are normally made in stocks, mutual funds, index funds, or bonds, although other vehicles can be used as well. Investments are made with after-tax contributions, and as stated above all of the principal and interest can be withdrawn tax-free upon reaching an age of 59 1/2.

Roth IRA vs. Traditional IRA

In a Roth IRA, contributions are made with after-tax money, while traditional IRA contributions are tax deductible. Contributions to a traditional IRA are made with pre-tax money, but the withdrawals during retirement are taxed (both principle and interest) at you ordinary income tax rate at that time. Therefore, a Roth IRA can benefit someone who anticipates being in a higher tax bracket at retirement age. However, because contributions are made after tax, a tax-deferred option such as the traditional IRA can allow someone with a lower income the opportunity to put money away with a lower decrease in their take home income. There are no rule on the age of required minimum distributions of a Roth IRA, which is currently 70 1/2 for a traditional IRA and a 401k. (This means in a traditional IRA or a 401k, you are required to start taking out money when you reach age 70 1/2.) There are certain situations when money earned (in the form of interest) can be withdrawn as well, while the traditional IRA is far more restrictive on withdrawals. As long as the Roth has been open five years, earnings can be withdrawn if the participant becomes disabled. Contributions can be withdrawn from a Roth IRA at any time, since they have already been taxed. In some cases, up to $10,000 in earnings can also be withdrawn to acquire a principal residence.

Roth IRA Income Eligibility Rules

Income Limits for 2008

Single - Up to $101,000 (modified adjusted gross income)

Married filing jointly- Up to $159,000 for full contribution, partial between $159k and $169k

Roth IRA Contribution Limits-2008

For 2008, the maximum contribution to a Roth IRA is $5000 for those age 49 and below, and $6000 for those 50 and above. This limit is slated to increase $500 per year starting in 2009 to account for the effects of inflation. The $5000(or $6000) limit applies to all IRA contributions, so that is the max. that can be contributed to either a traditional IRA or a Roth IRA.

Roth IRA Conversion

If you have saved money in a traditional IRA, and wish to now pay tax on that money and convert it to a Roth IRA, you are able to do so if you meet the income limitation. A conversion is good for someone who has an existing traditional IRA, and has the money available to pay taxes on it now in order to eliminate future tax liability. This is especially attractive if the person anticipates being in a higher tax bracket in the future. However, only taxpayers with a modified AGI of $100,000 or less are currently eligible to convert a traditional IRA to a Roth IRA. This limitation is slated to be removed starting in 2010, so already many people are planning to do a conversion then. The tax liability will be able to be spread over 2 years (2011 and 2012), as well, which is an added bonus for many.

One of keys of achieving a comfortable retirement is starting your retirement saving as early as possible. As a new graduate, you may make more money in the next year than you have in your entire life thus far. When you think about it, it can be quite exhilarating. But…., before you make grand plans for your increased income, even if they are practical things you may want or need like a new car or saving for a down payment for a house, think about your future and retirement plans for a few minutes.

How long do you want to work?
Do you want to retire early?
How much will I need for retirement?
Do you plan on getting married and maybe having children?

Whatever the answers may be to the above questions may be, NOW is the best time to start saving for your retirement goal. The power on time and compound interest are on your side, so the longer you wait the more difficult it will be to achieve your retirement goals.

How do I Start Saving for Retirement Now?

Fortunately for you and the rest of us, there are two great options available that stand out above any normal saving or investing you could use to save for retirement, the 401k and the Roth IRA, and they each have advantages.

Investing in an employer sponsored 401k plan:

A 401k is a tax-deferred retirement plan in which you make tax free contributions now, and pay tax on your withdrawals during retirement. Most employers offer a 401k plan, and the majority, but not all, offer some kind of match. This match is free money. Some will offer a 100% match up to a certain percentage, while some will offer a 50% match for each dollar you put in, up to a certain percentage. The contributions you make to your 401k plan will come out of your paycheck tax-free, meaning you do not pay tax on this now. By not paying tax on your contributions, the actual decrease in your paycheck is less than the amount you are putting into your 401k. For example, if you are in the 15% tax bracket, to put $100 per paycheck into your 401k will only decrease your take home pay by $85.00. This should allow you to put a little more than you might otherwise be able to, and you should. At a minimum, you should enroll in your employer sponsored 401k and invest the amount required to get the full match from your employer. Most employers will let you participate from the beginning, although some make you wait a certain period of time. As soon as you are eligible, start contributing to your 401k at your new job.

Opening and investing in a Roth IRA-

A Roth IRA is a self-directed retirement fund you set up and contribute to yourself. A Roth IRA is funded with after tax contributions, but your withdrawals during retirement, both principle (your contributions) and interest, will be tax-free. If your employer does not offer a 401k or does not offer any kind of employer match, a Roth IRA is a great place to begin your retirement savings. You should also consider opening a Roth IRA for any amount you are able to contribute from your salary above the amount required to get the employer match for your 401k plan. Because you will likely be in a lower tax bracket now than later on in your career, investing in a Roth with after tax income will not have as big an effect now on your take home pay as it may in the future.

Why both?

Investing in both a 401k and a Roth IRA allows you to diversify the tax treatment of your future retirement income. Money from your 401k will be taxable when you withdraw it, while money withdrawn from a Roth IRA will be tax free. By focusing on your retirement and starting now, you can set the foundation for the retirement you want in the future.

I recently was faced with a decision that I believe many people have faced while trying to get out of debt. In an effort to pay off debt as quickly as possible, one would obviously like to direct as much money as possible towards debt repayments. Cutting back on luxuries or items you consider frivolous to start your debt snowball is not necessarily that difficult a decision to make, but you have to be determined to cut back in those areas. However, one category where the decision can be difficult and not really clear-cut is whether one should stop making contributions to your retirement plan, either a 401k, 403b, or other retirement savings vehicle in order to free up more money for debt repayment. I think there are several factors which can come into play when deciding which option is right for you.

• Age- I am in my mid-thirties, and while I have a strong desire to become debt free as soon as possible, my retirement age is getting closer and closer. By stopping my contributions, I am basically delaying my retirement. On the other hand, the younger you are, the longer you can contribute to your retirement savings, so stopping for a short period of time to pay off high interest debt may not hurt you too bad.
• Whether your employer offers matching contributions- If your employer offers matching contributions and you stop contributing to your 401k, you are leaving free money on the table. Many employers match the first few percent of your salary that you contribute, or match 50% of your contributions up to a certain percent, which is what mine does.
• How much debt you have and when you expect to pay it off-I looked at the time-line I have set up for paying off my debt, and I hope to have it paid off by the end of the year, even with contributing to my 401k. However, I could shave several months off this time frame if I stopped my 401k contributions. If the time frame were longer, I might consider stopping my contributions to shorten that period of time.

For me, after I though about it for a while, I decided it did not make financial sense to stop my 401k contributions completely, nor would I feel very comfortable doing so. I would be missing out on my employer match, which is 50% for the first 5% I put in. None of my CC debt has a higher interest rate than 50% , so what I am doing now is to put in the amount up to my employer match. If my employer did not make matching contributions, I would have to think really hard about whether or not I would stop making contributions, and I have a feeling I might do so. But the automatic 50% return is too good for me to pass up.

One thing this dilemma has inspired me to do is to try to pay off my credit card debt as fast as possible, and focus on earning more and spending less in order to speed up the process. What are your thoughts on this issue?