Funding Your Retirement

It's never too late -- or too soon -- to start planning. Here, we explain the options.


Retirement conjures many pleasing visions: moving to a warm climate, spending time with grandchildren, reading all those books you never had time for during your working life. But your so-called golden years can also breed anxiety. Who's going to pay for it all?

"If you don't put away for your retirement, it's unlikely anyone else will," says Ed Slott, a certified public accountant in Rockville Centre, N.Y. and publisher of the Ed Slott's IRA Advisor newsletter. "There are so few real pension plans left -- so you're on your own."

An intimidating thought. Social Security isn't likely to cover all of your expenses in retirement, and few of us are independently wealthy. That means you have to save to support yourself.

You've probably heard about the virtues of 401(k) plans and IRAs before, but they're getting better every year. Not only can you enjoy tax-deferred growth, but these days, you can set aside more than ever before.

How 401(k)s Work

The 401(k), named for the IRS tax code that created it, is a savings plan offered by employers. There are variations on the 401(k), such as 403(b) plans (offered by employers in the health care and education fields) and 457 plans (offered to government workers), but they all work basically the same way. (401(k)s are the most common, so that's what we'll discuss here.)

"It's a tremendous vehicle and I would say that just about everybody should put as much as they can in their 401(k)," says Bryan Lee, a certified financial planner and President of Strategic Financial Planning in Plano, Texas.

The first benefit of a 401(k) plan is that you can save a portion of your income pre-tax. That means if you earn $50,000 and you save $10,000 in a 401(k), you're only taxed on earnings of $40,000. That could put you in a lower tax bracket.

Next, your account grows tax-deferred. That means the earnings aren't taxed until you withdraw money from the plan, presumably after you reach age 59 1/2. (The savings are supposed to be earmarked for retirement, so early withdrawals before age 59 1/2 mean you'll owe taxes and face a 10 percent penalty.) We keep saying age 59 1/2 -- there is an exception. If you're age 55 or older, you can be eligible for a so-called "separation of service" exemption. This means at age 55 if you're leaving your job you'd be able to start withdrawals from your 401(k) without penalty.

If you're not the most diligent saver and you tend to spend whatever money comes into your pocket, 401(k)s can put you on the right track. Because your contributions are taken directly out of your paycheck, you won't have a chance to spend the money first.

If you work for a generous employer, you may even get some free money in the form of an employer match. For example, as an incentive to save, your employer may offer to add $1 for every $2 you save, up to a certain percentage of your salary.

"The match is like free money," says Rick Fingerman, a certified financial planner with Financial Planning Solutions in Waltham, Mass. "Even if your investments don't earn any interest but they're giving you a match, that's money that you didn't have before."

But if your boss doesn't match contributions, 401(k)s are still a great bet because of the tax benefits, planners agree.

"Even if there is no match, you can't beat the tax-deferred savings," Fingerman says.

There are contribution limits to 401(k)s. In 2002, you can save $11,000 a year (not counting employer matches) into your plan, and the contribution limit will rise each year until it reaches $15,000 in 2006. (See chart on page 4.)

Should everyone contribute to their 401(k) or other employer-sponsored retirement plan? Probably, say financial planners. One reason not to invest is if the plan only offers very limited investment choices, such as company stock. That's because planners generally recommend you have no more than 10 percent of your entire portfolio in one stock. If you're only able to buy company stock in your 401(k), you'll probably be overweighted in that stock pretty quickly. You also have to remember that 401(k) savings are for the long-term, and you can't access them until age 59 1/2 without paying taxes on the earnings and a 10 percent penalty.

"This is money that needs to be for retirement," says Lee. "If someone is sitting there with $20,000 in credit card debt at 18 percent interest or they can't make their mortgage payment, they should without a doubt pay off debt first."

How IRAs Work

IRAs, short for Individual Retirement Accounts, share some qualities of the 401(k).

They're basically a retirement plan, but instead of selecting investment choices as offered by your employer, you can invest in any mutual fund, stock, bond or combination of investments that you want. You have to remember to send in a check to the investment company -- contributions can't be taken out of your paycheck. Today, there are two different kinds of IRAs -- the traditional IRA and the Roth IRA.

With a traditional IRA, you can set aside a certain amount each year (amounts change over time), and that contribution can be deducted from your adjusted gross income when tax time rolls around, as long as you meet certain income requirements. 

Like a 401(k), the funds in an IRA grow tax-deferred until you take them out at age 59 1/2 (otherwise you'll face taxes on the earnings and a 10 percent penalty for early withdrawal). When you do take out the money after age 59 1/2, you'll owe income taxes on the earnings.

That's where the Roth IRA parts from its older cousin. If you choose a Roth (named for Senator William Roth from Delaware, who spearheaded the legislation that created it in 1998), you can also save $3,000 a year in 2002 and the money grows tax-deferred. You can't take a tax deduction, though, because the Roth offers a bigger benefit -- you can withdraw the funds tax-free when you reach retirement age.

"You pay income tax now but it's like paying tax on the seed and the crop grows for free," says Slott. "The Roth IRA is so powerful because the money you take out is tax-free."

To show the big difference between the Roth and a traditional IRA, Slott gives the following example: Two 35-year-olds invest $3,000 a year -- one uses a traditional IRA and the other uses a Roth. They'll both have $367,038 over 30 years if the account earns an average of 8 percent. The person who invests in the traditional IRA will have to pay taxes when the funds are withdrawn, and after taxes, the account would only be worth $244,067 in the 27 percent tax bracket. The person who invested in a Roth will be able to keep the entire $367,038, tax-free. Of course, the person who saved in the traditional IRA was able to deduct contributions from their taxes each year, but planners agree those savings are small compared to the enormous tax-free growth of a Roth. The Roth also has income limits. To contribute to a Roth, singles have to earn less than $95,000 a year and married couples have to earn less than $150,000 a year.

So which type of IRA is best for you? That depends, of course.

"For a young person in their 20s, the benefit of getting the deduction from the traditional IRA is not going to touch the tax-free benefit of the Roth," says Lee. "If you qualify for the full deduction, then you have to look at how old you are. For someone who is younger, the Roth is a better choice in most cases."

Start Saving Now

You don't have to choose between 401(k)s and IRAs -- you can invest in both. Whichever savings vehicle you choose, the sooner you start, the better. Slott gives this example of the value of long-term investing:

Say someone at age 25 starts saving $3,000 a year in a Roth IRA. If the account earns 8 percent interest over 40 years, the account would be worth $839,343 at age 65. A 35-year-old would have $367,038 at 8 percent over 30 years until age 65, and a 45-year-old would have $148,269 in 20 years at age 65.

"The key is that you got the compounding on those extra years," Slott says. "Compounding is the eighth wonder of the world."


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