CHAPTER
21

401(k)s and IRAs

In This Chapter

• Planning for your retirement, now
• Why it’s better to start saving early
• The importance of funding your 401(k)
• Building retirement savings in IRAs

At your age, retirement probably seems like a concept for consideration in the distant future—certainly not today. However, although you are decades away from retirement, it’s a topic that should be at the forefront of your financial planning. Most financial experts agree you need to have more than $1 million saved to ensure a comfortable retirement.

The average yearly expenses for a person between the ages of 65 and 74 were around $46,000 a year in 2013, according to the Bureau of Labor Statistics. Those costs will no doubt be significantly higher in 30 or 40 years when you are ready to retire. And it may be that you’re not starting to save as early as you would have been able to do otherwise because of high amounts of student loans and other debt that needs to be repaid.

Fortunately, systems are in place that enable you to start saving for your retirement early, and they don’t require you to contribute huge amounts of money—although you certainly should save as much possible. As with any savings, even a little bit of money is better than nothing.

In this chapter, we look at two popular retirement savings vehicles, 401(k)s and individual retirement accounts (IRAs), both of which offer tax advantages when left in place until you reach the age when you’re eligible to withdraw funds.

Why Every Year Counts

It used to be that most people who worked had pensions provided by their employers. Between their pension checks and Social Security payments, retirees had enough money to live comfortably.

Times have changed though, and pensions are a thing of the past for the most part. In addition, the Social Security system may be targeted for restructuring, and there are questions about the certainty of its future. With the average length of retirement at 18 years according to the U.S. Census Bureau, anyone who wants to ensure a comfortable future should be saving now.

Studies show most people will require about three fourths as much money to maintain their standard of living during retirement as they required before retiring. Of course, all kinds of factors go into that estimate, which is, remember, an average, and with the increase in prescription drug costs and Medicare supplement insurance premiums increasing at a rate much greater than inflation, this number may increase in the years ahead. At this point, there is no way to know what your retirement years will bring. You can’t predict what your health will be like in 40 years or what other circumstances will be affecting your life.

Remember these two important facts about saving for retirement:

• The earlier you start, the easier it is to accumulate the money you’ll need.
• Little savings can add up over the years to make big savings.

If you find it hard to believe that a couple years makes a big difference in what you’ll be able to save, let’s look at an example: if you invest $5,000 when you’re 25 at an annual rate of return of 6 percent and let it sit until you’re 60, you’ll have $38,430. But if you wait until you’re 35 to invest $5,000 at the same rate of return, you’ll have only $21,459 when you turn 60. If you wait until you’re 45 to invest the money, you’ll have only $11,983.

It makes more sense, and in the long run is much easier on your wallet, to start saving money as early as possible. Retirement seems eons away when you first start working, but the years pass by quickly, and you’ll have other financial commitments along the way.

401(k) Plans

Although they’ve only been around since the 1980s, 401(k) plans—or 403(b) plans, if your employer is a nonprofit organization—have become one of the most widely used and popular vehicles for retirement savings. 401(k)s offer tax advantages because your savings aren’t taxed until you withdraw them. As of 2016, you can contribute up to $18,000 a year into a 401(k) account, and your employer can match some or all of your savings.

Participation in 401(k)s

The Great Recession affected nearly everything financial, including 401(k) plans. Participation in 401(k)s dropped off during the recession, when jobs were hard to get and any type of investment seemed uncertain. Many employers who had been matching their employees’ 401(k) contributions stopped that practice as well.

A turnaround got underway in 2014, however, according to a 2015 Bank of America Merrill Lynch analysis of 2.5 million people participating in retirement plans the company administers. The data showed that 64 percent more employees between the ages of 18 and 34 began contributing to 401(k)s in 2014 compared to the same age group the previous year. Matching contributions by employers was on the upswing, too. With that increase in participation, overall participation in 401(k)s among American workers with access to plans stands at nearly 80 percent.

The increase is attributed to a more robust job market and belief that the economy is stronger. Younger workers also have responded favorably to automatic enrollment plans with automatic contribution increase features. That’s good news. Younger employees have the most opportunity to benefit from participation in retirement plans because they have more time for their investments to grow before they need them.

To encourage participation among employees, the Pension Protection Act of 2006 made it possible for employers to automatically enroll new employees in their 401(k) plans. Your company can attempt to enroll you as often as once a year, requiring you to opt out if you don’t want to invest.

Companies that offer the automatic opt-in choose a default investment fund and savings rate. Unless you opt out, you will have a set percentage of your pay invested. However, you are free to change funds and rates of deferrals. Your company can automatically increase the amount of your default contribution every year to encourage more savings, which is good because it increases your investment.

Taking Advantage of an Employer Match

In addition to providing flexibility, 401(k)s sometimes also offer a great savings incentive by way of an employer match. The amount of the match varies greatly from company to company. If you’re really lucky, your employer will match your contribution dollar for dollar up to a certain percentage of your paycheck. The most typical match is for every dollar an employee contributes up to 6 percent, the employer throws in 50 percent. By taking advantage of the match, you get an automatic 50 percent return on your money.

Companies trying to attract new hires in competitive marketplaces may offer matches or partial matches to contributions up to 10 percent or even higher. Not taking advantage of those opportunities while they’re available can have a real negative effect on your retirement.

Some firms, but fewer than ever, match an employee’s contributions with company stock. Company stock can be a good thing, but it isn’t always a good thing.

If you’re with a company that’s matching your 401(k) contributions with company stock, be sure to keep a close eye on the value of your account.

Investing in Your 401(k)

What happens to your money after it goes into the 401(k)? You get to decide where it should be invested by choosing from a list of investment options provided through your employer plan. If your employer has the 401(k) account in various mutual funds or a family of funds (which provide a variety of fund choices within the same company), you could divide your money between stocks and bonds with perhaps some fixed-interest rate investments or money market funds thrown in for good measure.

Understandably, selecting investments can be a daunting proposition for someone who knows next to nothing about investments. But experts say the process of choosing these options has served as a crash course for a lot of young people who otherwise would know nothing about investing money. They say selecting investments is not that complicated if you keep it simple.

Employers are prohibited by the Department of Labor from offering investment advice regarding their employees’ 401(k)s and can be held liable if they do. Financial advisers, however, have come up with some guidelines to direct employees in investing their 401(k) plans. Your employers’ 401(k) should have a financial adviser you can talk with about your allocation.

Most advisers suggest investors in their 20s and 30s put at least 60 percent of their money in a large U.S. company stock fund such as the T. Rowe Price Capital Appreciation Fund. The rest, they say, could be divided among international stocks, small company stocks, and bonds. Your company should provide meetings about the various investment choices and how they pertain to you. If it doesn’t, ask to have the service provided because it’s required by law. You must understand your choices; your future depends on it.

Keep in mind that your 401(k) money is a long-term investment, and you shouldn’t plan to use it until your retirement. This makes it conducive to equities—what most people consider the stock market—where you have to accept that your money is in for the long haul and be willing to ride out the market’s ups and downs.

It is imperative, however, to increase your contribution level as you get raises. Remember, you can contribute up to $18,000 a year, so be sure to increase your contribution as much as you’re able to as your salary increases. It’s easy to save what you never see, and the salary increases are new money to you, so put some or all of it away for your retirement instead of making bigger contributions to Uncle Sam. If you keep increasing your contribution level by 1 or 2 percent a year, over time, you’ll have a lot more money put aside for your retirement than you ever imagined possible, without much pain at all.

Another easy way to build up your 401(k) is to contribute all or part of a bonus into it—your account gets a nice contribution, even when your paycheck doesn’t change. This is a great way to supplement your annual contribution level.

The idea of contributing 5, 10, or 15 percent of your salary is daunting, but gradually increasing your contribution levels makes your account balance grow a step at a time.

Tax Advantages of 401(k) Plans

Historically, a great advantage of 401(k) plans is that the money you put into them is both pretax money and tax-deferred money. That means you win twice. Your 401(k) contributions are taken out of your salary before your salary is taxed for federal income taxes. The contributions are still subject to Social Security taxes, and some states subject the contributions to state and local income taxes. Still, not having to pay federal income tax on the money you contribute is a great benefit.

The money you contribute also is tax-deferred, which means you don’t pay any tax on it, or the money it earns for you, until you withdraw it, either prematurely or during retirement. An individual in the 25 percent tax bracket pays 25¢ less tax on every $1 invested in a 401(k). Here’s another way of looking at it: if you’re in the 25 percent tax bracket and invest $100 per month in your 401(k), your federal tax liability is $300 less per year than if you didn’t invest in the 401(k).

Employers now are able to offer Roth 401(k)s. The money you invest in a Roth 401(k) is post-tax, with only the employer contributions and the earnings tax-deferred. This can be a good investment for people in their 20s and 30s who generally fall into lower tax brackets. By investing in a Roth 401(k), your contributions go in post-tax, but when it’s held for at least 5 years and not touched until you reach age 59½, the earnings can be withdrawn tax free.

If you believe you could end up being in a higher tax bracket after retirement, paying taxes on the contribution now and withdrawing in a higher bracket later leads to a net savings on the amount in the Roth 401(k).

Managing Your 401(k) When Changing Jobs

It’s likely you’ll have numerous employers during your years of working. And every time you change employers, you’ll need to address your 401(k) plan.

Basically, you have four options when changing jobs:

• Roll over the account to your new company’s plan.
• Leave the account where it is.
• Cash out the account.
• Roll over the account to an IRA.

If you transfer your 401(k) account to the plan your new company offers, your savings are held in the same place and can continue to grow. There are no tax implications or early withdrawal penalties, and the money keeps growing for your future. Just be sure your new employer’s plan allows for a rollover; some do not.

You also can leave your 401(k) plan in place with your old employer, if that’s permitted, and if it’s cash neutral, which means there would not be a transaction that would require net cash. Some plans allow you to maintain the account without changes indefinitely, while others require that you transfer your assets within a particular time period. There probably will be a cost to you when you transfer.

Cashing out your 401(k) account generally is not a good idea, as the whole point of it is to preserve funds for your retirement. If you’re under the age of 59½, you’ll probably get slammed with a 10 percent early withdrawal penalty, plus you’ll have to pay taxes on the distribution. Unless there’s a compelling reason to liquidate the account, it’s always better to keep the money in a retirement account.

Another option is to roll over your money into a traditional individual retirement account (IRA). (You read about IRAs later in this chapter.) Once your money is safely within an IRA, you can choose different investment options with the account or convert the account to a Roth IRA.

Be sure to consider all these options carefully and think about which makes the most sense for you. The whole point is to enable your money to grow so it’s available when you need it.

Understanding Vesting

Vesting is the length of time you’re required to work for a company before you’re entitled to the funds your employer has put into your retirement account on your behalf. There are two types of vesting:

• Cliff vesting
• Graduated vesting

Cliff vesting (usually 5 years) means you must work for your employer for 5 years before you’re entitled to the matching funds placed in your 401(k). If you change jobs after only 2 years and your company has 5-year cliff vesting, you’ll only have your own contributions available to move elsewhere. This portability is what makes 401(k)s so popular. If you leave this employer after 5 years, you receive the employer’s match as well as your own contributions.

With graduated vesting, you’re partially vested after 2 years, but you must stay with your employer for 6 years before you’re 100 percent vested. The following table outlines the schedule.

Years Employed	Percent Vested
After 2	20
After 3	40
After 4	60
After 5	80
After 6	100

When you change jobs, whether you’re vested or not, you have your contribution to your 401(k). You can withdraw these funds (but don’t forget income tax liability and penalty), roll them over into an IRA, or even possibly roll them over into your new employer’s 401(k) plan.

If your new employer has a 401(k) plan, see if you can transfer directly from your former employer’s 401(k) plan to your current employer. If you can’t, roll the funds into a separate IRA and then roll them into your new 401(k) later, if permitted.

Getting Money Early from Your 401(k)

Unfortunately, sometimes it’s absolutely necessary to get money from your 401(k) account before you are of the eligible age of 59½. In certain situations, you may withdraw from your 401(k) for hardship, but you must demonstrate real need to your employer to be able to do so. In some cases, your employer will let you borrow against your 401(k) plan and deduct the repayment from your paycheck. The money you repay goes right back into your account, and you pay yourself, not a bank, with the principal and interest.

If you withdraw your 401(k) money before the eligible age, expect some stiff financial consequences. You’ll pay a 10 percent penalty, and the money is taxable, which can be a significant blow at tax time. The IRS directs that people who withdraw funds from their 401(k) plans have 20 percent withheld from the money to be used for tax payment. The problem is, that amount usually isn’t enough money to pay for both the penalty and the taxes owed on the withdrawal.

For example, if you withdrew $5,000 from your 401(k) plan and had the standard 20 percent withheld ($1,000), you would receive $4,000. But if you were a taxpayer in the 24 percent bracket, you’d owe $1,200 in taxes, plus $500 for the penalty, for a total of $1,700. The 20 percent taken out wouldn’t cover those costs, and you’d be $700 short on April 15. Not a nice surprise!

Still, the 401(k) is your money, and you can get it if you have a real need—and if you’re willing to pay the penalties.

Individual Retirement Accounts (IRAs)

As of the beginning of 2016, anybody who earns any money working can contribute up to $5,500 a year in an individual retirement account (IRA).

An IRA is a tax-deferred type of retirement savings plan, meaning you don’t pay taxes until you withdraw money from the fund. Of course, this money can only be contributed if you work. If you make $5,500 a year mowing lawns and shoveling snow but never report a penny of it, those earnings don’t make you eligible to contribute to an IRA. (They could, however, get you in trouble with the IRS!)

IRAs used to be the hotshot investment vehicles. Things changed, though, when lawmakers dumped all kinds of restrictions on them in 1986. Back in the good old days, anybody could deduct his or her IRA contributions. Now the money you contribute might be tax-deductible, but it might not be.

Contributing to an IRA

Currently, if you earn less than $5,500 a year, the maximum amount you can contribute is the amount you’ve earned. If you earn $1,650 scooping ice cream at Ben & Jerry’s, for example, that’s the amount you can stash in an IRA. If you have no income but do receive alimony, you’re eligible to contribute to an IRA. And as of 2016, if you’re married but not working, your spouse can contribute up to $5,500 a year for you, or $11,000 total for the family.

Let’s look at how it breaks down. If you’re single and do not have an employer-sponsored retirement plan, you can put up to $5,500 a year in an IRA. The full contribution is a dollar-for-dollar deduction from your taxable income on your income tax return.

The incremental increases as of 2016 and beyond are as follows:

• Under age 50: $5,500
• Over age 50: $6,500

After 2016, the limit may increase in increments of $500 annually to keep pace with inflation.

If you’re single, covered by an employer-sponsored plan, and your annual adjusted gross income is $61,000 or less in 2016, you can contribute up to $5,500 to your IRA and deduct the full amount. If your income is between $61,001 ($98,001 for joint filers) and $70,999 ($117,999 for joint filers), the deduction is prorated. If you make more than $71,000 a year, you can contribute, but you get no deduction.

If you’re married and file jointly, have an employer-sponsored plan, and your annual adjusted gross income is $98,000 or less, you can deduct the full amount. The figure is prorated from $98,000 to $118,000. After $118,000, you can’t take any deduction.

For workers over age 50, there’s a “catch-up” provision for those contributing to an IRA. In 2016, workers who are over age 50 can contribute an extra $1,000 (for a total of $6,500) to an IRA.

If your spouse doesn’t have a retirement plan at work and you file a joint tax return, your spouse can deduct his or her full $5,500 contribution until your joint income reaches $184,000. After that, the deduction is prorated until your joint income is $194,000, at which time you can’t deduct the IRA contribution.

Even if you can’t deduct the contributions, they still help out with taxes because the income earned within the IRA is tax-deferred. It’s not as great as tax-deductible, but it’s the next best thing. IRAs are good savings vehicles, but if your IRA contributions aren’t deductible, be sure you take advantage of the programs on which you can get a tax deduction, such as 401(k)s, first.

Roth IRAs

The Roth IRA, a variation on the basic IRA, has been popular since it was introduced in 1998. The Roth IRA is different from the traditional one in several ways, and many financial experts agree it is better than the traditional IRA for people with the right circumstances, especially for those in their 20s and 30s.

Your contribution to a Roth IRA is made with after-tax money, as opposed to pretax money you invest in a traditional IRA. This means you don’t have to pay tax on the income and appreciation on a Roth IRA. If you have at least 20 years in which to let the funds grow, a Roth IRA probably is the best choice.

When you contribute to a regular, deductible IRA, you put in an amount, let’s say $5,500, before you pay tax on that money. When you take your contributions and your earnings out at retirement, you have to pay taxes on that money. With a Roth IRA, your $5,500 contribution comes out of income you’ve already paid taxes on (that is, earnings), and the contributed funds grow tax-free. If the funds are held for at least 5 years and you’re at least 59½ when you claim them, you never pay tax on the money withdrawn.

Yep, that’s right. If you follow the rules and hold the funds within the Roth for 5 years, you never have to pay tax on the account again. That means you get all the earnings on that $5,500 completely tax-free, which is a very appealing feature of the Roth. Contributions to a Roth IRA, however, are not tax-deductible.

You can get your Roth money without penalty any time after you reach 59½ years of age, but you’re not required to take it out when you reach 70½, as you are with traditional IRAs. You can just let that money sit there if you want to, continuing to grow, tax-free. You can even leave the money and all the earnings there to pass on, tax-free, to your heirs.

There are income limits to Roths, though. If your income is more than $132,000 and you’re single, you can’t get a Roth IRA. If you and your spouse have a combined income of more than $193,000, you’re not eligible for a Roth IRA.

SEP-IRAs

If you are self-employed, you should consider a SEP-IRA, or a Simplified Employee Pension IRA. SEP-IRAs are not very complicated and are a great deal for a person who is self-employed or owns a business with only a few employees.

SEP-IRAs allow people who are self-employed or are owners of small companies to add more funds to a retirement account than they can with a traditional IRA. As with other types of IRAs, the interest you make in a SEP-IRA is not taxed until you take out the money.

If you work for yourself, you can contribute up to about 13.04 percent of your income, or up to $53,000, into a SEP-IRA every year. The money you contribute is deducted from your taxable income, so your contribution can save you a lot on federal and maybe also state taxes, depending on where you live. You can open and contribute to a SEP-IRA up until the day of your tax-filing deadline.

SEP-IRAs are advantageous for people who need to save on their own. They might sound intimidating, but you can have a SEP-IRA anywhere you could have a regular IRA. It just requires a little additional paperwork. Ask your tax preparer or financial consultant about changing your IRA to a SEP-IRA.

The disadvantage of a SEP-IRA for a small business owner is that you are required to contribute the same percentage of income you contribute for yourself for each of your employees, which can be a daunting proposition.

Timing Your IRA Contributions

Most people start thinking about funding their IRAs when they meet with their accountants in April. Funding an IRA at that time of year is better than never, but you should know that the earlier you stash some money in your IRA, the better.

If you fund an IRA in January or February, the funds begin to work, tax-deferred, with gains starting immediately and accumulating for the entire year. You get 12, maybe 15 months of deferral by funding your IRA in January, rather than waiting until it’s time to file your tax return in April.

If it’s not financially feasible to fund your IRA all at once, you might consider contributing some money each month, beginning in January. To fund your IRA to the allowable limit, you’d make monthly payments of $458. If you break it down ever further, you’d pay $105.76 a week. Smaller, more frequent payments often are easier than making a large payment all at once.

The Least You Need to Know

• It’s important to start saving for retirement early because it gives your money more time to grow.
• Contributing funds to an employer-sponsored 401(k) plan is a convenient and popular means of building up a retirement fund.
• If your employer matches your contributions up to a certain percentage, it’s important that you try to contribute at least as much as the employer matches.
• When shopping for an IRA, compare information about different types of plans available before choosing the one for you.
• Consider spreading out contributions to your IRA over the year to avoid having to come up with one large lump sum.