Investing in your future!
It is impossible to save money for every potential situation or goal. So after your emergency fund is established in savings, your next priority needs to be investing for retirement. Only after you are able to stash away 20% of your annual salary for retirement should you start thinking about other goals such as funding your children’s higher education. One key thing to remember is that over a span of time, inflation is your greatest enemy in investing. So you want to put your money where it will see the most long-term return. For the purposes of this article, we will focus on investing for retirement, though the investment vehicles discussed can be used for a variety of goals.
Employer Sponsored Plans
The 411 on 401Ks
A 401K is a long term savings vehicle for retirement through your employer that allows you to take money out of your paycheck pre-tax. You can pick where your money goes from the funds selected by your employer’s plan. In 2011, each individual can defer up to $16,500 or their annual compensation whichever is less. If you 50 or over, you can make what are called “catch-up” contributions in the amount of $5500.
If your company matches contributions, they are generally after you contribute a certain percentage of your pay. If you cannot max out your 401K personal contributions at least contribute enough to get the employer match! Also, find out when you are 100% vested for your employer contributions meaning you will get 100% of that money should you leave the company.
Next you have to figure out how to divide your contributions among the funds available to you. This is otherwise known as asset allocation. Your 401K is made up of mutual funds (see below) of varying types. You can choose from bond funds, stock funds or a mixed fund. How you choose to allocate your contributions depends on how much risk you are comfortable with, how long until you will retire and what other investments you have. Make sure to diversify your fund selection because that will maximize your long term returns. As some funds go up, others will go down-so if you put all your money in a fund made up strictly of technology stocks and the value on those plummet, you’ll have to wait for them to recover to start earning money again.
Though many people do it, generally it is not a good idea to take a loan out on your 401K or an early withdrawal if you can at all avoid it. For those under 59 1/2, you will face penalties and taxes on the withdrawal.
Once you take a loan against your 401K the obvious problem is that you lose out on the compound interest you could be earning if that money was still in your account. In addition, many employers will not let you contribute to your 401K until the loan is paid back. If you leave your job for any reason and you have an outstanding loan against your 401K, that will be viewed as a withdrawal and you will be faced with taxes and penalties. However, the one exception to this right now may be if you have a high amount of high interest credit card debt. Because you are paying the money back to yourself, a 401K loan is a very affordable option. According to SmartMoney.com, an individual with a credit card balance of $5000 at 20% interest could save himself $800 in a year by borrowing against his 401K to pay that credit card debt off.
In some cases, you may be able to take a withdrawal under IRS law 72(t) with a fixed amount per year based on your life expectancy. Withdrawals must be for at least five years or until you are 59 1/2. You would not face the 10% penalty but would have to pay income taxes on the annual distribution. Depending on your age, this becomes less and less of an attractive option as for younger taxpayers, the amount you are able to withdraw is very small and you will pay taxes on that money until you reach 59 1/2.
If you leave your job, roll your 401K over to another 401K at your new employer or into an IRA. Whichever you do, make sure you ask for a “trustee to trustee” transfer. This avoids the problem with your employer cutting you a check that you then have to deposit into the new account within 60 days. The employer holds 20% back for taxes and you are forced to come up with the difference within 60 days or face a 10% penalty. You do get that 20% back when you file your income taxes the next time, however this can be a pretty large amount of money for the regular working American to come up with.
When you are ready to retire, a 401K plan offers you many ways to access your money. You can leave it alone (not always an option), take a lump-sum distribution, roll it over into an IRA, take periodic distributions or purchase an annuity (see below). Generally it is advised that you take from the taxable accounts first and leave the tax-deferred money alone. That will not work in all cases, especially if your 401K plan is less than desirable.
What is a Roth 401K?
A Roth 401K combines the benefits of a 401K with a Roth IRA (see section on IRAs) but like with a Roth IRA, contributions are made after tax. Anyone whose employer offers a Roth 401K plan, can contribute to one. Unlike a Roth IRA, there are no income limits to be able to contribute but like a 401K you can only contribute $16,500 annually or $22000 if you’re over 50. However, this is a combined amount with any regular 401K you may have so you cannot contribute $16500 annually to both. Employers may match contributions just like they do for a regular 401K and if they do, that money will be pre-tax and put in a separate account to grow until retirement where it will be taxed upon withdrawal.
If you think your tax rate in retirement will be higher than it is now, a Roth 401K may be for you. Withdrawals taken during retirement are not subject to tax as long as you’re at least 59 1/2 and you have had the account for five years or more. For younger workers, just starting out, they can most likely bank on being in a higher tax bracket come retirement. However, no one can predict what tax changes will come in five, ten or twenty years so this is a gamble.
403b and 457 Plans
A 403b is very similar to a 401K plan however is only offered in non-profit organizations. The same contribution limits apply as they do for 401K plans. There may be less choices in funds however one advantage to a 403b is that you are generally 100% vested from day one. A benefit of a 403b is you have the ability to rollover money to an IRA even while you are still contributing. However you need permission of the employer. This can present a potential issue if your employer goes out of business and you need to rollover to avoid getting hit with a penalty-you can’t do so without permission of your employer. This is a good reason to rollover as much as you can while still employed at your current job.
A 457 plan is again similar to a 401K but offered to state and local government employees and some non-profit employees as well. Again the money is tax deferred until you withdraw the funds but unlike a 401K there is no penalty for early withdrawals. You will however have to pay taxes on the money to withdraw. Another benefit of the 457 is that if your company offers a 401K or 403b in addition to the 457 plan, you may contribute $16,500 to both (or more if over the age of 50).
Thrift Savings Plans
Thrift Savings Plans (TSP) are like 401K plans for federal employees including armed service members. The money is taken right from your paycheck and grows tax-deferred like in a 401K. You may contribute the same at this time as you can in a 401K, $16,500 annually per individual and $5500 additional as a catchup, if at least 50.
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