RETIREMENT ACCOUNTS

Overview

Although growing old isn’t on most people’s wish lists, they do dream of retirement and the freedom to do what they want every day. To reach that goal, you need to save and invest for retirement. There are a wide variety of retirement accounts that can help make that dream a reality.

There are retirement accounts for:

• Individuals
• Employees
• Businesses, even if it’s a one-person company

Generally, you may contribute to more than one type of retirement account if you meet the requirements.

A qualified retirement account receives favorable tax treatment. These tax breaks enable you to save for retirement without having taxes impede your progress.

When you’re saving on your own for retirement, individual retirement accounts (IRAs) are one of the most popular options. To make an IRA contribution, you must have earned income such as:

• Wages
• Salaries
• Tips
• Commissions
• Self-employment income

Types of Retirement Accounts

Traditional IRAs and Roth IRAs

It is important to distinguish between two types of IRAs, the traditional IRA and the Roth IRA. Here’s how they work:

• The traditional IRA gives you an immediate tax deduction and the ability to avoid paying taxes on the growth in your account until you withdraw the money someday. The IRA shelters your money, even after you retire. The earnings continue to compound and escape taxation until you’re ready to make withdrawals. Assuming you wait until age 59 1/2 to withdraw money or meet other conditions, you won’t pay the 10 percent penalty that applies to premature withdrawals.

• The Roth IRA came into existence years after the traditional IRA. Although the Roth IRA offers no immediate tax deduction, you may be entitled to make tax-free withdrawals someday if you follow the rules. That’s a nice option if your account grows over the years with additional deposits and earnings on your investment.

Your income determines whether you are eligible for a traditional or a Roth IRA.

401(k)s and other employer-sponsored retirement accounts

The days of traditional pensions are gone. The traditional pension, otherwise known as a defined benefit plan, offered employees a specified payment after the worker attained milestones based on years of service, salary and age.

Today, most workers are eligible to participate in defined contribution plans that specify what the employee may contribute to the company’s qualified retirement savings plan. There are no guarantees as to what workers will receive when they reach retirement age. Employees’ nest eggs are based on how much they contributed and how well their investments performed.

When you enter the workforce, here are a few of the plans that are typically offered:

• 401(k) retirement savings plan – The 401(k) is the most common retirement savings plan offered by companies. The plan permits employees to make contributions prior to taxes. The employer usually matches some or all of your contribution. For example, if you contribute $100 per month to a 401(k), your employer might add $50 to your account. All of the money in your 401(k) is shielded from taxes until you make withdrawals.
• 403(b) retirement savings plan – The 403(b) plan is similar to the 401(k), but is offered to public school employees and certain tax-exempt organizations.
• 457 plan – The 457 plan is available to employees in the public sector.

The names of these plans aren’t catchy. They take their names from the tax code section that authorizes them.

The employer’s contribution is not yours to keep until you are with the company for a specified period of time. At that point in time, you are vested as to the some or all of the employer’s contributions.

Some companies offer 401(k) plans where the employer’s contribution is vested sooner than required by these vesting schedules.

Tax Considerations

Qualified retirement savings plans grow more quickly, because of tax-deferred compounding. Just like compounded interest, your original investment grows in value as does the return on your investment. Even better, taxes don’t eat way at your nest egg which will hopefully become gigantic over the years.

Most tax-sheltered retirement accounts require that you reach the magic age of 59 ½ before taking out your money. Otherwise, you pay a premature distribution penalty, unless you meet certain conditions. This penalty might be 10 percent of the amount withdrawn, plus any taxes that are owed.

The beauty of tax-sheltered retirement savings accounts is that they give you an incentive to invest for retirement. You either get a tax break now or down the road. Since putting away more money in a 401(k) saves you taxes, your take-home pay won’t be too much lower, even though you’re contributing to a retirement savings plan.

There’s also a Retirement Savings Contributions Credit that gives you an additional tax incentive to contribute to an IRA or 401(k). If you qualify, you receive a tax credit of up to 50 percent of amounts contributed to an IRA or 401(k). A tax credit reduces your taxes more than a tax deduction. The credit can’t be used by full time students or someone who is claimed as a dependent on someone else’s return.

Withdrawal Rules

401(k) retirement savings plans and IRAs are long-term investments. They are not meant to be tapped when you’re short of cash. Taking money from your retirement accounts will cost you much more than just the amount withdrawn. You’ll also lose the earnings that might accrue over decades.

Aside from cashing out, here are ways to tap your 401(k) retirement plan at work:

• Borrow against your 401(k). Although you pay interest on the loan, you are actually paying it to your own account.

• Make a hardship withdrawal. A 401(k) may permit hardship withdrawals, but you’ll pay taxes on the money withdrawn and a 10 percent penalty if you’re younger than age 59 ½. A hardship withdrawal is not a loan. Hardship withdrawals are only permitted if you can prove an immediate financial need, such as college expenses, a mortgage, significant medical bills or to avoid eviction. Employers are required to verify your need for a hardship withdrawal and the amount withdrawn can’t be greater than your need.

You can also withdraw money from your IRA before age 59 ½ without a penalty if certain conditions are met such as:

• You’re making the withdrawal to pay for qualified higher education expenses.
• You’re using the money to buy your first home.
• You’re disabled.
• You need to pay certain medical expenses not covered by insurance.
• You’re unemployed and must pay certain health insurance premiums.

With Roth IRAs, you can always withdraw your contributions, not the earnings, without paying taxes or a penalty.

Tips & Common Mistakes

Common mistake: Cashing out your 41(k)

When you’re young, it’s easy to be short-sighted about your 401(k). If you leave a job where you’ve been participating in a 401(k), don’t make the mistake of cashing out. Here’s why:

• You pay taxes on the distribution.
• You pay a premature distribution penalty on the withdrawal.
• You lose the opportunity for that small 401(k) to grow over the years.

Here are the options you have when leaving a company:

• Leave the money in your former employer’s plan.
• Roll over the money into an IRA or your new employer’s plan.
• Take a lump sum distribution and pay taxes on the whole amount at once.

Taking a lump sum distribution is a huge mistake, because you’ll pay more taxes and lose the ability to grow wealth. If you roll over your 401(k) into an IRA at a brokerage firm, you can choose from hundreds of investment options, not just those offered in your new employer’s plan.

Whichever you choose, your safest bet is to have the 401(k) transferred directly to your new plan. If the proceeds of your 401(k) are sent directly to you, it is imperative that the money be rolled over within 60 days or you’ll pay a penalty and taxes. Since the money in the 401(k) hasn’t been taxed yet, it must be rolled over into a traditional IRA, not a Roth IRA.

Tip: Diversify

Make sure the money you’re investing for retirement is spread among different kinds of investments. Don’t make the mistake of putting too much money in one stock, especially if it’s your employer. If your employer runs into problems, both your job and your retirement account will be in jeopardy.

Getting Started

Once you start working, ask about the company’s 401(k) plan and when you’re eligible to make contributions. Some plans even allow part-time workers to participate in the company’s 401(k). You should sign up as soon as you’re eligible, even if you don’t expect to work there too long. Make some contribution, even if it’s only one or two percent. If possible, try to contribute the maximum amount that your employer will match.

The Pension Protection Act permits companies to enroll employees automatically in their 401(k) plans, but you may choose not to participate. In the long run, however, that choice will cost you a great deal of money. If you invest $300 per month from age 25 to 59 at 5 percent, your account will grow to $320,734. If you begin at age 30, it will grow to $234,021.

IRAs can be set up directly with:

• A bank
• A brokerage firm
• A mutual fund company

You can handle the paperwork online, by phone, or in person. Many financial institutions permit you to make your IRA contribution in small chunks. You can arrange for your contribution to be deducted automatically each month from your savings or checking account.

FAQs

Should I invest for retirement, even though I’m in my early 20’s?

You can accumulate far more money if you start investing early. Even modest contributions at a young age can grow into an enormous nest egg someday. Furthermore, if you need some of your money now, there are ways to tap your retirement accounts without a penalty.

Is it smarter to invest in a Roth IRA or a traditional IRA?

Although a traditional IRA gives you an immediate tax deduction, Roth IRAs are usually the best choice for long-term investing. Assuming you follow the rules, all of your withdrawals someday will be tax-free. That is a far more valuable benefit than a small tax deduction right now.

Can I depend upon Social Security when I retire?

With far fewer employers offering traditional pensions, you are on your own to save and invest for retirement. Even assuming there are no changes in Social Security, you can’t depend on that benefit to fund your lifestyle. The average retirement benefit recipient received $1,007 per month as of June 30, 2006.

Although you’ll receive cost-of-living adjustments, Social Security benefits only replace about 40 percent of the average worker’s pre-retirement income. Since most financial planners say you’ll require 70 to 80 percent of your pre-retirement income to live comfortably in retirement, you’ll need personal savings to make up the difference.

You can accumulate far more money if you start investing early. Even modest contributions at a young age can grow into an enormous nest egg someday. Furthermore, if you need some of your money now, there are ways to tap your retirement accounts without a penalty.