My parents and many of their contemporaries didn’t have to worry too much about saving for their retirement years, since many of them were covered by defined benefit plans funded by their employers.
How times have changed! Fewer and fewer employees are that lucky today. Instead, most of us are solely responsible for funding our golden years. Fortunately, Uncle Sam has provided several vehicles, in addition to social security, that make it easy to save—and, sometimes, they come with significant tax advantages.
The 401(k) Plan
The first is a defined contribution plan—the 401(k), a savings and investing plan that Congress created via the Revenue Act of 1978. In this plan, the individual makes contributions, deducted from your paycheck—on a pre-tax basis—according to a stipulated formula. And then your employer may elect to match part or all of your contributions—in essence giving you free money.
For 2019, the 401(k) contribution limit went up by $500, to $19,000. If you are age 50 or over, the catch-up contribution limit stays the same at an additional $6,000.
The “all sources” maximum contribution (employer and employee combined) rises to $56,000, up $1,000. And plan participants who contribute to the limit in 2019 can receive up to $37,000 from match and profit-sharing contributions ($56,000 minus $19,000).
One of the best attributes of the 401(k) is this: because your contributions are on a pre-tax basis, you are not taxed on them until you begin to withdraw them—ideally upon retirement, when your tax rate will be smaller than during your working years.
And since your contributions are deducted from your paycheck, contributing becomes automatic. Think of it as a forced savings plan, in which you don’t spend it because you don’t see it! 401(k) plans are tremendous savings vehicles, but unfortunately, they are not often used to their maximum abilities. Here’s why:
Most 401(k) plans are underfunded, usually because folks think they can’t afford to sock money away. If you fall into this category, you are making a big mistake. Chances are, you won’t even miss those pre-tax dollars coming out of your paycheck. An easy way to do this is by consistently and immediately increasing your contributions by a portion of any raises and bonuses you receive. Hey, how can you miss it if you never had it?
Additionally, most employers offering 401(k) plans at least partially match your funds, and that amounts to free money! Add in the beauty of compounding interest—i.e. making interest on interest—and before you know it, you have a real retirement account.
It’s understandable that when you first open your 401(k) you may be unsure about the level of your contributions. So, if you don’t think you can afford much, start with just 1% or 2% of your income. Then make a commitment to increase that rate every year until you hit the maximum amount.
Once you’ve decided how much to invest, your next step is to choose among the investments your employer’s plan offers, which will usually be an assortment of mutual funds and Exchange-Traded Funds (ETFs). And that requires a bit of effort on your part. Your employer will most likely invite the plan administrator in to give you an overview of the plan, but you will need more assistance than that. So, just refer back to section 7 for help in choosing the right funds or ETFs for you.
And don’t forget—your plan need not be stagnant. As you become more used to directing your own retirement funds, you may find that you will want to change your investment strategy from time to time. Fortunately, most 401(k) plans are now set up to accommodate those changes.
Before we leave the subject of 401(k)s, I want to caution you about two common scenarios that will adversely affect your ultimate goal of a sunny retirement.
- Make sure you roll your funds over when you change jobs. Many folks who change jobs make the mistake of taking the cash out of their 401(k) plans. This is a terrible idea! One, you’ll probably spend it on something you don’t need. Worst of all, when you get the money in your hands, you have just subjected yourself to significant early withdrawal penalties as well as hefty income taxes. And that doesn’t even address the opportunity cost of losing the ability to compound the returns on that money you just withdrew. A better idea: Roll the money over into your new employer’s plan or into an individual IRA that you can set up easily at your bank or brokerage firm.
- Don’t borrow money from your 401(k) unless it’s a dire emergency. Here’s why: 1) You’ll have less in the account compounding for your future; and 2) you may find it hard to pay back the loan and keep contributing at your current rate. If you absolutely need money, look for other loan alternatives. But keep your retirement out of reach!
If your company offers a 401(k) plan, my advice is to contribute as much as you can to it, consistently. You’ll be amazed at how quickly the funds can build up over time.
The second retirement vehicle you should utilize—after you have maximized your 401(k) contributions—is an Individual Retirement Account (IRA). Individual Retirement Accounts were created in 1974, to help folks who had no company retirement plan or those of us who realized that, lo and behold, retirement was sneaking up on us and we needed money in the bank!
Almost everyone is familiar with traditional Individual Retirement Accounts. Like 401(k) plans, traditional IRAs let you save with certain tax advantages. The concept is simple: If you meet income guidelines, you contribute pre-tax dollars, yearly, to an account, and the money compounds over time.
For 2019, traditional IRAs increased annual contribution limits to $6,000, from $5,500. And the additional catch-up contribution remains $1,000.
As for the amount you can contribute, pre-tax, here’s the new IRS guidelines:
“In 2019, the deduction for taxpayers making contributions to a traditional IRA is phased out for singles and heads of household who are covered by a workplace retirement plan and have modified adjusted gross incomes (AGI) between $64,000 and $74,000, up from $63,000 and $73,000 in 2018. For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $103,000 to $123,000 for 2019, up from $101,000 to $121,000.”
The amounts differ if you are not covered by a workplace retirement plan. Please ask your accountant or financial planner for the specific details that apply to your situation.
Bottom line, if you fit the above guidelines, you can erase $6,000 of your taxable income, and if you’re in the 24% tax bracket (adjusted gross income of $82,501 to $157,500), that $6,000 becomes a $1,440 tax savings ($6,000 x 24%)—enough for a small vacation or maybe a new smartphone! (I know I’m being a smart aleck, but who would have ever believed a cell phone could cost so much?
To further sweeten retirement savings, in 1998, Congress created Roth IRAs, which offer several advantages over traditional IRAs. And for 2019, like traditional IRAs, Roth IRAs’ increased annual contribution limits are $6,000, up from $5,500 in 2018. And the additional catch-up contribution is $1,000.
Roth IRAs are funded with after-tax dollars rather than pre-tax dollars, unlike a traditional IRA. But because of this, you owe no taxes on your withdrawals (including earnings), as long as the withdrawals are qualified (primarily meaning after age 59 ½, and if you have owned the IRA for at least five years). So, while you forfeit any tax advantages in the current year, you should more than make up for them by avoiding taxes on your principal and earnings when you withdraw them.
Additionally, special circumstances, such as the first-time purchase of a home, qualified education expenses, unreimbursed medical expenses or health insurance may allow you to make tax-free and penalty-free withdrawals from a Roth IRA. This makes the Roth IRA an attractive investment vehicle for many other uses in addition to retirement and savings.
And because the annual income levels used for determining your ability to make contributions are much higher for a Roth IRA than in a traditional plan, more folks can participate. The modified adjusted gross income (MAGI) for singles must be under $137,000; contributions are reduced starting at $122,000. For married filing jointly, the MAGI is less than $203,000, with phaseout starting at $193,000.
Lastly, unlike a regular IRA, the Roth IRA doesn’t require minimum withdrawals when you reach age 70 ½ .
My advice: If you are eligible for a 401(k) plan, fund it first. Unfortunately, not all employers offer 401(k) plans. But nearly everyone is eligible to have an IRA. And an IRA does have the advantage of offering you a wider choice of investment options than what you will find in your company’s 401(k) plan.
If you don’t Meet the Income Qualifications…
Now, even if you don’t meet the above income qualifications, you may still open a traditional, non-deductible IRA or opt for a Roth IRA.
But you may ask, if it’s not deductible, why should I bother? Because…
- Your money compounds over time, which makes the next advantage even more important…
- Your earnings and deductible contributions are not taxed until you withdraw the money. And for non-deductible contributions, just part of the withdrawal will be subject to taxation. But there’s one more big plus: Taxes are assessed at ordinary income tax rates, and since you probably won’t be working in your retirement years, your tax bracket should be lower than it is now. Consequently, your tax bite will also be less, probably considerably so.
Bottom line: You can accumulate a significant sum of money from now until you need it—money that will most likely be reduced by just minimal taxes at that time.
Now, many investors think: I have a company-sponsored 401(k) plan—either through my current employer or a previous employer(s). Why do I need an IRA?
One, because an IRA simply helps you accumulate additional retirement monies, complete with the above advantages. Most of us realize that we will need a lot more money for our golden years than the amount our 401(k) allows us to save. Therefore, once your 401(k) is funded at the maximum amount each year, start directing your extra money to your IRA.
But, the second reason is an important strategy that many investors often overlook: rolling over an existing 401(k) from a previous employer to a self-directed IRA. I would place a bet (and win!) that most of you have one (or more) of these accounts lingering from an earlier job. And I would further bet that they have substantial sums in them.
You are making a big mistake by leaving your 401(k) monies with an administrator who is probably reducing your account by his management fees—in addition to the expenses and fees you are already incurring in the mutual funds in which your 401(k) is most likely invested. But the fees aren’t the only problem. An even larger disadvantage is this: You have little or no control over your monies left in your old 401(k) plans.
Sure, you can change the options a little, and maybe go from a conservative to a more aggressive strategy. But you must stick with the available investments in the plan. Alternatively, you can roll those funds over to an IRA and you will have the option to put your money into virtually any investment you choose—stocks, bonds, mutual funds, ETFs, real estate or commodities.
And… should the market or economy inspire you to alter your investment choices, you can switch them around whenever you desire, not when your previous employer changes administrators and/or 401(k) plans. Best of all, there’s no worrying about capital gains when you make your changes. The tax man doesn’t come knocking until you begin making withdrawals!
Lest you think this is just too much trouble, be assured that it’s as easy as setting up an IRA account at your favorite bank or brokerage house (which can be quickly done online), calling your 401(k) administrator to request the transfer form, then completing the form so your monies are made payable and sent to your new IRA account. Presto! You probably won’t even have to see or handle the money, as most administrators will just send the check directly to your new account.
One important note here: Please make sure the check is made payable to your new account and financial firm—not you—so that you don’t incur substantial penalties.
If you are self-employed, you have a couple of options that allow even greater annual contributions, so make sure to consult your tax professional if you fit into that category.
Just remember: You are in the driver’s seat of your retirement. If you wish to really make your retirement years ‘golden’, you must maximize your savings. And a 401(k) plan, as well as an IRA, are the absolute first steps you will need to ensure your goals are fulfilled.