Financial Idea's Blog

What Kind Of Money Should I Put Away Before 2010?

This is the kind of question that depends completely on you. By that I mean it depends on your goals and your needs. Let me explain a little more about what your options are. If you might need access to that money in the next few years, then you might not want to put it in an IRA or a company 401(k) where there’s a penalty to take it out before you’re age 59 ½. In that case, you’ll pick a regular taxable brokerage account for the money.

Or, maybe you know you’re okay with having it locked away until retirement (because you actually have a budget and you actually follow it), so the money is going into some sort of retirement savings plan, but which? The three most basic choices are a company 401(k) plan, a traditional IRA, and a Roth IRA and the decisions revolve around company matching funds, vesting schedules, investment choices and tax considerations.

In the case of a company 401(k), employees typically can save 15% of their gross income, up to $16,500 (in 2009). That money will be deducted from the gross income used to calculate how much tax you owe, and accordingly, a lower amount of tax will be withheld from your paycheck. You will eventually have to pay taxes on the money, but you can defer them until much later. The following chart shows just how wonderful that is.

In this example, we assume that you got $10,000 at age 20 and put it in a tax-deferred account, then never invested anything else after that. We also assume that you earn 10% on average for the next 50 years, which is do-able, and that you’re in the 25% tax bracket.

The orange line shows what your account would be worth if you paid the taxes due on your earnings from the account every year. The green line shows what would happen instead if you deferred the tax bill to the end, and the sharp drop in the green line is what would happen if you took all that money out at once at age 70 and therefore had to pay all the tax at once, which I wouldn’t recommend.

In addition, companies often match a portion of your contribution as an incentive to work there. It’s common for a company to put 50 cents in your account for every $1.00 you put in, up to a pre-defined (by the company) limit. One company I used to work at matched at that rate up to 6%, meaning that when I put 6%, they’d put in 3%. If I put in 5%, they’d put in 2.5%. But 6% was the limit, so if I put in 6.5% or more, they were still maxed at 3%.

That’s a pretty good deal. If you work at a company which matches, put in at least that amount necessary to get the maximum match. If you don’t, you’re leaving free money on the table, subject to the vesting schedule. In some companies, you are 100% vested from day one. That means that, should you leave the company, you’re entitled to 100% of their matching contributions in addition to your own money. Often, however, companies will choose to have a 4- or 5-year vesting schedule. This means that, after one year of employment, you’re entitled to 1/4^th or 1/5^th of their matching contributions if you leave, and only after 4 or 5 years are you entitled to the full amount of the match. So, if you’re thinking that you won’t be there that long, the match is much less important.

Now, what about the other 9% (in my example)? What to do with that? Now it gets a little more complicated.

You could put that extra money in the 401(k) and get more of a tax benefit, but keep in mind that there are literally thousands of investment choices out there, and you only have access to a dozen or so through your plan at work, not all of which are likely to be good ones. A tax benefit is nice, but if the investment choices underperform, it may not be everything you hoped.

You might instead choose to have a traditional IRA with a brokerage firm, because up to certain income limits, you may still be able to deduct your contributions, and you’re getting a bigger world of investment choices with the help of a professional advisor.

If you’re getting a big tax refund already, you might not need further deductions and could instead choose to put the money in a Roth IRA, which doesn’t give you any tax-deduction NOW, but instead it allows all of the earnings to grow completely tax-free, provided you adhere to a few fairly easy rules.

In the case of either type of IRA, your savings limit for 2009 is $5,000 per person, or $10,000 for a married couple, and it doesn’t matter if both spouses are employed. If you’re 50 years of age or older, you’re entitled to a “catch-up” contribution of an extra $1,000.

If that’s not enough or you just want to save more, there’s another level of options not commonly known which we can implement which might be the right thing for you.

The keys are to do it – the earlier the better. If you have questions or would like me to help, contact me now and let’s get started.

Email: John@financialideasblog.com

Technorati Tags: 401K, Compound interest calculator, Retirement, Roth IRA, rule of 72, traditional IRA, young investors

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