After Partyyyy, Retirement Style!

Posted on May 30, 2012 by Cole

Now that this retirement party has wrapped up it’s time to get to the good stuff, as you know the real party isn’t until the after party anyway. Mr. 401(k) and Roth IRA have had enough Red Bull vodkas to stay up all night and they have roped us into a late night post party conversation we never intended to be apart of. But, no fears, the data they are about to give is extremely valuable and it would be wise to listen carefully. They are going to explain why you need to be investing in a retirement account, specifically a 401(k) or Roth IRA (don’t worry all the data has been fact checked by myself and I’m sober as a stone).

Why invest in a 401(k)?

*If you need a quick refresher on how the 401(k) works check out my 1^st retirement party post here, I will proceed assuming the basics are understood.

The best and most concise way to explain why you need to be investing in your companies’ 401(k) plan (if offered) is through and example, so let’s jump right in!

Jillian has just started her 1^st job after graduating from UCF, as an entry-level business analyst at IBM. The company offers a traditional 401(k) plan with a 5% match and Jillian is trying to determine if she should save on her own, say at her local bank, or partake in the 401(k) plan. To help make the decision she has set up an analysis of the two options.

Before she completes the analysis she writes down the key figures needed to project her future account value in each scenario.

Gross Income: $45,000/year
401(k) match: up to 5% dollar-for-dollar
Average stock market return: 8%-12%
Savings time horizon: 35 years
Local savings account interest rate: .25%

401(k) Projection

If Jillian decides to take advantage of the 401(k) plan she will contribute up to the maximum match of 5% or $2,250 per year. Since IBM will match that 5% dollar-for-dollar they will also contribute $2,250 each year for a total annual contribution of $4,500. To keep the analysis simple Jillian assumes she will not get a raise over her savings time horizon, meaning her 401(k) contribution will be the same each year.

She plans to invest the 401(k) funds into the general stock market where average returns are usually between 8%-12% per year, but she will be slightly conservative and use the assumption of a 7% average market return per year.

Knowing this information Jillian can project what her retirement account value will be at the end of 35 years. After the math is complete she determines her 401(k) account will be valued at $665,611 and out of that amount only $78,750 had to come from her own pocket! Her employer contributed $78,750 and the remaining $508,111 is the projected return from the market[1]. (Image of math can be seen here)

Looked at another way her return is almost 745% over 35 years or an average of 9.97%[2] a year, not bad. Taking into consideration the likelihood Jillian’s salary would increase and the market return may be greater than 7% this could a very wise retirement investment!

Local Savings Account Projection

The other option Jillian has, is to save 5% of her income each year on her own at a local bank, in a traditional savings account, with an average annual yield of about .25%. If she were to choose this option after 35 years she projects an account value of $82,396 which out of that amount she would have had to contribute $78,750 from her own pocket (the same amount she otherwise would contribute to the 401(k)).

Now that the analysis is done it is easy to see there is no comparison, it should be loud and clear that the 401(k) is the superior savings vehicle for retirement. Jillian has projected she would have $583,215 more in a 401(k) retirement account compared to a traditional savings account, even with the exact same contribution amounts. This example illustrates the power of the employer match but more so the power of compound interest over a long period of time, two factors not to be ignored when planning for retirement.

Why invest in a Roth IRA?

*If you need a quick refresher on how the Roth IRA works check out my 2^nd retirement party post here, I will proceed assuming the basics are understood.

Just as the 401(k) the best way to explain why you should be using a Roth IRA for retirement saving is though an example, so let’s rejoin Jillian a few years later.

Jillian has been working for a few years and decides she wants to save additional money for retirement outside of her 401(k). She could save in a traditional savings account but has already determined that for long-term growth that is not the ideal savings strategy. She knows stocks can provide greater returns over long time horizons so she is considering either opening a Roth IRA or investing in the stock market using a normal brokerage account.

In either scenario she will invest $3,500 a year for a time horizon of 25 years into the general stock market and assume an average rate of return of 7% a year. In both cases her projected future account value is going to be the same, $236,868 (Image of math can be seen here). The difference between the two options will be attributed to the tax she has to pay on the capital gains from her investments once withdrawn.

With the Roth IRA she would pay no taxes and keep the total $236,868 as long as she didn’t access the funds before retirement. If she were to make these same investments using a normal brokerage account she would end up owing $22,405 in capital gains tax[3] and keep only $214,463. While the results with the Roth IRA are less impactful when compared to the 401(k) example (mainly due to the company match) there is still a 15% difference between the two options and one clear winner, the Roth IRA (that is unless you prefer to pay more taxes).

Well, that will officially wrap it up for this retirement party. If you missed any of the action you can catch up on all the posts regarding retirement here. Hopefully you found this retirement mini series useful and educational. As always if you liked what you read or think others can benefit from this post please share it! Also, you can subscribe (look to the right) if you don’t want to miss a beat. Until next time I’ll leave you with this retirement mantra, save early and save often.

[1] These values do not account for taxes she would have to pay upon withdrawal of funds

[2] Based upon her contributions alone

[3] Assuming the capital gains tax rate is 15%

This Retirement Party is Coming to a Close

Posted on May 14, 2012 by Cole

All good parties must come to an end, and this one is no exception. The old geezers of the group, grandma and grandpa Pension, are complaining that the music is too loud and that it’s past their bed time. They have however agreed to do one last meet and greet before this shindig wraps up. So without further ado it is my pleasure to introduce you to Mr. & Mrs. Pension (they are cranky so we will keep this short).

So what is it? Pensions are company sponsored retirement plans that provide retired employees with a fixed payout, usually paid monthly, for the remainder of their life. A common requirement is that the employee work for the sponsoring company for a specific period of time determined by the company (this is referred to as vesting) in order to qualify for the pension benefit.

How does it work? The employee first must sign up for the pension plan then complete a vesting period, usually 5-7 years of active employment, once complete they are entitled to a fixed benefit in retirement (age 65). The amount paid is usually determined by number of years worked for the company and salary level upon retirement or throughout the employee’s career. Traditionally pension plans do not require employee contributions, the employer provides all the funding, however there are some plans that may require employees to contribute.

Example[1]: Sam worked for Procter & Gamble for 30 years; his Pension plan states that he will be paid 2% of his average salary multiplied by the number of years worked for the company, each year once he retires. Sam’s average salary during his employment was $70k per year. To calculate his pension payment Sam multiplies 2% by his average salary ($70k) then multiplies the result by years worked (30) to get $42k (2% x $70k x 30). The result, once Sam retires he will receive $42k a year in pension benefits, or if paid monthly $3,500 a month for the rest of his life (pretty sweet deal in my opinion).

Important information to note: Over the past few decades pension plans have become scarcer, especially in the private sector mainly because of the high cost to maintain. With no employee contribution in many cases, and guaranteed befits, the employer must offset any market downturns to maintain the fixed benefits. It should be no surprise that direct contribution plans like the 401(k) have become the retirement vehicle of choice due to lower costs and the ability to pass the responsibility for retirement planning on to the individual employee.

So that about wraps it up for this retirement party, if you have any additional questions about pensions drop a comment below and I’m sure we can convince Mr. or Mrs. Pension to get back to you. If you missed all the action until now you can catch up here with the 401(k) and here with the IRA.

I hear there is an after party in the works for sometime next week, make sure to tell your friends (I hear Facebook, Twitter, and Google+ are good ways to do that ;)) so they can catch up on all the action before it happens!

[1] This is a very simple example; the math behind the real calculations can be much more complex.

What is a Vesting Period?

Posted on May 9, 2012 by Cole

A vesting period, when mentioned in reference to retirement plans, is the length of time an employee must work for a company before he or she can claim 100% of employer provided benefits. The term vesting period is most commonly used with retirement plans like a 401(k) or pension, but may also be used with stock options.

Example: My current employer requires that I work five years before I am 100% vested in my 401(k). This means if I leave and go to another company before that time I will forfeit my right to the employer contributions made to my 401(k). It doesn’t however mean I forfeit 100%, my company has an incremental vesting period, meaning each year I work for them my vested percentage increases.

2 years: 40%
3 years: 60%
4 years: 80%
5 years: 100%

Each company is different however and for some it may be 0% until the vesting period elapses.

Let’s say I leave my current company after 3 years, and up until that point I have contributed $5,000 to my 401(k) which my employer has matched, giving me total of $10,000 (not counting any gains or losses). When I officially leave my 401(k) will be reduced to $8,000 in total, I would only be entitled to keep 60% of the company match or $3,000 ($5,000 x 60%) in addition to what I have contributed.

Note that vesting only applies to contributions from your employer, everything you contribute you keep. Any gains incurred because of the employer contribution are also forfeited but any gains on your contribution or vested amount is yours to keep

Kicking This Retirement Party Into High Gear

Posted on April 11, 2012 by Cole

It’s a known fact that the cool folk don’t get to the party until after it’s started, and that fact remains with this retirement extravaganza. We are nearing the half way point (8:00pm, this is retirement after all) and who shows up to join the 401(k), none other but the Traditional IRA or Individual Retirement Account and his younger brother the Roth IRA, arguably two of the most popular and discussed retirement plans available today.

So what is it? The traditional IRA is very similar to the traditional 401(k); it is a plan that allows you to make pre-tax contributions to a retirement account lowering your taxable income; however it is not company sponsored, the account is opened individually outside of your employer. Institutions like banks (ex. Bank of America) or brokerages (ex. TD Ameritrade) are the main types of companies that offer IRA’s, which can usually be opened quickly and easily online.

How does it work? Once the IRA is set up through your chosen institution contributions can be made throughout the year to the account. It might make things a little easier if you think of the IRA like a type of savings account, all deposits are up to you, and if you don’t actively deposit money it won’t automatically happen for you, unlike a 401(k), unless you are able to set up direct deposit through your employer. Simple example: Joe has a taxable income of $50,000/year if he opens an traditional IRA and contributes $3,000 his taxable income will be reduced to $47,000/year.

Quick technical detail, because this account is set up outside of your employer, contributions made are actually after tax has been withheld from your paycheck. When you file your annual taxes a deduction is applied for the amount contributed to the plan, lowering taxable income the same amount as pre-tax contributions would have. There are multiple choices of where to invest funds contributed to an IRA, common investment options include, index funds, mutual funds, bond funds, and individual stocks (if a self directed IRA). Once you retire and begin withdrawing funds, those distributions are then taxed at the ordinary income taxes rates at that time.

Important information to note: an IRA is not like a normal bank account, it is governed by different laws and regulations. The biggest difference is you can not access your money whenever you want, because it is a retirement account you are not eligible to withdraw funds until you reach the age of 59½. Now, there are certain instances when funds can be withdrawn before this age but you could be subject to penalties or additional taxes. Each situation is unique; if you need to withdraw money early from your IRA it is best to speak with customer service where the account is held or a financial advisor. There are also limits to the amount you can contribute to the plan in a given year, for 2012 the limits are as follows

$5,000 if younger than 50
$6,000 if over 50
If you file as single and make[1] over $68,000 a year or file jointly and make over $112,000 you are ineligible for a tax deduction on Traditional IRA contributions.

Soooo what about that Roth IRA? A Roth IRA is very similar to the Traditional IRA except for a two key differences

Contributions are made after tax instead of before
The income limits for eligible contributions are higher.

Making contributions after tax means you receive a tax benefit in retirement instead of when the contribution occurs. When money is withdrawn in retirement there is no tax since it was already paid. The contribution limits in 2012 for a Roth IRA are as follows, if you file as single and make less than $110,000 or file jointly and make less than $173,000 you are entitled to make the full contribution of $5,000 or $6,000 if 50 or older.

Now many people want to know which plan is better, Roth or Traditional, and the truth is one is not “better” than the other in all cases. The choice of which plan to choose largely comes down to your individual tax situation, weather you prefer to pay taxes now or later, and your assessment of future tax rates, something very hard to determine.

Other notes about the Roth IRA: There are a few beneficial features of a Roth IRA worth mentioning.

You can withdraw any contributions made to the IRA tax free at any time even before age 59½.
- For example if you have contributed $5,000 and earned $2,000 of interest since opening the account you would be able to withdraw up to $5,000 without penalty.
If you are a 1st time home buyer you can withdraw up to $10,000 in principal and interest towards the purchase your first house (also applies to Traditional IRA).

IRAs can be hairy animals but you should now have the basics down, if you would like more information on Individual Retirement Accounts check out the two links below.

http://www.ira.com/

http://www.irs.gov/retirement/article/0,,id=137283,00.html

So do party with an IRA? If so, did you chose Traditional or Roth, and why? Leave your comments below, and if you learned something new hit the share button!

If you happen to be one of the cool folk that missed the first half too, don’t worry, click here to get brought up to speed on everything you missed.

[1] The law is actually based upon Modified Adjusted Gross Income, but I used “make” to keep things simple, if you would like further information on Modified AGI see here

It’s a Retirement Party!

Posted on March 8, 2012 by Cole

I have received many requests to write a blog post on the various types of retirement plans. This isn’t surprising, since many of my friends are recent college graduates starting their first big boy (or girl) jobs and have never given retirement planning a thought. Instead of doing one long post covering every type of plan I am going to write three separate posts covering the most popular plans, the 401(k), IRA, and Pension. With that little introduction out of the way let’s kick this retirement party off with the big daddy, the traditional 401(k).

So what is it? The traditional 401(k) is a company sponsored retirement plan that allows you save for retirement by making pre-tax contributions to the plan. Not every company offers a 401(k) and you can not open one on your own, it must be through an employer.

How does it work? You elect through your employer to contribute funds to the plan on a pre-tax basis, usually a set percentage of each paycheck (for more information on pre-tax deductions check out the mini series your paycheck). The company sponsoring the plan will provide the employee with multiple options where they can choose what to invest the funds in, common investment options include, index funds, mutual funds, bond funds, and company stock. Once you retire and begin withdrawing funds, those distributions are then taxed at ordinary income taxes rates (see here for example) In many instances your company will match your contribution up to a certain percent (aka: Free Money![1]).

For example, say I make $10,000 a month (I wish!); and the company I work for will match my contribution up to 6% dollar for dollar. This means if I contribute 6% of my paycheck ($600) the company will also contribute an additional 6% ($600) for a total contribution of $1,200.

Matching varies from company to company and the terminology may differ as well. You might find out that your company matches the 1^st 3% dollar for dollar then a 2^nd 3% at .50 cents on the dollar, up to 6% total. This means the first 3% of your contribution is matched in its entirety and the subsequent 3% is matched at 50%. Using the $10,000 example from above an employee contribution of 6% ($600) would equate to an employer match of 4.5% ($450), the first 3% dollar for dollar equaling $300 and the second 3% .50 cents for each dollar totaling $150.

Important information to note: a 401(k) is not like a normal bank account, it is governed by different laws and regulations. The biggest difference is you can not access your money whenever you want, because it is a retirement account the money can not be accessed until you retire or reach the age of 59 and a half. Now, there are certain instances when funds can be withdrawn before retirement but you could be subject to penalties or additional taxes. Each situation is unique; if you need to withdraw money early from your 401(k) it is best to speak with your HR department or a financial advisor. There are also limits to the amount you can contribute to the plan in a given year, for 2012 the limit is $17,000 and if you are over 50 you can contribute an additional $5,500 for a total of $22,500. These limits do not include employer matching.

What’s all this noise about a Roth 401(k)? A Roth 401(k) is the same as the traditional 401(k) except for one key difference, contributions are made after tax instead of before. When money is withdrawn in retirement there is no tax withheld since it was already paid. Now many people want to know which plan is better, Roth or Traditional, and the truth is one is not “better” than the other. The choice of which plan to choose largely comes down to your individual tax situation, weather you prefer to pay taxes now or later, and your assessment of future tax rates (something very hard to determine). If you think tax rates could be higher when you retire it may be beneficial to choose a Roth plan, if you think rates will be lower the Traditional plan may suit your needs better.

WTF does the (k) mean? The (k) refers to the sub-section of section 401 of the IRS code. Not nearly as exciting as you thought the answer would be, was it?

Next up is the Individual Retirement Account, or IRA.

[1] It’s for this very reason that if your company offers a 401(k) you should be contributing!!

I'm Bad at Spending Money

A Personal Finance Blog for Those a Little to Good at Spending Money

Tag Archives: Retirement

After Partyyyy, Retirement Style!

This Retirement Party is Coming to a Close

What is a Vesting Period?

Kicking This Retirement Party Into High Gear

It’s a Retirement Party!

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