There have been many books written on retirement investing and there will be many more. But I really don’t understand why a distinction is so often made regarding investing for your golden years, because basically all the investing you’re ever … Continued
There have been many books written on retirement investing and there will be many more. But I really don’t understand why a distinction is so often made regarding investing for your golden years, because basically all the investing you’re ever doing is for retirement. In other words, the whole point of investing is to make money, and the whole point of making money is so you can stretch out on the sand at the earliest possible moment. So in terms of strategy, there’s really no need to distinguish between investing for retirement and any other kind.
That being said, there are a few characteristics specific to retirement investing that do merit mention. For example, the types of accounts you use. Notice I’m saying accounts, not investments. The investments are the same either way. But there are types of accounts that are unique to retirement investing, and you do need to know about the ones that might be available to you.
Just to make sure that we’re on the same page when I’m talking about accounts versus investments, let’s use an example. Picture a Mason jar filled with beets. The Mason jar is like an account: a place to hold something…in this case beets. The beets are like stocks and bonds: something that needs to be put somewhere.
The point is that an IRA isn’t an investment, and neither is a 401(k) or its non-profit cousin, the 403(b). Like a joint account, a trust account, a uniform gift to minor’s account, or any other type of account, they do have certain unique characteristics. But when you shift to retirement investing, you’re not reinventing the wheel. The accounts you’re dealing with may be a little different than your garden variety, non-retirement accounts, but the investments won’t be. Beets are beets whether they’re in a Mason jar or Tupperware. So when you’re investing for retirement, keep your life simple by sticking with the investments you just learned about: a stock index mutual fund for the owner portion of your savings, and an intermediate-term, high quality bond fund, coupled with a money market fund, for the loaner part. If you’re in an employer-sponsored plan that doesn’t offer these specific options, you’ll just select the options that most closely resemble them.
If all that talk about investments vs. accounts seemed too confusing, just remember this: you can put a stock certificate in a Mason jar, but you can’t deposit beets into your IRA.
Now that we’ve cleared that up, let’s look at what makes retirement accounts different. There are five main things, many of which you may already know.
- Sometimes you get free money when you put money in a retirement account.
- If you take money out of your retirement account before retirement age, you’ll probably pay a penalty to do it.
- You don’t pay income taxes on the money you invest in most retirement accounts. (Or, if you’re investing money that’s already been taxed, you could get a write-off on your income taxes.)
- You don’t have to pay income taxes on the profits you make in retirement accounts, at least until you take the money out of the account. The other side of this coin, however, is that you also don’t get to deduct any losses you suffer in these accounts.
- Because retirement accounts have these tax advantages, you’re limited as to how much money you can put in them in any given year, and how long you can ultimately leave it there.
Ok, let’s go over these distinctions one by one, starting with my personal favorite, free money.
Let’s say you work at a company with a 401(k) retirement plan. If so, it’s likely that your company is handing out money for nothing. For some reason, however, they don’t call it that. They call it a company match, because for every dollar you put into your 401(k) account, they’ll match your dollar with some money of their own. For example, you put in a buck of your money, they put in 50 cents of theirs. Some companies match dollar-for-dollar, some match 50 cents to the dollar and a few, like mine, offer no match at all. If they do match, they’ll put a limit on the total you’re eligible to get in matching money in any one year; typically six percent of your salary. But however you slice it or dice it, a company match is free money. And since free money is the easiest you’ll ever make, my advice is whenever it’s offered, take it. If you have to contribute six percent of your salary to pick up every cent they’re putting down, do it. Because getting 50 cents for every dollar you invest is like earning a guaranteed 50% on the first day. Think you can do better than that in some other form of investment? Think again. The only scenario when you wouldn’t contribute enough to get the entire company match is when you can’t possibly survive parting with that much of your salary. Even then, I’d rather see you collecting aluminum cans on the side of the road to make ends meet than to leave free money on the table.
The second unique characteristic of most retirement accounts is that if you take your money out before you reach retirement age, you’ll have to pay a penalty. When the government says “retirement age,” they don’t mean the age at which you choose to retire. When it comes to retirement accounts, they mean age 59 ½. This may strike you as confusing, since when it comes to Social Security, the government apparently thinks that retirement age is either 62 or 65. Then why is retirement age 59 ½ for retirement accounts? The only explanation I can offer is that perhaps when you’re in Congress, and therefore don’t actually work for a living, the term “retirement age” is a bit more slippery to wrap your mind around.
In any case, the penalty for withdrawing money from a voluntary retirement account is typically 10% of the amount you withdraw, and that penalty isn’t deductible. In addition, since you most likely haven’t paid taxes on that money yet (we’ll get to that in a second) you’ll also have to pay taxes on money you prematurely remove. Bottom line? You’re better off collecting aluminum cans on the side of the road than taking money out of your retirement plan early.
Depending on the type of retirement plan you’re in, there could be a few situations where Uncle Sam will waive the early withdrawal penalty, but if your contributions we’re taxed going in (like in a 401(k) or tax-deductible IRA) they’ll always be taxed coming out. For example, you can take out up to 10 grand from an IRA (but not a 401(k)) without penalty to buy your first house. Meet the requirements and you won’t have to pay a $1,000 penalty. But you’ll still have to add $10,000 to your income when you file your taxes that year. Which conceivably means increasing your tax bill by thousands of dollars.
Suffice to say your retirement account should be considered in the same vein as a roach motel: your money checks in, but it doesn’t check out. Until you’re at least 59 1/2, that is.
The third thing that makes retirement accounts unique is that you don’t pay income taxes on the money you put into them. Take Sanford Weill for example. If he earns $30,000,000 this year, and contributes $13,000 of it to the Citicorp 401(k) plan (that’s the maximum contribution allowed for 2004) the W-2 that he gets at the end of the year will only show earnings of $29,987,000. Not paying taxes on that $13,000 will save him more than $5,000 in federal taxes alone. Smart move, Sandy! Now you can buy that boss skateboard you’ve been dreaming about.
What if you’re self-employed, and therefore don’t have access to an employer-sponsored retirement account, like a 401(k) or 403(b) plan? You can still get a tax break. If you contribute $3,000 to an IRA (the maximum for 2004, unless you’re over age 50, in which case the maximum is $3,500) you get to deduct your investment, which is the same thing as not paying taxes on that much income. In fact, even if you have a 401(k) plan with your employer, you can still put money into an IRA and deduct it, providing your income isn’t too high.
In addition to being able to exclude retirement account contributions from our income, we also don’t have to pay taxes on any earnings that we make in these accounts until we see that money again. This is a very cool benefit when we’re kicking butt in the stock market, because we could be making money, but getting no 1099 tax form at the end of the year and therefore paying no taxes. But there’s no free lunch, either. Because when we ultimately take that money out, it’s going to be taxed as ordinary income. If it were outside of our retirement account, we might be eligible for capital gains tax rates, which means we’d pay less tax. In addition, while gains aren’t taxable in our retirement accounts, losses that we incur in these accounts won’t give us any write-offs, either. And losses outside of these accounts would give us write-offs. We’ll talk more about these topics in the chapter on income taxes, but keep in mind that a retirement account is no place to lose money. But then again, there is no good place to lose money.
Now we arrive at the final thing that makes retirement accounts a little different. Because of all these tax advantages, Uncle Sam will only let you put aside so much every year. That amount changes, but for 2004, the maximum you can sock away in a 401(k) or 403(b) or 457 is $13,000 and the maximum amount for traditional IRAs is $3,000. Keeping in mind that this is roach-motel money, we’d like to put as much money as possible in these accounts because of the tax advantages. Think of the example with Sandy Weill that I used a little while ago. Socking $13,000 into a 401(k) saves him five grand in taxes. That’s a lot! And even though he’ll eventually be paying taxes on the money when he reclaims it, he’s compounding it in the meantime. In other words, deferring taxes is like getting an interest-free loan from Uncle Sam: you’re “borrowing” the money you’d otherwise be sending to Washington and using it to make more money.
Before we conclude this chapter, let’s go over a few more salient points. First, you’ve probably heard of Roth IRAs. What are they? Simple. Hold a traditional, deductible IRA up to a mirror and you’ve got a Roth IRA. A Roth doesn’t let you deduct the money you’re putting in. Instead, it lets you not pay taxes on the money you’re taking out. There’s also such thing as a Roth 401(k), but they won’t be available until 2006. But the concept will be the same. After-tax money in, tax-free money out.
So, do you want a Roth IRA? Is it better than a regular IRA? The definitive answer is that there’s no definitive answer. That’s because to determine the correct answer you’d have to know things that you can’t know. For example, most financial planners will assume that you’ll be in a lower tax bracket when you retire than you are now. If that’s indeed the case, then you’d be better off taking tax deductions now with a regular IRA, then paying taxes on the gains at your lower tax bracket when you retire. But you can’t know what tax brackets will be when you retire, much less which one you’ll find yourself in. For all we know, the United States will have a socialist government when you retire and you’ll be in a 90% tax bracket. Or you’ll die when you’re 59 ¼ and taxes will be of no concern to you.
I’ve read a lot of articles on this Roth vs. Regular IRA thing and I’ve come to the conclusion that if there is a difference, it’s either based on assumptions that are none too reliable or it’s not enough of a difference to worry about. The one thing that we can say about a Roth IRA, however, is that it’s more flexible than a regular IRA. Because the money that’s going in has already been taxed, Uncle Sam doesn’t get as hinky penalty-wise when you start withdrawing it.
One additional note about 401(k)s: if you happen to work for a publicly traded company and your employer offers their own stock as an investment option within your 401(k) plan, treat that stock like you would any other individual stock. Just say no. The fact that the stock being offered is that of your company doesn’t make it any safer than any other individual stock. And the fact that you’re already staking your paycheck on the bottom line of your company means that putting your retirement eggs into this same basket doesn’t make you the brightest bulb in the box. The only exceptions? When your employer gives you their stock free, since we love free stuff. Or when you have legitimate inside information and are willing to illegally profit from it. In the latter case, remember; sharing is caring. Please let me know.
One more retirement issue, then we’ll call it a chapter. That issue is other sources of retirement income that we normally don’t think about.
When I was a commission-based investment advisor, i.e. a salesman, I was thoroughly trained in the use of fear as a motivator. And what’s more fear-inspiring than the thought of spending your retirement years living in a cardboard box and pushing a shopping cart around? Consider the following sample conversation…
Me: So, Ms. Prospect, how old are you?
You: I’m 35.
Me: And how much have you put away for retirement so far?
You: Well, let’s see…total? About $1,500. But I’m adding $100 a month to that.
Me: Congratulations! That’s great! If you retire at 65, that means you’ve still got 30 years to go. Let’s see how much you’ll save. (At this point, I pull out my calculator and start tapping away.) Hmmm…$1,500….$100 a month…we’ll assume a 10% annual return…alrighty then! Keep it up and by the time you retire, you’ll have a whopping $255,805! Of course, 30 years from now that amount of money will probably only buy a candy bar. But let’s look at a best-case scenario and assume that there won’t be any inflation at all. And we’ll assume that when you turn 65, you’ll start using the interest on your savings to generate retirement income. That means you’ll be getting $25,580 a year..10% of your $255,000. You won’t have any problem living on a couple grand a month will you?
You: Live on $2,000 a month? Of course I can’t live on $2,000 a month! What are you, nuts?
Me: Then I guess we better start saving a bit more, wouldn’t you say?
You: Well, I guess so. I’ll just cut back on a few expenses. Electricity and water are really just foolish luxuries anyway, right? And, now that I think about it, who needs a phone?
Me: Now you’re talking! Let me just get your signature on a few papers here….
What’s wrong with this picture? Plenty. First, I conveniently forgot to mention one major retirement plan you’re already contributing to. Namely, Social Security. If you go to www.ssa.gov/planners, you’ll find a lot of very useful information, including calculators that will help you estimate what you’ll be getting when retirement rolls around. For example, simply input the age of 35 and the annual income of $50,000, choose to see your estimated benefit in future (inflated) dollars, and in the blink of an eye you’ll see that at age 67, you could be receiving $5,000 a month in Social Security benefits. If you choose “today’s dollars” instead of “future” dollars (future dollars reflect the probable result of inflation) you could be getting an extra $1,500 a month. Granted, $1,500 bucks a month isn’t radical wealth, but it’s certainly not something to ignore when you’re planning your retirement. And if estimated amounts aren’t good enough, the Social Security website also allows you to request your own Social Security Benefits Statement, which will reveal more precisely how much you’re personally likely to receive.
Another thing that I forgot to ask my prospect is what they might stand to inherit. Even if you come from modest means, it’s certainly possible that at some point prior to reaching retirement age you’ll get a cash injection by inheriting some money. How many financial advisors ask this question and add the answer into the mix? It’s important…so when you’re doing your own retirement planning, don’t forget it.
In conclusion, the point of this chapter is to illustrate that investing for retirement is no different than any other kind of investing, and therefore should require little additional time and little additional knowledge. As you may have noticed as I went over various retirement accounts, these plans have tons of niggling rules attached, and those rules are always changing. Therefore nobody knows them, at least not for long. While I could have swelled the pages of this book by delving into each variation and specific rule applying to each account, I didn’t see the point. Because at the end of the day the only plan that matters is yours and the only time the niggling rules affecting your account matter is when you need to know them. And odds are that’s not now. If you work at a company with a 401(k) plan, there’s a person there who will tell you more than you’ll ever want to know about the rules affecting your specific account. If you’re self-employed and need to know what options you have, ask an accountant or go to a website like irs.gov, or do a search for “tax advice” or “retirement plan advice.” But once your retirement plan is in place, providing you follow the same simple asset allocation rules that we’ve already discussed, you don’t have to think about it more than a few minutes a year.
The bottom line is that whether your assets are taxable or tax-deferred, they’re still your assets and therefore subject to the same common logic of asset allocation that we’ve already discussed. Subtract your age from 100. That percentage belongs in ownership stuff. Whether that stuff is in a Roth IRA, a 401(k) or a joint account with your Aunt Agnes doesn’t matter. When you boil it down, the only differences between retirement accounts and any other is tax breaks when you put money in and tough breaks if you need it before retirement.
Use your retirement accounts to get as many tax breaks as you can, and avoid tough breaks by only investing money in these accounts that you probably won’t need to withdraw prior to retirement. Simple enough?