Money Talks

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.