Kicking Financial Ass
Page 16
There are many different investment accounts: 401(k)s and IRAs in the U.S. and RRSPs and TFSAs in Canada. What if you chose the wrong account or invested in the wrong thing?
This chapter is slightly technical. So, if you do not need to know the specifics, then skip to the section “The Money Allocation Order for Americans and Canadians.”
The data in the chapter is based on the rules for 2018. Keep in mind that limits on retirement accounts change every year. So, search the web for the latest information.
In the case of personal bankruptcy, most of the money in retirement accounts is off limits from creditors. Another perk is retirement accounts are often excluded when college financial aid offices determine how much a family can pay for college.
CHAPTER 11A
AMERICAN ACCOUNTS
Whether you work for an employer or own your own business, you have access to some tax-favored plan. If you work for an employer, you will likely have a 401(k) plan or 403(b) if you work for a non-profit. For simplicity’s sake, I refer only to 401(k)s from this point on because a 403(b) is essentially the same. If you work on your own, you can open an individual retirement savings account (IRA). The differences between them are:
•401(k)s are retirement accounts available to most employees of a company or non-profit.
•IRAs are available to the self-employed and those who work for an employer that does not offer a 401(k).
Each account has benefits that I will discuss in more detail. The idea with these accounts is that your money is left alone over the years so that it can compound over time.
With a 401(k), your employer typically narrows down the investment options for you whether it is an actively managed fund, index fund, bond mutual fund, international fund, or money market fund. Watch out for the fees, however. Often, company 401(k) plans invest in terrible, high-fee funds, so look at where your money is going.
IRAs are a little more involved since it is up to you to choose the type of investment that it will go into. The best option is almost always a stock index fund.
With either account, your funds are locked away until you are 59½. If you withdraw early, you will be hit by Uncle Sam and subject to a penalty.
401(K)S
One of the most important things to know about 401(k)s is that most employers match your investment up to a certain percentage. For example, you can put in 3% of your salary, and your company matches it. That is the same thing as saying you are getting a 100% return on your investment! Nowhere else will you receive the same return, so it is imperative that you start contributing to your 401(k) if you have not already. And remember the concept of compound interest? You want to invest as much as you can the earlier you can.
Here are some scary facts about employees age 25 and under in the U.S.:
•Less than a third participate in a 401(k),
•Less than 4% max out their contributions, and
•Only 16% contribute enough to get the full company match.
There are some reasons for this. For private sector employees aged 22 and younger, 41% have no access to a 401(k) through their employer, compared to 35% of Gen Xers and 30% of baby boomers.63 This is not an excuse not to save. If your employer does not offer a 401(k), open an IRA.
Also note that while a 401(k) is one of the best ways to save for retirement, it has restrictions. Typically, when a company matches your contributions to the plan, you cannot tap into those immediately. There is a vesting period, which is the amount of time you must work for your company before gaining access to its payments to your 401(k). Think of it as an incentive to stay at your job for a few years. Your contributions always vest immediately. So even if you leave your job before your employer contributions vest, you keep your money.
The IRS mandates the contribution limits for 401(k) accounts. Look up the current contribution limit for your tax year before contributing.
Two different 401(k)s exist: Traditional 401(k), which is more common, and Roth 401(k). Chances are your company offers a Traditional 401(k). Read about each below to determine which one you should invest in.
Traditional 401(k)
Most large employers have the option of saving money in a Traditional 401(k). These accounts essentially offer two tax breaks— one up front and the other over the long term. First, you do not have to pay taxes on the money you contribute to a 401(k). This is known as a pre-tax contribution.
For example, if you earn $60,000 a year and contribute $5,000 to a Traditional 401(k), you are only taxed on $55,000 that year. If you are in the 20% tax bracket, you save $1,000 that year in taxes.
The second tax break is not needing to pay taxes on the interest your investments make over time, which is a substantial amount over 40 years. You are only taxed when you withdraw at retirement, saving you thousands of dollars.
Roth 401(k)
The Roth 401(k) is relatively new, so not all employers offer it. However, it has grown in popularity since its first release in 2006. With a Roth 401(k), you make an after-tax contribution, meaning you pay with after-tax dollars. So, you pay taxes on your money as you normally would, and then after you make your contribution, you never pay taxes on it again, even when you start making withdrawals. In other words, you cannot deduct your contribution from your income and pay less tax up front. Rather, you save on taxes when you withdraw at retirement.
How Your 401(k) Grows
Let’s say you are 25 and start investing $5,000 a year, and your employer matches $5,000 per year into an index fund growing at 10% per year.
By age 40, your investment with employer matching would grow to $370,384 compared to $195,635 without the match. And by the time you turn 65, you would have a little over $5 million compared to $2.6 million if your employer did not match, a difference of over $2.4 million! And, this assumes you are not paying into an IRA on top of that.
Should I Invest in a Traditional or Roth 401(k)?
If you think that you will pay a higher tax rate in retirement, then opt for a Roth 401(k) so that you can pay taxes now at a lower rate. Otherwise, choose a Traditional 401(k).
If you start with a Traditional 401(k) and want to switch to a Roth 401(k), some employers allow this but not vice versa. This transition is known as a Roth 401(k) conversion.
Tip: When you change jobs or retire, you can roll your 401(k) into a Traditional IRA. You might want to do this because of the wider investment selections available with IRAs, like index funds or funds with lower fees. IRAs also are more flexible for withdrawals relating to a first-time home purchase or education expenses. But be careful because if the company cuts a check payable to you, 20% of the funds will be withheld for taxes. If you were planning to make a tax-free rollover, you must fund the amount taken by the IRS and put it into an IRA within 60 days or else any portion of the payout not rolled into an IRA within that time will be considered a taxable distribution.
The best route is a direct rollover from the 401(k) custodian, or trustee, to the IRA. A custodian or trustee is often an employee of the company, but companies can hire outside service providers to handle the recordkeeping and administration of the plan. That way, the money never reaches your hands, and there is no risk of triggering an accidental tax bill. You can only make one IRA rollover a year. Furthermore, be careful with the fees associated with rollover IRAs because they are often higher than workplace retirement plans and can eat into your savings.
Tip: If your company goes out of business, do not worry. Your 401(k) is off limits. The plan will most likely be terminated, in which case you can roll your 401(k) over into a Traditional IRA to avoid paying the 10% withdrawal penalty and income taxes. Withdrawing from a 401(k)
You do not have to start withdrawing from your 401(k) until you turn 70½. Withdrawals are technically referred to as “distributions” and should only be used as a last resort. However financial emergencies happen, so keep this in mind:
•If you withdraw from a Traditional 401(k) early, defined as before the age
of 59½, then all the money is subject to income taxes and a 10% penalty.
•If you withdraw from a Roth 401(k) early, you can withdraw your contributions tax-free, but your earnings are subject to income taxes and a 10% penalty. You must be over 59½ and have had your account open at least five years,64 which is counted from the day you make your first contribution, to withdraw without incurring income tax and the 10% penalty on earnings withdrawals.
Borrowing from a 401(k)
With a 401(k) loan, you can withdraw up to $50,000, or half the vested balance in your account if it is less than that. You then repay your account over a period of up to five years. You will pay some interest on the amount withdrawn, and most 401(k) plan providers and platforms charge fees to process and service the loan. This adds to the cost of borrowing and repayment.
Another thing to consider is that your employer may not offer these loans. Your odds are better if you work for a larger company, many of which now include 401(k) loans as part of their retirement package.
While borrowing from your 401(k) might be an option, it should only be considered in a true financial emergency, otherwise you sacrifice years of compound interest and retirement savings, drastically extending how long you need to continue working before retiring.
Switching Employers
If you are tempted to cash out a 401(k) when switching employers, consider these four reasons for why65 you should not:
1. It Is Unnecessary
If you switch employers, you do not have to make any moves with your 401(k). You can keep the money in your old company’s plan and let it continue growing at that tax-deferred rate. There are, however, drawbacks, like no longer being able to contribute to it and the admin fees. But if the plan is better than the one your current employer offers, leaving your money behind can be the best move.
2. Fees and Taxes
The early withdrawal penalty also applies to cashing out your 401(k). If you ask your retirement provider to liquidate your account and send you the proceeds, you pay that fee to the IRS if you are under the age of 59½. You also pay income taxes on it, which can add another 10% to 37%.66
3. Rolling Over Is Easy
Rolling over your retirement plan from your previous employer to your new employer or an IRA is an effortless process. Your new HR department will have a form that you fill out to allow them to pull the funds and reinvest them. You avoid both income taxes and the dreaded 10% early withdrawal penalty.
4. Lost Growth Potential
Each $10,000 withdrawn and spent could be worth $64,870 in 20 years.67 It is better to roll over your investment to your new employer or an IRA, and let it grow tax-free.
Traditional 401(k) Roth 401(k)
Contributions are Pre-tax Post-tax
Can be started by Employer only Employer only
Maximum annual individual contribution $18,500 (2018) $18,500 (2018)
Can roll-over to New employer’s Traditional 401(k), Traditional IRA, or Roth IRA New employer’s Roth 401(k) or Roth IRA
Pay taxes at Withdrawal at retirement Time of contribution
Can begin withdrawing earnings without penalty At age 59½ At age 59½
Taxes in account No taxes on dividends, capital gains, or interest. No taxes on dividends, capital gains, or interest.
IRAS
IRAs are another form of retirement account, although employers do not offer them. IRAs are private accounts set up through mutual fund companies, banks, and brokers. Even if you have a 401(k), you can still open an IRA.
The maximum the government allows you to contribute to an IRA, as of 2018, is $5,500 per year plus an additional $5,500 to your spouse’s IRA if he or she does not earn any income. If he or she does work, they can contribute $5,500 to their own account. These limits apply to your total IRA contribution, whether you contribute to a Traditional or Roth IRA.
Traditional IRAs
This is like a Traditional 401(k) except you are responsible for the account. As with a Traditional 401(k), you deduct your contribution from your income, meaning an “up-front” tax break. The Traditional IRA’s up-front tax breaks are called deductible IRAs. You only pay taxes with the withdrawals at retirement, which allows your money to grow tax-free and compound over the years. This process is called “tax-deferred growth.”
For example, if you earn $60,000 a year and contribute $5,000 to a Traditional IRA, you only pay taxes on an income of $55,000. If you are in the 20% tax bracket, you save $1,000 in taxes that year.
If your employer does not offer a 401(k), then in almost all circumstances, you can contribute up to the full $5,500 limit to your Traditional IRA. The one exception is that if you are married to someone who has an employer 401(k) plan. In this scenario, you can only make the full contribution to a Traditional IRA if your combined annual income is $186,000 or less (as of 2018), and you and your spouse file a joint return.
What if your employer already offers a 401(k)? You can instead make the full $5,500 annual contribution to a Traditional IRA if:
•You are single, and your adjusted gross income is $62,000 or less, or
•You are married, file jointly, and your adjusted gross income is $99,000 or less.
If you are married and file separate tax returns, you cannot claim the full deduction no matter what your income is.
Roth IRAs
Just like with Roth 401(k)s, you do not have the up-front tax break on your contributions. Also, as with the Roth 401(k), it will grow tax-free for life. Even when you withdraw in retirement, you will not pay taxes.
Like with Traditional IRAs, you can open a Roth IRA even if you already have a 401(k) at work. As of 2018, you can make the full $5,500 annual contribution to a Roth IRA if:
•You are single, and your adjusted gross income is $118,000 or less, or
•You are married, file jointly, and your adjusted gross income is $186,000 or less.
You can still have a Roth IRA even if you have a higher income, but the amount you can contribute will be less than the full $5,500.
You can still make a partial contribution if:
•You earn under $133,000 as a single person, or
•You earn under $196,000 as a couple filing jointly.
It varies depending on income. Research online to see what your partial contribution can be.
Ask yourself these questions when trying to determine whether to invest in a Traditional or Roth IRA:
Do You See Yourself in a Lower or Higher Tax Bracket in Retirement?
The reason to invest with a Traditional IRA before a Roth is that you will likely be making less money in retirement and thus be in a lower tax bracket than you would be with your after-tax contribution with a Roth IRA. If you think you will be making more money in retirement and be at a higher tax bracket, then invest in a Roth IRA instead.
What if You Need to Withdraw Funds in the Next Few Years?
With Roth IRAs, you can withdraw your contributions at any time without penalty. The earnings, however, are a different story. However, this is inadvisable since you should keep your money in as long as possible to grow tax-free. If you feel you may be tempted to withdraw in a non-emergency, keep your money in a Traditional IRA. Since withdrawals face a 10% penalty, the cost will serve as motivation to keep the funds in place. If you feel you might need the money for an emergency, then a Roth IRA provides greater flexibility.
What Is Your Financial Situation?
The choice between a Traditional or Roth IRA often comes down to your financial situation. If you are financially stretched, consider taking an immediate deduction with the Traditional IRA. You can use the savings to pay down other debts or pursue another financial goal. If you feel more financially confident, choose the Roth IRA. But whatever you do, make sure the deposits are automatic so that you spare yourself the hassle at tax time.
Withdrawing from an IRA
First, you do not have to start withdrawing from your IRA until you turn 70½. Withdrawing from an IRA depends on
what kind of IRA you have.
•For Traditional IRAs, you pay income tax and a 10% penalty on withdrawals before the age of 59½.
•For Roth IRAs, you can withdraw your contributions at any time without paying any taxes or paying the 10% penalty fee. Your earnings from your Roth IRA are taxed when you make an early withdrawal before the age of 59½ and before you have held the account for at least five years. Earnings are defined as any withdrawals that exceed your total contributions. Also, your account must be open for at least five years,68 starting from the day you made your first contribution, to avoid incurring tax and the 10% penalty on earnings withdrawals.
There are exceptions to paying taxes on Roth IRA withdrawals on your earnings, called qualified distributions, but you need to have the account open at least five years without incurring the early withdrawal 10% penalty and taxes. If you have your account open for at least five years, then you can avoid taxes and the penalty on your earnings for the following reasons:
•Higher education costs for you, your spouse, or your children.69
•Unreimbursed medical bills, if they exceed 10% of your adjusted gross income, or health insurance premiums you pay while you are unemployed.
•Home buying costs, which can include a down payment or closings costs, of up to $10,000. This is the lifetime cap per person, reserved for people who have not owned a home in the past two years.
•You become disabled.
If a withdrawal is not a qualified distribution, then you will also have to pay income taxes on top of the 10% early withdrawal penalty.
You can also borrow money from either a Traditional or Roth IRA and put it back within 60 days without paying taxes or the 10% penalty, but this should be used as a last resort. If you fail to pay back the full amount, you will pay taxes and the penalty on the entire amount of the withdrawal. So, borrower beware!