The Money Class

by Suze Orman

  RETIREMENT PLANS OFFERED BY EMPLOYERS

  Many of us have access to a retirement plan at work. They have many different names, but essentially they all work in the same way. The most common workplace retirement plans are 401(k)s, 403(b)s, 457s, and the Thrift Savings Plan.

  A 401(k) is offered by for-profit companies. A 403(b), also known as a tax-sheltered annuity (TSA), is a retirement plan for certain public-sector employees such as teachers, as well as some nonprofit workers. The 457 plans are offered to government employees and can also be used by nonprofits as well. The Thrift Savings Plan (TSP) is offered to federal civilian employees as well as members of the military.

  The basic structure of all of these employer-based plans is similar: You contribute a portion of your salary into a personal retirement account held at your place of work. Some employers add a matching contribution and some do not.

  In 2011, the maximum annual amount allowed by federal law that you may contribute to a 401(k) if you are under 50 is $16,500. (This amount is adjusted annually, when necessary, to keep pace with inflation. Check with your plan at the end of October to find out if the limit will be raised for the coming year.) Your employer has the right to set an even lower limit. For example, if your employer allows contributions equal to 10% of your salary, and you make $40,000, your contribution will be limited to $4,000.

  Your contributions lower your taxable income. Money you invest in a company-sponsored retirement plan reduces your taxable income for that year. So, for example, if you make $60,000 and you put $10,000 into a 401(k), your taxable income drops to $50,000.

  Your money grows tax-deferred while it is invested. You owe no tax as long as your money stays inside your retirement plan. That is, your money grows tax-deferred. There is a big difference between tax-deferred and tax-free, so I want to make sure you understand this completely. Tax-deferred means that you will eventually owe taxes on the money, just not now. Tax-free means you owe no tax. But make no mistake, the tax-deferred benefit is indeed valuable. Allowing your money to grow over decades without having to pay taxes each year is a big deal.

  RETIREMENT PLAN WITHDRAWAL RULES

  Once your money is invested in a company retirement plan you will want to leave it untouched until you are at least 59½. That’s the age when the federal government says it’s okay to start making withdrawals. If you want to withdraw money before that age you will have to pay a 10% early withdrawal penalty. (One exception is if you leave the employer where your 401(k) is and you turn 55 or older in the year you left service; in that case you can make withdrawals in any amount you want from that account without owing the 10% penalty. Please note, however, that this exception does not apply to IRAs.)

  Any money you withdraw from your traditional 401(k) will, however, be subject to ordinary income tax. Through the 2012 tax year, ordinary income tax rates range from 10% to 35%, based on your income.

  Some employers now offer a Roth 401(k), in addition to a traditional 401(k). I explain Roth 401(k)s in greater detail later in this chapter.

  NON-WORKPLACE RETIREMENT ACCOUNTS

  Whether you work for a company or not, you are eligible to contribute to an individual retirement account (IRA). There are two broad types of IRAs: traditional IRAs and Roth IRAs.

  A traditional IRA works much like a 401(k). Based on your income, you may be able to make a tax-deductible contribution, and your IRA money grows tax-deferred while it is invested. When you make withdrawals in retirement you will pay income tax. Again, in most cases if you withdraw money before you reach age 59½ you will owe a 10% penalty in addition to the regular income tax owed on all withdrawals. Please note that all traditional IRAs are eligible to be converted to a Roth.

  In 2011 you can contribute up to $5,000 to an IRA if you are younger than 50. Married couples can contribute a total of $10,000, as long as at least one spouse has earned income of at least $10,000.

  You can make a contribution to a deductible IRA if:

  You have access to a retirement plan at work and your income is below $66,000 ($110,000 for married couples that file a joint tax return);

  You don’t have an employer-based retirement plan (there are no income limits in this case); or

  One spouse has access to a employer-based retirement plan but your joint income is below $179,000.

  NONDEDUCTIBLE IRAS

  If you do not meet the deductibility rules, you can still contribute to an IRA. The only difference is that your contributions will not be deductible, so you will not get a break on your income tax return for that year. But your investment earnings still get the same advantage of growing tax-deferred until you start making withdrawals in retirement.

  ROTH IRAS

  If you have been following my advice for years, you are well aware that I think a Roth IRA is the best retirement account you can have.

  A Roth IRA does not allow you to claim any tax deduction for your contributions. You invest money that has already been taxed (after-tax income). As a result, in retirement your withdrawals will be 100% tax-free—yes, tax-free, not tax-deferred. No income tax, no capital gains tax. As long as you wait until you are 59½ to withdraw earnings on your original contributions and you have had the account for at least five years, there will be no tax on any of it. Your contributions can be withdrawn at any age, any time you want, without a penalty or income tax.

  The ability to have tax-free income in retirement is the most compelling aspect of the Roth IRA. In the coming years I expect tax rates to rise. If that comes to pass, having tax-free income will become even more valuable.

  Beyond the tax issue, the Roth IRA gives you other valuable benefits. There is no required minimum distribution (RMD) for a Roth IRA. If you do not need the money in a Roth when you’re retired, you can leave the account untouched. With a traditional IRA, Uncle Sam insists that you begin to make withdrawals (RMDs, in IRS-speak) after you turn 70½. A Roth can also be a backup emergency fund. Because your contributions are made with after-tax dollars, you are free to withdraw them (though not the earnings on them) at any age without incurring taxes or penalties. I want to be clear: Your goal should always be to leave every penny in your Roth IRA untouched until you retire. Your Roth should not take the place of an emergency fund, but it can serve as a backup in case your primary emergency fund isn’t enough to cover your needs in a true emergency.

  Roth contribution limits are the same as those of a traditional IRA: In 2011 you can contribute a maximum of $5,000 to a Roth IRA. Married couples can contribute a total of $10,000 (again—as long as at least one spouse has earned income of at least $10,000).

  Anyone can invest in a Roth—2010 brought this welcome change in legislation. If you meet the income limits (see below), you can invest directly in a Roth. If your income exceeds the limits, I explain below how you can still benefit from having a Roth.

  Income Limits for Direct Investment in a Roth IRA

  If you are single and your modified adjusted gross income (MAGI) is under $107,000 or if you are married and your joint income is below $169,000, you can invest directly in a Roth IRA up to the full annual limit. (For most of us, our MAGI is the same as our standard adjusted gross income [AGI] on our federal tax return. So what’s AGI? It’s all the money you made in a year—your income and earnings on taxable investments—minus certain deductions.) Reduced contributions are allowed for individuals with MAGI between $107,000 and $122,000 and married couples with joint MAGI between $169,000 and $179,000.

  If your income is too high for a direct investment in a Roth IRA you can make a contribution to a nondeductible traditional IRA. Fairly simple paperwork is required to then convert that account to a Roth IRA. If this is the only IRA account you have and you make the conversion immediately you will likely owe no tax. However, if you have old IRAs, you may owe tax at the time you convert. I recommend you work with a trusted tax advisor if you have other IRA assets and you are considering a conversion, because the tax rules can be complicated. Your tax advisor
can also show you how converting smaller sums over the years can be a smart option.

  RETIREMENT PLANS FOR THE SELF-EMPLOYED

  If you are self-employed you have a few other options in addition to the traditional IRA and Roth IRA. A SEP-IRA allows you to make a tax-deductible contribution of as much as 25% of your income, up to a maximum of $49,000. A solo 401(k) and a SIMPLE IRA are other kinds of retirement plans for the self-employed.

  Go to The Classroom at www.suzeorman.com:

  For those of you who are self-employed, I encourage you to learn more at my website about the special retirement accounts you can invest in.

  LESSON 3. HOW MUCH YOU NEED TO SAVE FOR RETIREMENT

  Once again, as a first step, I’m going to begin by asking you to commit to living below your means. As I explained at the very beginning of this book, acceptance of this concept—wholly, with your head and your gut—is essential for creating your New American Dream, and it is particularly important when it comes to reaching your retirement goals. The reality is that you must find a way to save as much as possible today for your retirement, no matter how many years away it may be. Finding ways to reduce your expenses today will have a double payoff for you: First, you will free up money that can be redirected into retirement savings. Second, you will have trained yourself to live on less, so you will need less money in retirement to support your (less expensive) lifestyle.

  Now that brings us to the two questions I am asked all the time:

  How much do I need to save for retirement?

  Which retirement account is best for me?

  THE RETIREMENT FORMULA

  The more you save today, the better. If you ask me, there is no such thing as putting away too much money. At a minimum I want you to figure out a way to set aside 15% of your pre-tax salary each and every year, starting as early as possible. If you wait until your 40s and 50s to get serious about saving, you will need to set aside 25% or more of your gross salary. Let’s be honest: Playing catch-up at the rate of 25% of your salary is not likely something you will be able to do.

  I know, I know. Fifteen percent of your salary today sounds like so much to give up. But it is in fact a solid rule of thumb to make sure the combination of your savings and your Social Security benefit will give you enough retirement income to match about 70% or so of your pre-retirement living expenses. Trust me on this one.

  The Best 401(k) and IRA Strategy

  Now we’re ready to learn how to make the most out of your retirement savings. The goal for most of you will be to have a mix of 401(k) and IRA savings. Here is a step-by-step strategy for how to save for retirement:

  STEP 1. Save in a 401(k) plan if your employer offers a matching contribution. Contribute enough to qualify for the maximum company match.

  More than 20% of workers don’t contribute enough to earn the maximum their company offers to match. I don’t care what other financial issues you are dealing with in your life—you must always take advantage of a match when it is offered. That match is just like a bonus, and if you turn your back on this bonus it is literally throwing money away.

  Every company has its own method for calculating the match. A common formula is that your employer will give you 50 cents for every dollar you put into your 401(k), up to a limit of 6% of your salary. In other words, if you contribute 6%, your employer will kick in another 3%. Let’s say your salary is $75,000. If you set aside 6% of your paycheck ($4,500) your employer would then contribute another $2,250. The employer match just boosted your account balance by 50%! That is a seriously great deal. And your 6% plus your employer’s 3% gets you to a total retirement savings rate of 9%. That’s more than halfway to our goal of 15%.

  Please check with your employer to make sure that you are in fact investing enough to qualify for the maximum company match. I have to warn you that an odd quirk in how 401(k) plans are set up for new employees means that many of you may be inadvertently contributing too little to get the full bonus matching contribution you are entitled to.

  A few years ago many employers switched to a new system that automatically enrolls all new employees in the 401(k) when they are hired. That is, rather than asking you if you want to join the plan, or waiting for you to sign the paperwork to start your retirement saving, the employer just automatically puts you in the plan. You can always choose to opt out after the fact, but the system is now set up to assume you want to be in the plan from the get-go. That is indeed a fabulous improvement in how our 401(k)s work; it means more people will start saving at a younger age. But there’s a kink that needs to be worked out. When most employers automatically enroll a new employee in the 401(k) they set your contribution rate at 3% of your salary. Why so low? Well, the theory is that they don’t want to scare you away by setting this “default contribution rate” any higher.

  You are being led into a costly mistake. As I just explained, many employers will match your contributions up to the first 6% of your salary, up to a set dollar limit. So if you are only contributing 3% because that’s what they set it at when they enrolled you, there’s a chance you may not be capturing all of the company match you are entitled to. Give HR a call and make sure you are indeed contributing at a level that guarantees your account will have the maximum employer match added to it.

  A word on vesting: The money you contribute to your 401(k) is 100% yours from the moment you make the contribution. But the money your employer contributes to your account typically becomes yours over time. For example, some firms have a three-year vesting formula. After the first year, one-third of the matching contribution becomes yours; after two years another third vests; and at the end of the third year all of the match is 100% yours—that is, you are fully vested. So if you left the company after one year—voluntarily or not—you would be entitled to keep one-third of the match, after two years you would keep two-thirds, and after three years all of the match would be yours.

  Opt for a Roth 401(k) if it is offered as part of your plan. A growing number of companies now offer the option of contributing to a traditional or a Roth 401(k). If your plan has a Roth 401(k), it is probably the best choice.

  A Roth 401(k) is a cousin to the Roth IRA described earlier in this chapter. The money you use to make your contribution comes out of your paycheck after taxes have been taken out. So there is no up-front tax break on your contributions as there is with a regular 401(k), but once again, the big payoff comes in retirement. Withdrawals from a Roth 401(k) after the age of 59½ are 100% tax-free, whereas withdrawals from your regular 401(k) plan will always be taxed as ordinary income. It’s my belief that the ability to have tax-free income in retirement is a smart move, regardless of what happens to tax rates in the future. The Roth 401(k) also gives you a lot more flexibility if you intend to leave money to heirs. Once you reach age 70½ the federal government insists that you start to take money out of a regular 401(k) if you are no longer working; this is what is called a required minimum distribution (RMD). With a Roth 401(k) there is no RMD; you can just let it grow for future generations. And when your beneficiaries inherit your Roth 401(k) they too will be able to withdraw this money tax-free.

  STEP 2. Contribute to a Roth IRA.

  Once you have contributed enough to your 401(k) to earn the maximum company matching contribution, or if there is no match available, your goal should be to fund your own Roth IRA.

  Caveat for those of you with a Roth 401(k): If you are contributing to a Roth 401(k) you could in fact skip this step on Roth IRAs. You could just keep contributing more to your Roth 401(k), above what you need to invest to get the company match. Remember, in most instances you can invest up to $16,500 in a Roth 401(k) in 2011 if you are under age 50. And indeed, if you want to keep things simple, it’s fine to focus all your money and attention on your Roth 401(k). The most important thing here is that you are indeed saving up. But if you want to get an A in this class, I think you should consider opening a Roth IRA even if you have a Roth 401(k). With a Roth IRA you have the freedom
to invest in thousands of low-cost investments, including exchange traded funds (ETFs), rather than be limited to the choices offered within your 401(k) plan. And even though I never want you to touch your retirement savings before retirement, the fact that you can take out money that you have contributed to a Roth IRA—though not the earnings—at any time without tax or penalty means it can moonlight as a backup emergency fund. So once you get the maximum match from your employer in a Roth 401(k), my advice is to then focus on a Roth IRA.

  ALTERNATIVE STEP 2. Contribute to a Traditional Nondeductible IRA and Convert to a Roth IRA.

  As I explained above, if your income disqualifies you for direct investment in a Roth IRA, you have a two-step option: Make a nondeductible contribution to a traditional IRA and then convert that IRA into a Roth IRA. If you have other IRA funds please work with a tax advisor before you make this move; the tax rules are tricky and you don’t want to have any ugly surprises.

  Go to The Classroom at www.suzeorman.com:

  On my website I explain the tax rules for Roth IRA conversions.

  How much to invest in your Roth IRA? Remember what I said earlier: The more you save for retirement today, the better your chances of reaching your retirement dreams. The annual maximum you can contribute in 2011 is $5,000. Make that your goal. What you can afford to save is of course a function of your current salary and your other financial obligations. But please stop here for a moment and seriously stand in your truth. Your future retirement success is rooted in the savings choices you make today. I want you to summon the lesson we discussed in Class 2: You are standing in the truth when the pleasure of saving equals the pleasure of spending. Saving for retirement is your most important savings goal.