Printable Version

Putting money into retirement plans

"Who is not ready today will not be ready tomorrow." -Proverb

Qualified retirement plans and IRAs offer a tax-advantaged way to save for your retirement and provide substantial wealth for subsequent generations. Today, if you work, you probably have some type of retirement plan-company sponsored or your own IRA, or both. You can even provide an IRA for a nonworking spouse. And new tax laws allow those age 50 and older to save additional amounts.

How you invest in retirement plans will affect the amount of money you have for your retirement. So make sure you understand your options and take advantage of strategies now and in coming years to maximize your savings.

Building up funds in retirement plans

Retirement plans are tax-deferred savings vehicles where funds compound without any reduction for taxes. This means that funds build up faster than in taxable vehicles. Over time, the difference can be quite dramatic (depending, of course, on the rate of return).

Strategy: Shift money into tax-deferred savings early in the year so to optimize the effect of compounding. Example: Although you are permitted to make a deductible IRA contribution for 2005 at any time between January 1, 2005, and April 15, 2006, a contribution at the start of 2005 means 15 months of additional compounding. Over time, this can add considerably to your savings.

Roth IRAs

The Roth IRA is the best of all possible worlds because it offers the opportunity for tax-free buildup of income. As long as certain holding requirements are satisfied, funds aren't withdrawn until the account has been open for five years and distributions are started at attaining age 59, paying first time home buying expenses (up to $10,000 in a lifetime) or becoming disabled or dying, there's never any tax on the earnings.

Catch: You must fund the Roth IRA with after-tax dollars, so you don't get any immediate tax benefit by making the contribution. And there are limits on eligibility to contribute to a Roth IRA. High-income taxpayers-modified adjusted gross income of more than $160,000 on a joint return or $110,000 for singles are barred from doing so.

401(k) contributions

401(k) plans are widespread because they allow companies to shift the cost of retirement contributions largely to employees. Employees can contribute limited amounts to company-sponsored 401(k) plans to build up their retirement savings. Contributions are made on a pretax basis through salary reduction agreements.

Example: If your salary is $50,000 and you agree to contribute $5,000 to your 401(k) plan, your taxable salary is only $45,000 ($50,000 less $5,000 salary reduction contributed to the plan).

There's an annual limit on salary reduction amounts. The limit is $14,000 in 2005. It will increase to $15,000 in 2006. Thereafter the dollar limit will be adjusted for inflation.

Those age 50 or older are permitted to make additional "catch-up" contributions regardless of whether they under contributed in prior years. The dollar limit on these contributions is $4,000 in 2005. The limit will increase to $5,000 in 2006. Thereafter the catch up contribution limit will be adjusted for inflation.

Despite the obvious benefits of participating in the plans, it's been estimated that about 30% of eligible employees don't participate. Whether you're a new or current employee, you may be automatically enrolled in your company's 401(k) plan. The company can set a limit on your salary reduction amount, but only you can choose whether to participate. Don't opt out! It's shrewd to contribute.

Your contributions may yield more than you think. Many employers provide matching contributions as a means of encouraging employees to participate in these plans.

Example: Your employer matches 50% of all employee contributions, so making your own $5,000 contribution would entitle you to a $2,500 employer contribution on your behalf. The $2,500 is like "free" money. You get it simply by making your own contribution.

Caution: Although your contributions through salary reductions are fully vested (you can't lose them even if you leave employment), you may have to complete a fixed number of years of employment to be fully vested in employer contributions. If you leave a job before you're fully vested in the plan, you will lose the employer contributions.

Timing contributions

Salary reductions are usually made ratably with each pay period or once a month. If you have employer matching contributions and you plan to make the largest permissible contributions, time your contributions to obtain the highest matching contributions possible. Generally it's advisable to make your annual contribution ratably over 12 months. So if you plan to contribute the maximum allowable amount of $14,000 in 2005, you would contribute $1,000 via salary reduction each month.

Example: If you earn $100,000 per year and participate in a company 401(k) plan that matches 50% of your contribution of up to 6% of your income, you may receive an employer contribution of up to $6,000. You're permitted to contribute $14,000 in 2005. If you make your $14,000 contribution in $1,400 monthly payments, you'll complete your contributions in October and lose out on some employer matching. The employer contribution in this situation would be only $2,500 ($83,333 x 6% x 50%), or $500 less than if you made your $14,000 contribution ratably over 12 months.

On the other hand, if you anticipate retirement or otherwise leaving employment during the year, accelerate your contributions to put as much into your account as possible.

Coordinating contributions for married couples

If you and your spouse both work for employers with 401(k) plans but as a couple can't afford the maximum contributions to both plans, consider coordinating the contributions that each of you makes. Decide how much you can afford to contribute in total as a couple. Contribute the maximum (up to the salary reduction limit) to the plan with the better investment options.

Example: Your budget permits total contributions for the year of $15,000 (when the salary reduction limit per participant is $14,000). Each person may contribute $7,500. Or you may contribute $14,000 to the plan that offers the better investment options and $1,000 to the other person's plan.

If both spouses' plans offer similar investment options, consider putting the greater share into the 401(k) of the younger spouse. This will allow for longer deferral, as funds won't have to be tapped until the younger spouse attains age 70 (or even later, if the younger spouse continues to work).

In deciding how to split your 401(k) contributions, consider the psychological benefit for each spouse having independent retirement savings. This may be especially important if you experience marital difficulties in the future. Note: Qualified retirement benefits may be divided in a divorce settlement on a tax free basis. Thus, if a couple decides that one spouse will make the full contribution and the other spouse makes no contribution, the noncontributing spouse could still receive a share of the other spouse's 401(k) plan if the couple splits up.

Selecting your investments

By law, your employer must offer a menu of investment options-at least three, but many companies' 401(k) plans typically offer 10 to 15 choices. Your employer does not give you investment advice and, in fact, is not permitted to do so by law.

However, your employer may provide you with information booklets or seminars and suggest Web sites that provide 401(k) investment advice. Research your investment choices through the Web sites of brokerage firms. Other useful sites include:

• InvestorLinks.com (www.investorlinks.com)
• Investopedia.com (www.investopedia.com)
• CNN Money (http://money.cnn.com)
• Morningstar (www.morningstar.com)

To make the most of your investment choices, use the same approaches and strategies you would adopt for personal investments made outside of the 401(k) arena. Most importantly, coordinate the holdings in your 401(k) with those in your personal investment accounts.

• Employer stock. You may be permitted to invest in company stock, an advantage because you usually obtain employer stock at attractive prices. The downside to this is that it concentrates too much of your financial interests in one company. Not only does your job depend on the fiscal health of the business, but your future retirement income is also dependent on the company's financial success if you invest your retirement funds heavily in company stock.