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The IRA is the best financial tool widely available to just about all of us. As we’ve discussed before,the traditional option of a pension is quickly becoming a fairy tale, or not even an option in some industries.
An IRA can be opened with numerous companies, in fact, you name them, they probably offer it. The basic principle behind the account is to add a portion of your income to some sort of investment vehicle like stocks, bonds, index funds, exchange traded funds, etc. and have your earnings grow tax deferred until you are ready to withdraw them at retirement. There are two basic types of IRA, a traditional and a Roth.
The two accounts are very similar. They both offer tax deferred growth on your money, which allows it to grow faster than if you were to pay taxes on your profits. Both accounts offer the same investment types as well and both accounts charge a penalty of 10% value on any funds withdrawn before retirement(59 1/2 years old).
The main difference between the accounts is how the taxes and contributions are handled. When contributing to a traditional IRA you pay taxes on the income as normal but have certain tax advantages and write offs in return . With a Roth IRA Qualified withdrawals are taken tax free. Deciding between the two is both a matter of personal opinion and income levels. Certain income levels allow for more tax breaks up front with the traditional IRA, but if you don’t qualify for the tax benefits, you’re better off in a Roth. You can check with the IRS to determine this years limits.
If you’re lucky enough to land yourself a full time job in this economy of ours, then by all means start contributing to your companies 401K plan right away. There are a few options that companies can give their employees for these plans, but for right now lets stick to the basics. Let’s go over a traditional 401K plan.
The traditional 401K is a set up by the company for which you work. They choose a series of investments, usually index or mutual funds of varying risk levels, and create their plan from them. You as the employee are eligible to contribute your pre-tax dollars to this plan and if the company offers a matching program, you are not taxed on their contribution either. (limits are $15,500, or $20,500 if you’re over 50–Thanks Joe*)
So let’s say your pay is $100 per week and you decide to contribute 10% of your pay. Let’s further assume you work for Awesome corp, who is willing to match your contributions by 50%. Each week, you earn $100, then pay out $25 dollars to taxes and you end up with $75.
If you contribute the 10% instead, you earn the same $100 but $10 goes to your 401K account first, then Awesome corp adds another $5 making it $15 added to your 401K. Then you are taxed on the $90 you earned and pay out $22.50 this week, leaving you with $67.50.
So what you have here is a take home pay of $7.50 less than you would have if you didn’t contribute, but you’ve gained $15 in investments which brings your overall pay to $90 instead of $75. In the end you pay less taxes, get more from your company in return and take a very small hit to your cash on hand. I call that a win -win.
All contributions are pretax, you don’t pay any income taxes on the money until you withdraw it. What this means for you, is that you have more money to add to the account and more money in means greater earning potential for you. When you withdraw the funds at retirement you are taxed at the current income tax bracket you are in at the time. This is what they call a tax deferred investment. I can’t stress enough how important this product is to anyone looking to retire in comfort. Find out what your company is willing to match and max out your earnings by taking advantage of every penny. If they offer a match up to 10% and you can afford it, do it for as long as possible. If they offer a match up to 1%, do that too. A good rule of thumb here is to contribute only what they will match, so every dollar you add earns more, anything past that could be better used in other investments.
Back in our parents generation things were simple. Get a job, earn a pension, maintain a savings account, buy a house and retire on that pension and paid off home.
Those were the days.
Big companies, long touted for their excellent retirement packages, have turned to reducing or eliminating benefits completely. Couple that with the fact that social security will be out of money in a few years and you see a bleak outlook for the upcoming generation of retirees. What this tells us, is that our generation will be the first to have to provide our own retirement packages. Although it seems that big business has screwed us once again, ……..well OK, they have.
So how do you survive the long haul when you can’t work anymore? Invest in you’re future now while you have income. There are many options to use to build personal wealth and you my friend, are going to have to use them all. I’ll go over what each option is and amend this article as I add new choices for you to go over, but for now, let’s hit the big ones:
When I started working for my last employer, I decided to take advantage of the matching offer their plan had at the time. Through fidelity, I opened my 401K and dumped 4% of my pay into it each week, for which the company matched 2% on top. Year by year it grew slowly and surely just as I was told it would, that is until the end of last year of course. By the end of 07′ I started taking little hits, just a few bucks here and there but mostly it did nothing, zero growth , to me anyway, is still a loss. Then when the clock struck 2008, it really headed south. As the country entered this “Not a recession” the markets, and my portfolio, decided to head south for the winter, and seeing as its now summer I had hoped they’d be back by now….guess they like it down there.
So as I do every month I opened up my financial spreadsheets and started crunching the numbers. I had lost over 4.4% of my portfolio in 08′ so far. To say the least I was a bit angry at this. I was in a set of funds that historically produced an average of 8% each year and I had lost over 4%. To me of course, in my own math I’m down 12.4% for the year. As I went over the rest of my spreadsheet I noticed id’ been losing a lot of money on a loan I had gotten a few years back. Comparing the loan with my 401K, I came to a realization.
The loan would take me about 2 more years to pay off. I added up all the interest payments I would have to make in those two years. Then I took the balance of my 401K and figured out how much money I would have lost If I continued to lose 4% a year, then how much I could possibly make on that same investment if I had gained the estimated 8% a year that it had historically earned. In both cases, the amount of money lost from the loan was a significant amount more than any amount I could have made by staying in the market.
I can already hear the cries in the background saying that the compounding of the investment gains have to be considered, but rest assured we’re dealing in fairly small amounts of money here, so compounding losses won’t hurt me in the long run. Also, the amount of money I’m saving on the loan can now be added to my Roth IRA, which will net me a greater savings and greater investment than having left it in my currently slumping 401K. So now all the money that was once going to that last debt every month is now going into building a positive investment instead.
Less loss + more savings = better deal
Next post: This old house, looking to our first home.