Monday, April 02, 2007

How to Save for Retirement

I was having lunch with some colleagues the other day, and the conversation turned to job benefits, as one of the people at the lunch was about to leave for a new job in a different field. He was surprised that his new job offered a good old-fashioned pension, which is increasingly rare. This got us talking about retirement savings, as one of the people at the table asked if everyone contributed to our company's 401k plan. I was happy to hear that everyone did. Then this guy said to me "If this is too personal a question you don't have to answer it, but what percentage do you contribute? Do you put in the maximum?"
I rarely have moments like this, where the reticence of my "real life" self collides with the openness of my blog persona. But I decided to answer the question fairly openly, saying that I had always tried to contribute the maximum. Then he asked "Do you mean the maximum to get the employer matching contribution, or the maximum overall?" This began to feel slightly more awkward to answer, as a couple of the people in the conversation were entry level staff for whom hitting the $15k maximum would consume half their salary, but again I said that I tried to hit the overall maximum. My interrogator then said "Wow, that's great, but I've heard some people say you should only do enough to get the matching contributions." I answered that yes, some people did believe you should do that, and then make contributions to a Roth IRA instead. His response:

"What is a Roth IRA?"

I found this really surprising. The guy who asked me is very smart, almost my age, and recently bought his first house. I found it hard to believe he had never heard of a Roth IRA, but I guess it's easy to forget that for people who aren't finance junkies, these kinds of topics might just be under the radar most of the time.
So I didn't run out to a phone booth and change into a Statue of Liberty costume and sunglasses, but I did inwardly put on my Madame X hat for a moment to explain the following to my lunch companions:

Retirement Savings 101: a lay person's very basic explanation.*

For most people like me, i.e. full time employees of companies that offer benefits, there are 4 basic ways you might fund your retirement.

1) Traditional Pension, aka defined benefit plan: this is a plan where you don't contribute anything. Your employer agrees to pay you a certain amount of money when you retire, probably a monthly or annual amount until you die. The amount will be higher the longer you've worked for the company. If you leave the company before retirement, you will probably be "vested" in some portion of that money, meaning they either pay you a sum of cash when you leave, or you have to get back in touch with your former employer to get whatever benefit may still be due to you when you retire. If you are so lucky as to have one of these, great! But you'd better save some other money too-- if your company gets into financial trouble or mis-manages its pension fund, your retirement money could be reduced if it's above the level the government insures.

2) 401k Plan, aka defined contribution plan: this is the more common form of retirement savings plan for most employees today. You have to choose to participate, and choose what percentage of your salary you'd like to contribute, up to an annual maximum which is currently $15,000 for employees under age 50. That money is then deducted from your income before taxes-- it lowers your taxable income, so you pay less in taxes. When you reach retirement age you can start to withdraw the money, and you will be taxed on it then. Most employers will match a percentage of your contributions. If you change jobs, you get to keep all of your own contributions, and whatever portion of the employer contribution you are vested in, depending on how long you've been at the job. You can then leave the funds with whoever currently administers them, or roll them over into the 401k at your new job. You could also cash it out, but you'd lose 20% to taxes right away.

3) Roth IRA, another defined contribution plan: for a Roth IRA, you're on your own, as it's not something you do through your employer. But it's easy to open one: any bank should be able to open a Roth IRA account in the form of a CD and online brokerages can give you a Roth IRA account if you want to invest the money in stocks or mutual funds, etc. You can contribute up to $4,000 for 2007, in a lump sum or gradually throughout the year. You even have until April 15th, 2007 to make your 2006 contribution, but beyond that, you can't backtrack if you miss a year. If your income as an individual is above $95,000-- not your salary but your adjusted gross income on your tax return-- your contribution limit is reduced. If your income is above $110,000, you can't contribute to a Roth IRA at all. With a Roth, you are contributing money after already having paid taxes, so when you withdraw it at retirement, no more taxes are due.

What you'll want to think about when deciding how much you want to contribute to a 401k and/or a Roth IRA is how best to maximize your employer's matching contributions, and what your taxes are now vs. what they are likely to be in the future. The usual thinking is that if you are starting out in your career and expect to be in a higher tax bracket by the time you retire, it makes sense to maximize the Roth IRA, so for many people, the priority should be to first contribute enough to a 401k to get the maximum match from your employer, then max out your Roth IRA. My personal opinion is that you should then continue to contribute more to your 401k, up to the annual maximum if you possibly can. It's a great way to save without having to think about it and if you get into the habit early enough, you'll find that you learn to live without that money and don't miss it much.

4) Social Security: you pay into the Social Security system via a payroll deduction whether you like it or not. And when you retire, you will be entitled to a payment from the Social Security system. There has been a lot of political debate about whether or not this system is sustainable, whether it should exist, whether the baby boomers will bankrupt it before the younger generations can retire, etc. My thinking is that you should not count on having whatever your Social Security statement says you will probably get. Save money for your retirement in other ways, as if those savings were all you'd have to live on. Chances are you WILL get something from Social Security, but let that be the icing on the cake.

So that is my very simplistic explanation of some ways to prevent starvation and homelessness when you're a senior citizen. Remember that no matter what method of retirement savings you choose, it's important to start now if you haven't already-- you need time to let those savings grow! I've been saving for retirement since my first job after college. I'm still under 40 and I have almost $200,000 saved specifically for retirement. Am I saving enough to have the retirement lifestyle I'd like to have? (i.e., comfortable, but definitely won't involve a pool boy.) We shall see-- though I think I'm on the right track, I do worry that I'll fall short. How do I know? That involves some educated guesswork that I'll discuss more in another post, but for a start, try a retirement calculator like this one online and plug in some numbers. I doubt you will be pleasantly surprised!

*PLEASE remember that I am NOT a finance professional and that you must do your own research to make the right choices for your own personal situation!


Amy K. said...

Two small comments:

1. A neat "are you on track to retire early" calculator is here.

2. Don't forget Traditional IRAs, another retirement vehicle for those with an AGI over the Roth IRA limit who want to contribute more than $15K/year to tax-advantaged accounts. Contributions to the Traditional IRAs are not taxed now (they're a deduction when you do your taxes) but they are taxed when you withdraw the funds in retirement. Contribution to traditional and roth IRAs COMBINED is capped at $4,000/year in 2007.

frugal zeitgeist said...

Sing it, sister.

An addendum to Amy's comment: traditional IRA's are convertible to Roth in 2010, the same year in which the income restriction on the Roth goes away. If you want to contribute to a Roth but are shut out, dump all of your IRA money into a traditional IRA and convert it in a couple of years.

Anonymous said...

You left out a newer Roth 401(k) option.

miranda said...

Excellent advice here!

I wish that there was more education out there. I, too, am amazed at times to realize that things I think are basic (like IRAs) are not general knowledge.


Anonymous said...

As to how to answer your co-workers about your level of contribution, you can say that you contribute maximum percentage allowed (which is 15%). You can say this without having to reveal or hint what your actual salary is.

Katrina said...

If you have a pension do/should you include it in calculating your networth?

Anonymous said...

One additional point, Traditional IRA's may not be deductible on your current year taxes based on 401K particpation + AGI limits. Still a useful savings tool though.

Anonymous said...

Anon 4/02/2007 6:48 PM:

15% is not the maximum percentage contribution allowed. That was a common limit at one point (up to a few years ago), but no longer. Now most plans will let you contribute 50% or more of your salary, as long as you don't exceed the legal maximum contribution of $15,000 a year (higher for folks over 50 who can make the catch-up contribution). (Yes, some companies may still limit your contribution to 15% of pay, but this is uncommon now.)

fin_indie said...

Retirement, my favorite subject!
Well, I was definitely NOT expecting him to not know about a Roth... Hope you set him straight.

So the question is: why don't we have more conversations like this "in-person"?? When I find friends who share my finance junkie attitude, I cling to them like a dingy in a vast ocean.

Anonymous said...

I am one of the lucky pension-having people. In my case, both my employer and I make a contribution. The part I contribute is tax-deferred, like with a 401k. The payments I get later will all be taxed.

If I leave early, I can withdraw my contributions, but not my employer's, so I like to include my contributions in my net worth calculation.

One note about IRAs--you can invest this money anywhere you want, so, for example, you can find index funds with the lowest fees. With your employer (the 401k), you can usually find something acceptable, but you might be able to find something better on your own (the IRA). However, you employer may also have been able to negotiate lower fees for the products it does provide.

Another thing about IRAs is that you can withdraw the amount you put in (but not the gains) at any time with no penalty. And if you retire early, you can make substantial, equal withdrawals over several years (based on a formula) to start getting the money at any age without paying penalties. So overall they are just a lot more flexible that 401k's, though smaller.

Finally, another option is to invest on your own. This is sort of like using a Roth except that a) there are no restrictions at all and b) you are taxed on the growth, but the capital gains are taxed at capital gains rates, which are much lower than income rates. Every time you sell one thing to buy something new, you pay the taxes on the gains you've got so far, so that's fewer taxes you'll be paying in the future (when I really think rates will go up).

My strategy: I have a good pension, then max out a Roth IRA (because I think taxes are going nowhere but up) and then contribute to a Roth 403(b) (it's like a 401k, only for nonprofits). (I am one of those people who could never contribute the max to a 401k because, you know, I like to eat and live indoors--so far I contribute only a token amount to my 403b, but it's a start.)

Madame X, you might want to talk to personnel to find out if they offer Roth 401k's and, if not, to say you would like them to. The more interest they hear, the more likely they are to offer one. This worked at my employer, who just started offering one this year, although we were allowed to starting last year.

Anonymous said...

For those Canadians who read this, there are very similar retirement options.

RRSP's: Registered Retirement Savings Plan. These are plans that you set up with a bank/other financial institution that all money you put in is not taxed (so you get a refund). You can use almost anything as part of your RRSP's, such as stocks, bonds, mutual funds etc.

Canadian Pension Plan: all employees have to contribute to this, but if you're around my age (28) don't expect to get much out of this when you're ready to all the baby boomers will have used up much of the fund.

Old age security: this depends on your income after retirement and is a sliding scale up to a certain amount. (~ $60,000)

and of course, any pension plans that you may have with your employer.

I am NOT a financial pro, check all of these for yourself!

Anonymous said...

If your company allows it (some cap the percentage you can contribute, based on your salary and the participation of lower-paid employees), the 2007 401(k) limit is $15,500.

Another quick and dirty retirement plan estimator:

zacharyfruhling said...

I just started a Roth IRA in January. it is my new best friend! lol

Adventures In Money Making said...

here's a link to

Anonymous said...

Some good tips here. I definitely suggest pursuing the roth IRA accounts because they are so easy to setup and invest in.

Pension plans are also good choices because many are mandatory, and you already earned it through hard work and dedication to the business.

I think people mistake the benefits of the 401k. It's only powerful if your company matches contributions. That way you earn twice the money when you max out on your part.