This article is part of our 52 week journey through Bill’s latest book, The Graduate’s Guide to Life and Money. Each week, a full excerpt from his book will be presented from beginning to end. To get your copy of his book, visit www.TheGraduatesGuide.com.
So where do you begin? Let’s start with your job. Does your employer offer any type of retirement account? Most employers offer a 401(k) plan, or something similar, such as a 403(b) or Thrift Savings Plan (TSP) account. This is usually the first place where you should put some of your money. (The terms 401(k) and 403(b) refer to the section of the IRS code where the rules for these plans are located – Section 401, paragraph k, for instance.)
There are several advantages to using a plan through your employer. Most plans offer some sort of matching amount, based on your contributions. For instance, if you save 5% of your income in a retirement account, your employer might match your 5% by adding an additional 5% into your account. In real numbers, if you earn $30,000 per year, and you put 5% towards your retirement plan, you will save $1,500 per year. If your employer offers a dollar-for-dollar match, your account would actually have $3,000 deposited for the year. That is an automatic 100% return on your money! If your account earns anything during the year, you will be in even better shape.
Of course, you need to ask your employer what type of plan they offer, and what the matching contributions are. Some employers only offer a 50 cents-to-the-dollar match. In this case, you would have to save 10% to get an extra 5% from your employer. In real dollars, if you make $30,000 and save 10%, you will have deposited $3,000 and your employer will have deposited an additional $1,500 in your retirement account. That is a 50% return on your money! Not as good as the last example, but still not a bad deal.
Another advantage is that your contributions come out before federal and state taxes (Social Security and Medicare are still taken out). If you are in the 25% federal and 5% state tax brackets, you are saving an additional 30% up front. The example in Figure 11-1 will show you the total benefits you will get from a pretax retirement account through work with a dollar-for-dollar match for the first 5%.
As you can see, by reducing your take-home pay by just $1,150 (less than $100 per month) you will have $3,000 in your retirement account! That does not even account for any interest you earn. Not a bad deal at all.
You should also notice that one of the first places you should park your cash is in a retirement account through work that has a matching contribution. One other advantage is that your contributions come out before you even see it. That’s right. When you get your paycheck, the money is already in your account, so you don’t have to have the discipline to remember to put it in each month (or each pay period) yourself. Since you never actually saw the money, you won’t really miss it. Now that is a great deal. You could have more than $3,000 in your retirement account after one year, and you never even realized you were sacrificing anything!
There are a few little tips we should cover about your 401(k) plan. You have the ability to get to your money in the event of an emergency (such as a medical emergency or loss of a job). If you do withdraw your 401(k) money before you retire, you will pay a stiff 10% penalty on top of your regular tax rate. In other words, if you withdraw $10,000 and you are in the 30% tax bracket, you will pay $3,000 in taxes (30% x $10,000) and pay a $1,000 penalty (10% x $10,000). Thus you only get to use $6,000 of your $10,000 that you withdrew. You don’t have to be a math person to see how bad of a deal that is.
You also have the ability to take out a loan from your retirement account for the purchase of a home or a few other reasons (based on tax law and company policy). Essentially you are paying interest to yourself for borrowing your own money. The only good part is that you are paying yourself the interest. Here is where it really gets tricky. Let’s say you borrow $10,000 from your 401(k) and then you lose your job or you quit and take another job. You have to pay back the $10,000 immediately (within a very small time frame) or else you will be taxed and penalized as if you withdrew the money. Generally, it is recommended you leave your retirement account alone if you can.
Finally, you have to be careful of the rollover IRA. Whenever you leave your employer, either by choice or by security guard escort, you have to decide what to do with the money that is already in your retirement account through that employer. In many cases, you are allowed to keep your money in the account through the former employer if you have worked for them for a certain length of time (such as three years) or if your balance is above a certain minimum. Whether you want to leave it or take it with you is up to you. Leaving it where it is would be the easiest approach, although if you continue to change jobs every few years, you might be dealing with too many accounts to keep straight. You should also check to see if you still have the same trading privileges you did as an employee. In other words, can you still move your money from one type of investment to another and log in or call to check your balance, etc. If not, you may want to move the money anyway.
So where do you put the money if you take it with you? Your best bet is either the rollover IRA or rolling it into your new company’s 401(k) if they allow it. The rollover IRA is simply an IRA you establish to roll your money into from your current 401(k) plan. Simply choose an investment advisor or financial planner and tell them what you want to do. They can help you with the paper work to get things started and move your money without incurring any penalties. Please be careful when you do this. If it is not properly handled as a “rollover”, the company will cut a check to you, not the brokerage firm, and they will take out your income taxes. Then, if you do not have the money deposited into a retirement plan within thirty days you will owe the 10% penalty as if you withdrew the money. Even worse, if your company takes out federal taxes when they send the check to you, you will pay the 10% penalty on the portion that was taxed, unless you can also come up with that money to put into your new retirement account. Let’s look at an example.
You leave your employer and have $20,000 in your 401(k). Instead of doing a rollover IRA, you simply tell your employer you want the money. They send you a check for about $13,000 (they held back $7,000, which is 35%, for taxes). If you immediately deposit the $13,000 check into a rollover IRA at this point, you will be assessed a 10% penalty on the $7,000 difference. Since the IRS knew you had $20,000 and now only deposited $13,000, they have to charge you this penalty. As you can see, it is very important that you rollover your money correctly. To make matters worse, if you don’t get around to depositing your money until after the 30 days has expired, you will pay a 10% penalty on the whole $20,000. Plus you will have missed your opportunity to put the money into an IRA since there are restrictions on the amount that can be deposited in one year.
If you are self-employed, you have several other options available to you to save for retirement with pre-tax dollars. You can use the Keogh Plan, the Simplified Employee Plan (SEP) or the Solo 401(k). These three plans allow you to save pre-tax dollars from self-employment. You can usually save more through these programs than an IRA.
The best part is that even if you have a regular job working for someone else, but you also have your own business on the side (perhaps you are a wedding photographer or freelance artist on the weekends), you can still contribute from the amount you earn through self-employment. Let’s assume you have maximized your contributions to your 401(k). If you earned $5,000 additional income from self-employment, the rules that apply for the Keogh, SEP or Solo 401(k) apply to that $5,000. In other words, with a Solo 401(k) you could save the entire $5,000 in your retirement plan and pay no federal income taxes on it. What a great way to fund your retirement.
Now that we’ve covered your retirement plan at work, where should you start parking your money? The next “category” that needs your attention is your emergency fund. What is an emergency fund you ask? Some people call it a rainy day fund. Basically it is money you have set aside in the event of an emergency.
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Bill Pratt is a former credit card executive turned student-advocate. He is the author of Extra Credit: The 7 Things Every College Student Needs to Know About Credit Debt & Ca$h and The Graduate’s Guide to Life and Money. Bill speaks at colleges to educate and entertain students about real-life issues in money, leadership, and success. His goal is to help students succeed personally and financially so they can improve the lives of those around them. You can learn more at www.ExtraCreditBook.com or www.TheGraduatesGuide.com.