Money Mommy

Stuff your mom should have taught you, but didn't…

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Category: Retirement

Returns are lower in IRA’s and 401K’s, Right?

I recently had someone tell me that they couldn’t make as much money in their IRA or 401K as they could if they just left their investment dollars in a regular taxable account. Huh?

Typical investment places include bank accounts, stocks, bonds, mutual funds, ETF’s. Money saved and invested in these places can be your taxable funds, as well as IRA’s and 401K’s.

The simplest and safest place to put your money is in a bank CD. You will earn a pittance in interest, but your money will be safe. Both your taxable money and your IRA money will earn the same interest rate. At the end of the year, interest earned in your taxable account must be included in your yearly taxable income, but the interest in your IRA will not be taxed.

Likewise, you can purchase $300 worth of stock from Company X with either your taxable money or your IRA money.  Let’s say you picked a great stock and your money nearly doubled! You choose to take your profit and you sell Company X for $500.00.  You now owe taxes on $200.00 if this was in your regular account. That same $200 profit earned in the IRA will not be taxed.

401k’s work essentially the same way. Generally, there is a more limited investment choice of mutual funds for your 401K dollars which will make an exact comparison a little more difficult. The concept is the same. If a mutual fund goes up; every account that has invested in that fund will go up whether it is a 401K, IRA, or regular account.

Whatever investment you have in a taxable account will be taxed the year you receive that money. This includes dividends and interest that may be reinvested. Whatever investment you have in a Traditional IRA or 401K will not be taxed UNTIL you actually take funds out at retirement. If you have these funds in a ROTH IRA or Roth 401K, you may never pay taxes on them.

So to be clear – whether you invest in regular accounts, IRA’s, or 401K’s, your money will grow at the exact same rate. What changes will be the tax you pay.  But that is for a later blog.

Roth IRA’s – One Size Fits All

OK.  Maybe not all.  But most.  Whether you are just starting out or well into your career the Roth IRA will provide you with an exciting way to save on taxes and ultimately hold onto more of your money.  I recommend it as the vehicle to save for that all important emergency fund, first home, college fund, and, of course, retirement.  And, let’s face it, unless you plan on kicking the bucket in a few short weeks, who doesn’t need an emergency fund or retirement fund?
The Roth IRA has one awesome characteristic.  All monies contributed to your Roth IRA are after tax dollars.  That means you pay your tax before you invest it.  All earnings from your IRA remain untaxed in your IRA until you withdraw these funds.  This includes interest, dividends, capital gains etc.  When you withdraw money from your Roth IRA after your 59 1/2 birthday (and your IRA has been open at least 5 years), all these funds will come to you totally tax free.  If you withdraw money earlier, then  any increase in your Roth IRA is subject to taxes and penalties.
But what about your initial contributions? Because the tax has already been paid on the contribution to your IRA, that amount can be taken out without tax or penalty.  Stash your  funds in a ROTH IRA and that money will remain available to you whenever you may need it.  Any earnings should be left if for the long run, but the original contribution may be taken out in an emergency with no adverse effect (other than decreasing your retirement savings).  If you need to tap these funds, simply withdraw the original contributions and leave the earnings for your retirement.  You will not have any penalty or additional tax to pay.
At the end of the year, you will receive a 1099R stating the amount of money that you have withdrawn from your account.  This must be listed on your 1040 federal tax form.  But you also get to list the original amount of your contribution.  This is known as your basis in your IRA and is simply the total money that you had invested and left in your Roth IRA.  If necessary you can withdraw funds more than once from your IRA.  Simply reduce your basis by the amount you have withdrawn in the past.  As long as you have basis, a pre-retirement withdrawal will not be included in your taxable income.
IRAs and retirement funds are not to be tapped lightly.  They are meant to provide security in your twilight years. The discipline of putting money aside for fifty years is daunting…you may be hesitant to commit funds for such a long time.  The Roth IRA encourages this savings by leaving a back door open to tap these funds.  Through the Roth IRA you will have taken your first step towards financial independence.

Winning the Lottery!

Win the lottery! Win a new life! The allure of gaining a new life by simply plunking a dollar on the table is mind boggling.  Just one dollar for a lottery ticket. Anyone can afford that. Why wouldn’t you?

I met Benny 3 years ago.  He was one of the lucky ones. Benny won a million dollars from his state lottery when he was 35.  For the next twenty years, he would receive a check for $40,000, with the extra $10,000 going for taxes. For Benny, with a high school education and a warehouse job, this was a fortune. Set for life, he decided to quit his dead end job and live on his winnings. The years went quickly.  Benny soon discovered that $50,000 was actually a modest amount – especially since he had to pay his own medical insurance.  His lottery check remained stagnant at $50,000 each year even though inflation was slowly eroding its purchasing power. Every April, he looked forward to receiving a $4,000 tax refund from the $10,000 he had had withheld.

I met Benny 3 years before his lottery money ran out.  At 52 years old with no education and no experience, he was now struggling to find a job.  While many people his age were starting to think about retiring and social security, Benny had realized that he had not been contributing to social security and was consequently not eligible to collect. He planned to sell his modest trailer home and hope his extended family would allow him to move in.

I saw Benny again last year. He had not received a lottery check the previous year. The twenty years had already passed. There would be no tax refund that year. He came in anyway, hoping for a miracle. He had not found a job and was getting his place ready to sell. He brought in a sack of losing lottery tickets. He pushed it across my desk saying that’s all he had to report this year. And I had to tell him there could be no refund because nothing had been withheld. He went away sad and discouraged.

I hope you never win the lottery. But if you do, never quit your day job.

401K “Let it be!”

Did you listen to me?

Did you start your 401K?

Excellent!

Now leave it alone!  No, I don’t mean the occasional rebalancing.  I mean the whole thing!  Leave it alone!

Nearly every year that I have prepared taxes, someone comes in with a decimated 401K. No, I’m not talking about a 401K that is riding the roller coaster of the market; I am talking about a 401K that has been purposely destroyed.  This is the account that was cashed out in one ill conceived moment.

Let’s review the attributes of the 401K.

It is first and foremost a retirement plan.  You are saving for your future self. With a little luck and a modest 6% return, it should double every twelve years.  That means that one thousand dollars (invested at 22) will turn into two thousand dollars by the time you turn 34; then four thousand dollars at age 46; eight thousand dollars at 58 and sixteen thousand dollars by the time you are 70 and ready to retire. Save two thousand dollars when you are 20, and you will have thirty-two thousand dollars at 70. Many companies will match whatever you are willing to invest in your own 401K.  So, if you save two thousand dollars in your 401K, your employer will place an additional two thousand dollars in your 401K.  Now you will have sixty-four thousand dollars at retirement, and all you had to do was save two thousand dollars in your 401K.

A 401K is designed to be used for retirement.  To encourage you to save, the federal government will NOT tax you on any money you put in your 401K.  This means that you will save $300 in taxes if you invest two thousand dollars in your 401K and you are in the 15% tax bracket.  Put another way, that sixty-four thousand dollar retirement only cost you one thousand seven hundred dollars.  If you are in the 25% tax bracket, you will have actually only spent one thousand five hundred dollars, since your taxes will be decreased by five hundred dollars. It is only when you retire and start using the 401K that you will pay taxes on this money. By then, your peak wage earning years will be over and you will probably be in a lower tax bracket. Until that future date you will not owe any tax money on your own contributions, your boss’s contributions, interest, dividends or any growth in your 401K.

So, we have a retirement plan with no tax liability until we take it out. Hopefully, we will be in a lower tax bracket when we take it out.  However, if we take it out BEFORE retirement age – usually 59 1/2 – there is a ten percent penalty on the money withdrawn early.  That doesn’t sound like much. IT IS!!!!

I have seen many naïve individuals in their peak earning years cash out their 401K’s early.  My last simpleton was 40 years old when he was laid off last year.  His severance package swelled his taxable income to nearly one hundred thousand dollars.  Then he decided to use his 401K to pay off his mortgage, so he cashed that out too.  With that decision, all of his 401K became taxable. Tacked onto his regular pay and severance package, the tax rate on his 401K  soared up to 28%.  An additional 10% was required to pay a penalty for early distribution.  With state taxes taking another bite, fully one third of his nest egg was used to pay taxes.

What should he have done?  Well, he used it to pay his mortgage off.  But, he could have tightened his belt and continued to make payments.  He could have taken the minimum necessary to survive from his 401K and allowed the balance to grow.  Assuming that he needed an additional one thousand dollars a month, he could have opted to only take twelve thousand dollars out last year.  The penalty would still be 10%, but the tax rate would have been lower, and he would have had time to find another job.  He could have opted to start taking annual payments from his 401K, generally known as a 72T to avoid any penalties.  (Google it if you are in these circumstances – Mommy)

My simpleton was 40. Last year, he had a 401K worth seventy-two thousand dollars.  By the age of sixty-six, assuming 6% growth, he would have had two hundred eighty-eight thousand dollars, over a quarter of a million dollars, to use during his retirement.  Instead he settled for just over fifty thousand dollars after taxes.

 

 

Start your 401K – Today!

For much of the 1900’s, pensions, social security and personal savings provided the retirement income for most working Americans.  This worked reasonably well for a time.

But there were limitations.

Since the 1970’s there has been concern that Social Security would run out of money.  In an effort to keep Social Security viable, there have been multiple tinkerings with the formula including increasing the social security tax rate, taxing higher wages and increasing the retirement age for full social security benefits.

Companies have struggled to pay their pension obligations through the years.  Many large and small companies have not been able to maintain the pensions that were due to their retired employees.  Several defaulted on pension payments or simply went out of business.  In an effort to protect the pensioners,  ERISA (Employee Retirement Income Security Act) was established to provide a portion of the lost retirement wages.

Traditionally a man or woman would start in a company fresh out of school and work there until they retired 25-30 years later with a company pension.  Now, however, we are a mobile society and most workers will not stay at a job the requisite 25 or more years necessary to receive a pension.  Fewer and fewer individuals can count on a pension.

Clearly, we Americans must save for our own retirement.

Among the arsenal of savings vehicles available to us  is the 401K.

The 401K became popular in the 1980’s as companies sought to divest themselves of pricey pensions.  Workers can now elect to put a portion of our salary into a 401K.  Rather than receive this pay, the money would be invested in a limited choice of investment vehicles.  Unlike other savings, money placed in a 401K account will not be taxed when it is earned.  Rather the full amount will be allowed to grow tax deferred until it is taken out in retirement.  In the 401K, we are investing money that would otherwise have been spent on taxes, in effect, money that is borrowed from future tax obligations. And, since most people expect to be in a lower tax bracket when we retire, we will greatly save on taxes when we actually withdraw the money.

Once we elect to place money in a 401K, it is done automatically for us.  Before we even receive our paycheck, a portion of our pay is being invested in our own retirement plan.  Financial advisors will tell you to pay yourselves first.  With the 401K, that is exactly what we are doing.

Start with 1% or 2% of your pay.  That is just $1.00 to $2.00 for every $100.00 you receive.  Pennies really.  Realize that this bit of money is being saved for you and belongs to you.  Each year as you get a hoped for pay increase, increase your 401K by one half of your raise.  Let your money grow!

I remember years ago when my husband first signed up for his 401K.  The amount that he put in wouldn’t even buy groceries for a week for our family of six.  I wasn’t sure if this would ever be enough, but he continued his course.  It was about seven years later that I looked at his 401K again.  He was still investing the same modest amount each month.  But, the monthly increase in our investments due to market growth was nearly twice as much as our current contribution.  Through the magic of compounding our investments were making huge gains.

Of course, we were riding the roller coaster of the stock market.  Some months were better than others.  Some years were better than others.  But for the long haul, you are reaping the benefits of steady investing.  Hey, when the market is down, you are actually getting your stocks and mutual funds at a sale price.  You wouldn’t run to the store when they advertise that prices are up.  Why wait to buy stocks until they are up?

So start your 401K today.  It is a great way to reap the long term benefits of investing.