The Money Class (23 page)

A few years ago many employers switched to a new system that automatically enrolls all new employees in the 401(k) when they are hired. That is, rather than asking you if you want to join the plan, or waiting for you to sign the paperwork to start your retirement saving, the employer just automatically puts you in the plan. You can always choose to opt out after the fact, but the system is now set up to assume you want to be in the plan from the get-go. That is indeed a fabulous improvement in how our 401(k)s work; it means more people will start saving at a younger age. But there’s a kink that needs to be worked out. When most employers automatically enroll a new employee in the 401(k) they set your contribution rate at 3% of your salary. Why so low? Well, the theory is that they don’t want to scare you away by setting this “default contribution rate” any higher.

You are being led into a costly mistake. As I just explained, many employers will match your contributions up to the first 6% of your salary, up to a set dollar limit. So if you are only contributing 3% because that’s what they set it at when they enrolled you, there’s a chance you may not be capturing all of the company match you are entitled to. Give HR a call and make sure you are indeed contributing at a level that guarantees your account will have the maximum employer match added to it.

A word on vesting:
The money you contribute to your 401(k) is 100% yours from the moment you make the contribution. But the money your employer contributes to your account typically becomes yours over time. For example, some firms have a three-year vesting formula. After the first year, one-third of the matching contribution becomes yours; after two years another third vests; and at the end of the third year all of the match is 100% yours—that is, you are fully vested. So if you left the company after one year—voluntarily or not—you would be entitled to keep one-third of the match, after two years you would keep two-thirds, and after three years all of the match would be yours.

Opt for a Roth 401(k) if it is offered as part of your plan
. A growing number of companies now offer the option of contributing to a traditional or a Roth 401(k). If your plan has a Roth 401(k), it is probably the best choice.

A Roth 401(k) is a cousin to the Roth IRA described earlier in this chapter. The money you use to make your contribution comes out of your paycheck after taxes have been taken out. So there is no up-front tax break on your contributions as there is with a regular 401(k), but once again, the big payoff comes in retirement. Withdrawals from a Roth 401(k) after the age of 59½ are 100% tax-free, whereas withdrawals from your regular 401(k) plan will always be taxed as ordinary income. It’s my belief that the ability to have tax-free income in retirement is a smart move, regardless of what happens to tax rates in the future. The Roth 401(k) also gives you a lot more flexibility if you intend to leave money to heirs. Once you reach age 70½ the federal government insists that you start to take money out of a regular 401(k) if you are no longer working; this is what is called a required minimum distribution (RMD). With a Roth 401(k) there is no RMD; you can just let it grow for future generations. And when your beneficiaries inherit your Roth 401(k) they too will be able to withdraw this money tax-free.

STEP 2. Contribute to a Roth IRA
.

Once you have contributed enough to your 401(k) to earn the maximum company matching contribution, or if there is no match available, your goal should be to fund your own Roth IRA.

Caveat for those of you with a Roth 401(k):
If you are contributing to a Roth 401(k) you could in fact skip this step on Roth IRAs. You could just keep contributing more to your Roth 401(k), above what you need to invest to get the company match. Remember, in most instances you can invest up to $16,500 in a Roth 401(k) in 2011 if you are under age 50. And indeed, if you want to keep things simple, it’s fine to focus all your money and attention on your Roth 401(k). The most important thing here is that you are indeed saving up. But if you want to get an A in this class, I think you should consider opening a Roth IRA even if you have a Roth 401(k). With a Roth IRA you have the freedom to invest in thousands of low-cost investments, including exchange traded funds (ETFs), rather than be limited to the choices offered within your 401(k) plan. And even though I never want you to touch your retirement savings before retirement, the fact that you can take out money that you have contributed to a Roth IRA—though not the earnings—at any time without tax or penalty means it can moonlight as a backup emergency fund. So once you get the maximum match from your employer in a Roth 401(k), my advice is to then focus on a Roth IRA.

ALTERNATIVE STEP 2. Contribute to a Traditional Nondeductible IRA and Convert to a Roth IRA
.

As I explained above, if your income disqualifies you for direct investment in a Roth IRA, you have a two-step option: Make a nondeductible contribution to a traditional IRA and then convert that IRA into a Roth IRA. If you have other IRA funds please work with a tax advisor before you make this move; the tax rules are tricky and you don’t want to have any ugly surprises.

Go to The Classroom at
www.suzeorman.com
:

On my website I explain the tax rules for Roth IRA conversions.

How much to invest in your Roth IRA?
Remember what I said earlier: The more you save for retirement today, the better your chances of reaching your retirement dreams. The annual maximum you can contribute in 2011 is $5,000. Make that your goal. What you can afford to save is of course a function of your current salary and your other financial obligations. But please stop here for a moment and seriously stand in your truth. Your future retirement success is rooted in the savings choices you make today. I want you to summon the lesson we discussed in Class 2: You are standing in the truth when the pleasure of saving equals the pleasure of spending. Saving for retirement is your most important savings goal.

Now, if you happen to have a big pile of cash ready to contribute to an IRA, that’s great. But what’s more likely is that contributing smaller sums throughout the year will be more practical. Here’s what you would want to save on a monthly or quarterly basis to reach the maximum annual IRA contribution limit:

*
In 2011 the maximum annual contribution limit is $5,000 for individuals below age 50.

The best way to do this is to set up an automatic investment system that pulls money out of your checking account each month and invests it in your Roth IRA. Do not leave this to your own best intentions; even if you vow you will make monthly contributions it can be hard to stick with a plan, especially when unexpected expenses pop up. It’s best to make this an automatic system that takes you out of the equation. The discount brokerage or fund firm you choose for your IRA will have an easy form for you to fill out that authorizes a monthly (or quarterly) transfer from a bank account to your IRA.

Where to Open an IRA Account

I recommend you use a reputable discount brokerage firm such as TD Ameritrade, Fidelity, Schwab, ING, Muriel Siebert, Scott-trade, or Vanguard. I prefer discount brokerages or no-load mutual fund companies because of their low (or no) trading costs, low account fees, and low-expense mutual funds and ETFs. Banks and insurance companies that offer IRA accounts typically charge higher fees. I’d prefer you keep every penny you can invested for retirement, rather than allow any to go toward paying fees. For that reason, discount brokerages or the mutual fund company itself are your best options. Under no circumstances would I open a Roth at a bank, credit union, or insurance company.

STEP 3. Increase Your 401(k) Contributions

If you max out on your Roth IRA contribution and you still aren’t at your 15% savings goal, then you are to increase your 401(k) contribution (match or not) to get you to 15%.

STEP 4. Save in a Taxable Account

If you don’t have a 401(k) and you have maxed out on your IRA for the year, you can keep saving more in a regular taxable account. A great strategy is to create a portfolio of a few ETFs. Unlike mutual funds, there typically is no annual tax bill with ETFs; the only time taxes are owed is when you sell your shares at a gain. That’s a great way to invest for your long-term retirement goals.

That’s it—four steps.

LESSON 4.
INVESTING YOUR RETIREMENT MONEY

Making the commitment to contribute to a 401(k) and an IRA is just half the job. You must also take responsibility for choosing the investments you own inside these accounts—yet another task prior generations didn’t have to stress over.

Based on the countless questions I get about this subject, it’s clear to me that many of you are totally confused about how to allocate the funds in your accounts. When I ask you how your retirement money is invested you typically tell me you have a 401(k) or an IRA. I then ask again, “Yes, but how is your retirement money
invested?
” and you look at me like I am nuts because you just told me you had a 401(k) or an IRA.

Please understand that a 401(k) and an IRA are simply retirement accounts that hold your investments. You must choose what investments to put inside your accounts. If you don’t make that choice, your 401(k) or the brokerage firm that handles your 401(k) will often just leave your money in a cash account. Another common scenario I see is that you try to invest the money in your accounts but you get overwhelmed and panic and you decide that cash is the best option.

And I know that some of you aren’t investing because you have no faith that investing is the way to go, period. You were spooked by the volatility of the stock market in 2008. The investing community is well aware of exactly how you feel. The CEO of one of the largest mutual fund companies has publicly laid it out that the financial services industry is on the verge of losing an entire generation of investors—young adults like you—who have experienced a whole lot of bear market pain without any offsetting bull market upside to temper your nerves and perspective. In a recent survey of investor attitude toward risk, the biggest drop in a willingness to take investment risk was among the youngest investors—those below the age of 35.

That makes complete sense. No one, not even financial industry honchos, would fault you for feeling that way given what you have lived through. But I am going to ask you to summon all your stand-in-the-truth strength and fight through those feelings. I am not asking you to forget those feelings, nor am I suggesting you are wrong for feeling hesitant to invest in stocks.

But here’s where we need to think through what your dream is: retirement. You are not retiring next year, or next decade. It’s a dream that is 30, 40, maybe even 50 years off. Yes, I am going to hit you with another riff on the power of time.

The first time-sensitive issue I need you to grasp is that by playing it safe today and keeping all your money in bonds and cash you will miss out on the opportunity to earn returns that exceed the inflation rate. And make no mistake, you must focus on earning inflation-beating gains. It’s simple: If your savings do not increase enough to counteract inflation you will not be able to maintain your standard of living in retirement. So I am here to tell you that you must consider investing a portion of your portfolio in stocks.

Just as a guidepost, keep in mind that the long-term average rate of inflation is about 3.5%. So at a minimum you want your investments to be earning at least that much, preferably more. If you are invested in the most conservative option in your company 401(k)—it can be a money market fund or a stable-value fund—you are not earning more than 1%, if that, right now. Yes, a money market or stable-value fund is “safe” in that its value will not go down, but when you are investing for a goal that is decades away you must also think about the risk of your money’s purchasing power not keeping up with inflation.

UNDERSTANDING THE UPS AND DOWNS OF THE STOCK MARKET

The truth is, right now is an absolutely fabulous time to be investing if you won’t need that money for decades. None of us can predict with 100% accuracy what is going to happen in the stock market over the next few years, or even the next few months. But when you are investing in a retirement account that you will not use for decades, you shouldn’t be focused on what happens right now. To be totally honest, you should look at any market drop as a good investing opportunity.