Are you employed? Does your employer offer a 401K (or 403B, or any number of similarly acronym’d up retirement plans)? Does your employer offer an employer match/contribution on dollars you contribute? If the answer is yes to all three, you better be contributing to your 401K. If your employer doesn’t offer a match, you should still be contributing to your own retirement though it’s not as pressing. It should take you less than ten minutes to sign up for your 401K unless your company is stuck in the stone ages. Give your HR a call or check out your company Intranet for a 401K enrollment form, fax/inter-office mail that baby over to HR/Benefits, and you should be all set. As for the what funds you should divvy up your hard earned money into, just wing it until the account is setup. You can figure all that stuff out later, time is of the essence!

For many recent hires, this is a non-issue because the Pension Protection Act of 2006 made employers auto-enroll their employees. So, for some, this tip took less than ten minutes! The next step is making sure you’re contributing enough. The law says that you’re auto-enrolled at 3% and then every year after that you’ll be bumped up 1% until you get to around 6% to 10%. Now, employers are not required to do this (they get out of some discrimination testing if they do), so there’s a chance your employer hasn’t done any of this (double check!). Also, this is what the employer must do, you can adjust it up or down or sideways as much as you want.

Let’s say your employer offers to match your contributions 50 cents to the dollar up to 3% of your salary. That means if you contribute 6% of your salary, they kick in 3%. Well, if you’re auto-enrolled at 3%, that means you’re leaving 1.5% of your salary on the table because you didn’t do anything. 1.5% doesn’t seem like much but:

1. It’s free.
2. In 40 years, with interest and years of 1.5% of your salary, that’s going to be a lot of money.
3. It’s free.

So, make sure you’re enrolled and make sure you’re contributing enough. If you saw a twenty on the sidewalk, you wouldn’t just walk by it would you?

Ever notice that tons of personal finance sites talk about Roth IRAs all the time but rarely talk about Traditional IRAs? I think part of the reason is that the Roth IRA is newer so there’s far less literature on it and because it’s sexier - forty years of tax free appreciation and then no tax on disbursement? That’s pretty hot. The downside is that some people can’t contribute to the Roth so they’re stuck with the Traditional route, something that isn’t discussed as much.

About Traditional IRAs

The Traditional IRA is much like the Roth IRA except contributions are tax deductible unless your employer offers a retirement plan. This means you get tax savings immediately since your income will be reduced by the amount of your contribution. It’s very much like a 401k from a tax perspective, which explains why the deductibility rules are structured the way they are. If your employer offers a 401k, Keogh, SEP-IRA, etc; then the deduction is limited. The rules are a little complicated so I direct you to a past article I wrote about IRS income phaseouts (specifically IRA contributions) with respect to contribution limits and deductibility.

From there, the Traditional IRA grows tax free much like a Roth IRA. However, whenever you start taking disbursements, those earnings are then taxed at your marginal tax rate. You are also required to take minimum disbursements once you hit the age of 70½, which is something you are not required to do with a Roth IRA. If you don’t take the required minimum distributions then you will be penalized (you will always want to take these distributions).

Finally one last distinction worth noting with respect to Traditional and Roth IRAs; if you make an early withdrawal on your Traditional IRA, you will have to pay taxes plus a 10% penalty. With a Roth, you can withdraw them contributions at anytime (since you’ve already paid taxes on it).

So, why a Traditional IRA and not a Roth? There are two reasons:

• Income restrictions. If you have too much income, you will be prohibited from contributing to a Roth IRA, this is the main reason why folks choose Traditional over Roth (or rather they settle, because they never had the choice).
• Tax law concerns. The government can always decide to tax Roth IRA disbursements, which means you’d be doubly taxed. This is less of a concern but still one that bears mentioning since it could always happen.

Traditional IRA Conversion

Another considering for those thinking about Traditional IRAs is that if you have a modified adjusted gross income in excess of $100,000, you currently cannot convert your Traditional IRA to a Roth IRA. However, in 2010 and 2011, that prohibition will be lifted so anyone can do the conversion. When you convert all or part of your Traditional IRA, you pay taxes immediately on the funds converted if you haven’t done so already.

Here’s a reader question I received this past weekend and I wanted to float by response with you all to see what you thought:

I had a curious question that you may have some experience with. My company’s matching contributions are 100% in the company’s common stock. The upshot of this is that the vesting is immediate. Nonetheless, since this is common stock, there is a small fee associated with selling it. Anyway, how often would you suggest rebalancing. I can’t quickly find any information on exactly what the fees are, but I think it is a per-share without a per-transaction fee. We can run on that assumption for now.

Anyway, the question is, how often should I be rebalancing my portfolio to reduce the amount of common stock in it? Annually? Quarterly? More often?

Thinking it out, I feel that since my plan is new and literally is a 50/50 split between company stock and everything else that I should rebalance quarterly and move pretty much all of it every time. Additionally, if I wait until dividends are distributed on the funds, it should mostly or completely offset the costs of moving the stock (dividends are automatically redistributed into the plan). Eventually, as the contributions became a smaller part of my portfolio, I think I could hold onto the stock semi-annually to yearly without exposing myself to too much risk. Does this seem like a sound investing principle?

In general, I think rebalancing should be done once a year but depending on how large of a balance you have (in terms of total dollar amount), it may not be worth it given the transaction fees. By this I mean if you have $500 in your 401k and each transaction costs you $5, you’re talking about losing 1% of your total portfolio just to make one trade… your rebalancing will take far more and it’s simply too expensive to rebalance.

I don’t think you should think about the dividends separately from your principal. It’s your money and not a very good reason to justify rebalancing, you know? You should think about the costs of rebalancing separate from what you earn.

If I were you, and I don’t know anything about your company, your total financial picture, or your 401k picture (so please don’t
construe this as direct advice, this is just what I’d do); I’d wait until I had more in my funds that the fees aren’t a significant
percentage (perhaps wait a year). Then I’d rebalance once a year after that (or just adjust my contribution allocations so that it would rebalance, thus avoiding the trading fees that it sounds like you pay).

So, what do you guys all think of my response?

By everyone I mean random people who reach the site via Google, but they’re common questions that I read or hear all the time so they make for a quick Q&A article. If you think any of my responses are off target, certainly give your opinion as well because I may very well be wrong!

Should I put more into my 401k or open Roth IRA?
The general consensus is that you should contribute enough into your 401k in order to earn the company match, if one is offered, otherwise maximize your Roth IRA contributions first. The logic behind this is that the Roth IRA is a powerful tool but not as powerful as free money (the match). This also has the added bonus of diversifying the tax burden of your retirement assets. So, get the match, max the Roth, then go back to the 401K.

Should I use my IRA account to pay off debt?
Noooooooooooooooooooo! Actually, you can do whatever you want but considering that you can’t put the money back into your IRA, I think it’s a bad idea. Don’t pilfer your retirement assets to pay off the debt, it may be better for you to pay off the debt in lieu of additional contributions or perhaps ratchet back your spending.

How much money should I put in my 401k?
If you can afford to, the maximum. Save for the future! Actually, what you should do is put as much as you can afford to while maintaining a reasonable lifestyle. You don’t want to max out your 401k at the cost of enjoying life now but you shouldn’t be making weekend trips to Paris and ignoring your 401k. If you want to make an error in either direction, then err on the side of caution and pump up the 401k now because time will be on your side. Waiting even five years to start contributing can result in a difference of tens of thousands when retirement comes around the corner.

What do companies match on 401k?
They will generally match your contributions up to a percentage. At my former job, if you contributed 6% of your salary then the company would contribute 3%. If you contributed 10%, then they still would kick in only 3%. If you contributed 1%, they gave you 0.5%.

Can a college student open a Roth IRA?
Anyone with income can open a Roth IRA and there are no rules for where the money has to come from. For example, if you had a summer job and earned $2,000 but blew it all on movies, diners, and dates then your parents can give you $2,000 to contribute to your Roth IRA. The only thing that matters is how much you earned. Also remember the contributions are after taxes so it’s not your gross income, it’s your take-home income that limits you.

If my investment became less can I put more than $4,000 in IRA?
Unfortunately no you cannot. The value of the Roth IRA contribution isn’t your limiting factor. So if you contributed $4,000 and because the market tanked the Roth IRA is only worth $1,000, then you cannot contribute another $1,000.

One of the classes I’ve been taking involves investing, discounting cash flows, blah blah; and so one of the things we’ve touched upon is retirement savings. One of our recent problems is calculating how much you need to save in during pre-retirement in order to guarantee (based on assumptions) a future cash flow. So, rather than study the textbook and answer problems with very little payoff (yeah yeah, I have a test), I figured I’d create my own problem and submit it to you all to see if I did it correctly.

Q. How much do I have to save each month for the next forty years in order to ensure that I can withdraw $5,000 a month, in 2007 dollars, for the next twenty years?

Assumption #1: No taxes.
Assumption #2: Inflation will be 3% a year for the next 40 years.

Given that assumption, $5,000 in purchasing power in 2007 will be $16,310 in 2047, so you’ll need to have enough retirement assets such that you can withdraw $16,310 each month ($195,720 a year) for the next 25 years. In order to calculate that amount, you’ll need to know the rate of return on your assets during those 25 years, as you draw it down.

Assumption #3: Your post-retirement assets will appreciate at 5% a year.

At 5% a year and drawing out $288,060 a year, you’ll need assets in the amount of $3,848,183 in Year 40. That means between now and year 40, you’ll need to save and appreciate nearly four million dollars in order to retire on $5,000 a month (2007 dollars) for the next 25 years. (if that seems a little high, it’s because you have to discount your rate of return by inflation each year) Scary huh?

So, how much do you need to save? Let’s hit up assumption 4…

Assumption #4: Your pre-retirement investments will appreciate at 10%.

Now, in order to have $3,848,183 in retirement assets in 40 years, how much will you need to save each month if your savings appreciate at 10% each year? (This time we don’t discount for inflation because it’s already taken into account by the payout each month) It’s actually quite reasonable, a mere $8,694.54 a year… or $724.55 a month.

(Someone please check my math!)

There’s an article over at Yahoo Finance, in their retirement section (if you aren’t looking at it today, June 27th, you probably won’t see it on the front page anymore), titled “The High-Stakes Battle Over Automatic 401(k) Picks.” The little blurb underneath reads:

Legislation stalled over what investments should be included in automatic-enrollment plans is causing millions to lose out on retirement savings. What forces are driving the dispute?

If you read that strictly as its written, it sounds like Congress is causing innocent Americans to lose millions of dollars because of their deadlock on what should be the automatic pick in auto-enrollment 401ks. It says that because that’s eye-catching and it’ll lead to a click from the reader, but ultimately it’s not Congress’ fault, it’s the employee who is losing out on retirement savings’ fault. If everyone was clued in enough to enroll in their employer sponsored 401k plan, Congress wouldn’t have to waste time on the issue, there are plenty of other issues to waste time on.

You are responsible for everything that happens to you, including your retirement savings, whether you like it or not. The moment you think that you aren’t responsible for your own life you can just pack it up and call it a day.

Enroll in your 401k, put it in something intelligent (warning: you might have to read something), and ask your legislative representative to do something useful like clean up the environment.

I entertained a curious question over the weekend - Should someone take out a 0% balance transfer to fund a Roth IRA?

I think the answer is, as usual, that depends.

I see two basic scenarios (almost all other scenarios equal an automatic NO):

• You expect a large tax refund but don’t have enough free cash now to fully fund the Roth IRA,
• You don’t expect a large tax refund and you don’t have enough free cash now to fully fund the Roth.

Given that it’s June and you have until April of next year to save the $4,000 contribution limit, I think that if you’re in either category then a balance transfer should not be your first option. You should either reduce your withholding or start saving (you can contribute now, no need to wait until April, in fact it’s likely better to contribute now because your money will be working a few months longer).

Now, let’s say it’s March 15th and you just started thinking about taxes, in that case you might want to consider a balance transfer so you can contribute in the prior tax year instead of the next one. That’s one extra year of contributions which can be huge many many years down the road. If you’re in category one, the large refund group, then I say you can safety take that balance transfer because you can pay it off when it comes due with the tax refund. This, of course, assumes a level of discipline, requiring you to not spend a large dollar amount sitting in your bank account earning interest.

If you’re in category 2, taking a balance transfer is very risky because you didn’t save $4,000 this year, what’s to say you can save it next year? If you take on credit card debt and can’t pay it off before it starts accruing interest, you’re shooting yourself in the foot. The credit card debt at such a high interest rate will negate the benefits of having a Roth IRA in the first place. This also applies to those in category one who lack the discipline to save the money until the balance transfer is due. If you can’t pay off the balance transfer, and be honest with yourself, don’t even consider a balance transfer as a funding source for your Roth IRA.