When you were a child, your parents may have given you a piggy bank, telling you to save a few pennies for a rainy day or deposit any extra change you had laying around. If you were lucky, perhaps you got a little weekly allowance or had a part-time job. The process was probably rote, occurring without much thought beyond the day you would shake your money free and buy something you wanted.
Fast-forward a few years and saving, although just as important, becomes a little more intricate. Sure, you can keep throwing change into a piggy bank, but building retirement savings that allow you to enjoy your retirement requires a little more planning.
Don’t fret. Just because you have to plan a little more doesn’t mean you’ll need a degree in finance to get on the road to a secure financial future. Following are three savings vehicles that can get you started.
Individual Retirement Account (IRA)
What it is: A personal savings plan.
How it works: IRA funds can be used for a variety of investments, including stocks, bonds and certificates of deposit. Depending on your income level, an IRA can be funded with pre-tax dollars. So, for example, if your annual contributions total $2,000 and your yearly income is $40,000, you’ll only pay taxes on $38,000.
Tax deductions, however, are limited to those who aren’t eligible for an employer-sponsored retirement plan, such as a 401(k). This limitation applies even if you don’t participate in the employer-sponsored plan.
The details: For 2009, the contribution limit for a person under age 50 is $5,000. If you’re 50 or older, the limit increases to $6,000. You can begin taking distributions at age 59 ½. At age 70 ½, you’re required by law to start taking minimum distributions, which are calculated using life expectancy.
The advantages: Contributions you make to an IRA are tax-free and your money grows tax-deferred . Unlike some other individual savings options, there is no maximum income level limiting your participation.
The disadvantages: Though contributions are taxfree, as the term tax-deferred suggests, distributions are subject to ordinary income tax. Additionally, a 10 percent penalty is assessed to funds withdrawn before age 59 ½, though some exceptions do exist. There is also a penalty for not taking your required minimum distribution.
Where to go: Your bank will be able to help you set up an IRA, though some may be limited in investment options. Those looking for the widest variety of investment opportunities may want to contact a brokerage firm.
For more information: For the basics, visit the Internet Retirement Alliance at www.ira.com, where you’ll find information on several retirement planning options. The Internal Revenue Service’s website—www.irs.gov/retirement—has a variety of information available, too. Also, consulting a financial advisor is a great way to determine what will work best for your individual needs.
What it is: A personal savings plan.
How it works: Like a traditional IRA, Roth IRA funds can be used for investments such as stocks, bonds and certificates of deposit.
The details: For 2009, the maximum contribution is $5,000 for those under 50 years old. If you are 50 or older, the maximum goes to $6,000.
The advantages: There are no minimum distribution requirements.
Investors can continue to contribute to a Roth IRA after age 70 ½, when minimum distributions begin with a traditional IRA. Or, if not making contributions, leave their assets to continue growing tax deferred. Also, because taxes have been paid on the contributions, distributions you take are tax-free . Principal contributions, not earnings , can be withdrawn at any time without penalty, though a few conditions may apply.
The disadvantages: Unlike a traditional IRA, earnings are not tax deductible, and withdrawals cannot be made before the IRA has been in place for five years. Earnings restrictions also apply: Only single filers making no more than $95,000 and married couples making a combined $150,000 can make full contributions to a Roth IRA. Partial contributions can be made by single filers making up to $110,000 and married couples making up to $160,000.
Where to go: Your bank or brokerage firm will be able to help you.
For more information: For basic information, try searching websites that give easily understandable descriptions of financial products, including www.moneychimp.com and www.themotleyfool.com. Also, seriously consider talking to a financial advisor who will be able to help you figure out what retirement vehicle best suits your needs.
What it is: A savings program for the self-employed and small-business owners.
How it works: There are two types of Keogh plans available—defined contribution and defined benefit. Money purchase and profit sharing plans are the two defined contribution choices. In a money purchase plan, a set amount is contributed yearly, regardless of profit or loss. A profit sharing plan allows the owner to decide each year if a contribution will be made, providing for more flexibility should the practice have a bad year. With a defined benefit plan, you decide what you’d like your distributions to be when you retire and contributions are calculated using this figure.
The details: Your contributions may be tax-deductible, and the principle and earnings grow tax-deferred until you begin taking distributions.
Upon withdrawal, the funds are subject to standard income tax rates. Contributions can be invested in various products, including bank accounts, stocks and bonds, mutual funds and annuities. Like the traditional IRA, minimum distribution requirements begin at 70 ½ and a hefty 10 percent penalty is assessed to funds withdrawn before age 59 ½. Full-time employees that have worked for you for three or more years must be included in this plan.
The advantages: The maximum contribution in this plan is much higher than a traditional or Roth IRA, allowing you to save as much as $49,000 of your net income. Contributions are made pre-tax, reducing your taxable income.
The disadvantages: Upon withdrawal, income is taxed at regular rates.
There is an option to take your savings as a lump sum, which might make you eligible for income averaging. These plans can be complex, so you’ll probably need some help.
Where to go: Keogh plans can be opened at your bank or brokerage firm. Credit unions usually offer this plan, too.
For more information: To get a general feel for what these plans require, do a few searches about Keogh plans on www.about.com. For more specific information and to find out if a Keogh plan might suit your retirement needs, talking to a professional financial advisor is a good place to start.
A Simple Glossary
Broker: An individual or firm that buys and sells investment products at the request of their customers. Some offer investment advice, and most will be paid a commission.
Distribution: Money you are paid out of your retirement plan. Some plans, like a traditional IRA,require you to receive minimum payments after a certain age.
Earnings: Any capital gains, or profit, made on your investments.
Investment: Financial product(s) you buy with the expectation of future positive returns. For example, stock in a particular company.
Principal: Your original investment funds.
Does another word have you scratching your head? Visit www.investorwords.com and www.investopedia.com, where you’ll find definitions for commonly used, but not always easily understood, financial terms.
For those of you who are eligible for an employer-sponsored 401(k) program, but don’t know much about these plans, here are a few things to think about.
The basics: A 401(k) plan is funded with pretax dollars that can be invested in a variety of ways, such as stocks, bonds and mutual funds. Investments grow tax-deferred until you begin taking distributions, at which time distributions are subject to ordinary tax rates. The funds are portable, so if you leave a position, you can roll your 401(k) savings into another retirement vehicle, like an IRA. Many companies have vesting schedules that determine what percentage of the employer’s contributions you can take with you. These schedules are often figured using years of service.
Get a grip: One of the first things you are going to want to do as you figure out how you want to invest in your 401(k) is gauge how well you tolerate risk. You should take into account several variables, including your age, how long you’ll be invested before retiring, your retirement goals and your earnings. Having more time to recover from a tumultuous market may mean you are comfortable taking on more risk. If you plan on retiring sooner rather than later, however, being more conservative may be wise.
More than one basket: As with most investment opportunities, one fundamental key to success is diversification. Sure, if you have 40 more years in the professional world, putting a greater portion of your portfolio in stocks might be a good choice. However, if you’re retiring next week, perhaps only a small percentage of your money belongs in high-risk investments. When you diversify your portfolio, you build security into your retirement plan.
Match made in heaven: If your employer offers to match a percentage of your contribution, make this percentage, if possible, the minimum you choose to invest. For example, should your employer offer a 3 percent match, you should make every effort to contribute at least 3 percent. Your employer’s match is free money, and you instantly double your contribution.