Retirement Planning - 401(k) Guide
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After years and years of hard work, we all hope to ease up and enjoy comfortable living in our golden years. No matter how young you are, it's never too early to start saving for your retirement. This comprehensive 401(k) guide can teach you how to retire smartly and worry-free.
What is a 401(k)?
401(k) plans are employer-sponsored retirement plans, where employees can choose to have a portion of their salary set aside into investment accounts such as stocks, bonds, money market investments, etc. A self-employed individual, regardless of how big or small one's business is, can set up a 401(k) account as well.
Types of 401(k) Plans
A traditional 401(k) plan allows you to invest and save for retirement while deferring income taxes until you withdraw the money at retirement. As a result of deferred taxation, the money in your 401(k) account has the potential to accumulate more quickly, and you will also save a lot of money on state and federal taxes each year.
401 k Strategy
A Roth 401(k) plan offers no upfront tax breaks but promises tax-free income in retirement. In other words, a Roth 401(k) account is funded with your after-tax income whereas a traditional 401(k) account is built up with your pre-tax dollars. With a Roth 401(k), you won't be able to cut down your annual income taxes, but after your retirement (when the tax rate may be higher) you will be able to withdraw your money or leave it to your heirs absolutely tax-free.
Traditional 401(k) and Roth 401(k) Comparison
- After-tax contributions, not affecting current income taxes
- Money from a Roth 401(k) account can be withdrawn tax free after the employee has had the account for at least 5 years and NOT before the year in which he turns 59 1/2, unless an exception applies.
- The account can be rolled over into a Roth IRA directly with no tax payment.
- Pre-tax contributions, reducing current income taxes
- All the withdrawals and investment gains will be taxed as ordinary income. Withdrawal of funds before the account owner turns 59 1/2 is prohibitted, unless an exception applies.
- If the account owner wants to roll over into a Roth IRA, the account must be rolled over into a traditional IRA first, then it can be rolled over into a Roth IRA (a retirement account that does not require the retiree to make annual distributions once he reaches age 70 ½). This roll-over process includes tax payments.
The Roth 401(k) has been favored over the traditional, especially among those employees who start saving for retirement early in their career. Having years of retirement with tax-free income, of course, sounds very idealistic. However, the Roth 401(k) is not right for everyone. Middle-aged workers who start late on retirement savings are probably not at risk of being in a higher tax bracket after retiring, therefore they may be better off sticking with a traditional 401(k) and enjoying the advantages of an upfront tax break now. Stephen Utkus, director of Vanguard's Center for Retirement Research, suggests that it is a smart thing for the employees to diversify their future tax liability by having both tradional and Roth 401(k) accounts, if possible.
Individual or Solo 401(k)
If you are self-employed, you are eligible to establish a Solo 401(k) account no matter what type of business you own or whether you have any employees. Unlike big corporation 401(k) plans, a Solo 401(k) is very easy to set up with no complicated administrative requirements. You can also roll over other retirement accounts into it, once the account is established.
In addition to the tax-break benefit, the Solo 401(k) also offers:
- Contribution flexibility - Each year you get to decide how much to contribute to your account. If your business is not doing so great, you can choose to put less money or nothing at all into your plan. But if your business is swell, you can also choose to contribute more.
- Higher contribution Limits - A Solo 401(k) plan, unlike other kinds of retirement plans, allows you to contribute more money to your plan on less income.
- Eligibility for a large amount of loan - You can get approved for a personal loan of up to 50% of your Solo 401(k) acount balance. The loan will be tax and penalty free as long as it is paid back on time.
List of some financial institutions that offer Solo 401(k) plans:
- AIM Investments
- A.G. Edwards
- T. Rowe Price
- Wachovia Securities
- Charles Schwab
- Fidelity Investments
- ING Financial Partners
Basic factors to consider when establishing a Solo 401(k) account
- You should set up a Solo 401(k) with a firm that charges no or low setup costs and annual fees. Compare setup, ongoing maintenance and administrative fees of various Solo 401(k) plans to make sure that you are not being overcharged.
- Look for investment flexibility. Try to find a plan that does not restrict your investment to a limited number of funds but allows you to invest in all kinds of stocks, bonds, mutual funds, and real estate.
- Open an account with a firm that offers low expense ratios for the investment fund options.
Books about Retirement Planning - Written by Financial Gurus
Expert Advice on How To Manage Your 401(k) During Slowing Economy
Managing your 401(k) account
- Try to diversify your retirement assets across a broad class of stocks and bonds.
- If your employer offers the option of purchasing the company's stock, you may want to say no to that or keep company stock to less than 10% of your portfolio. A number of employees at Enron and Worldcom, who invested the majority of their 401(k) funds in company stock, had their retirement savings wiped out when those companies collapsed.
- Stocks have the potential of rapid huge gains and also huge losses whereas bonds are not at all risky but provide little growth potential. So what is an appropriate balance of stocks and bonds should you have in your 401(k) portfolio? According to Wells Fargo Advantage Funds, the appropriate percentage range of stocks for someone 5 years from retirement is 30 - 45%, and approximately 25 - 35% for a 65-year-old. Many asset-allocation experts agree that a high percentage of stocks, especially during a bad economy, make investors vulnerable to tapping their accounts during a down market and lock themselves into losses they can't easily recover.
Recession-Proof Your 401k
- From age 57 to 65, it is time to juice up your retirement savings. Try to contribute a little more to your 401(k) account. It's now or never.
- Do not withdraw from your 401(k) before retirement. If you take a loan from your 401(k) and can't pay it back on time, it will be treated as an early withdrawal, meaning you will have to pay taxes and 10% penalty. Even if you are able to repay it punctually, it's still a bad idea because you reduce the possibility of compound investment earnings by doing that.
- When you switch jobs or get laid off, don't cash out your 401(k) balance. Instead you should transfer your accumulated retirement savings to a self-directed IRA or other retirement plans. Keep in mind that you have only 60 days to complete the rollover. If it is not completed within the time allowed, the balance will be considered ordinary income and will have to be included on your tax return. Besides, if you are younger than 59 1/2 when the withdrawal occurs, you will also have to face a 10% penalty.
- As you approach retirement, you should create a post-retirement plan. Look at all your possible sources of income from pensions, investments, Social Security, to the amount of equity in your home. Then plan how you are going to spend those funds in your retirement. Ideally, you should tap into your 401(k) last.
- Although you may be eager to leave the office and tap your nest egg, you can do yourself a huge favor by postponing your retirement a bit. Even just a few years of postponement can add quite a bit to your 401(k), which is simply the result of having more time to contribute. Late retirement can also save you money on other things. For example, most corporate health plans cover you until you are 65, so if you retire before that, you will probably have to spend extra money for an individual health plan until Medicare kicks in (at age 65). Plus, working longer will also boost your Social Security checks.
List of websites that provide 401(k) retirement calculators
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