Idea$ 2014 - February: Retirement accounts

During the month of January, it seemed as if everyday I went to the mailbox or checked my email, there was some kind of document related to my finances waiting for me.  On Monday I got a 1099 from my bank for interest earned during the year.  On Tuesday American Express sent me my "Annual Summary" which shows how much money I spent during the year and in what categories (which can be a great tool to use when making a Budget).  Then on Wednesday, I got my W-2, Thursday brought my 1098 mortgage statement, and on Friday I got a Form 5498 showing contributions to my Roth IRA.  The irony is, the 5498 also discloses the fair market value of the account at the end of the year, to which I responded "hmm, I figured it would be more than that....I wonder what I still own in there?"  

Between packing up holiday decorations and getting together tax information, retirement accounts don't carry as much priority this time of year.  But, this is a great time to go over your retirement accounts and analyze contribution amounts and investment allocations.  

Investment allocations

The investment allocation of your retirement portfolio is simply how you have your portfolio diversified between different types of investments.  There is a wide array of investment options out there, including common stocks and exchange traded funds (ETFs), to mutual funds and bonds.  There are even different allocations within some of these families.  For example, a mutual fund can own large-cap growth stocks or small-cap international stocks.  Determining how to allocate your retirement portfolio between these different types of investments is usually tied to your age.  A 30-year-old worker will want to have their portfolio allocated more to higher-risk investments like growth and international stocks, whereas a 60-year-old worker will want to have more of their portfolio invested in less risky assets such as dividend stocks or bonds.  This is true for two reasons: 1) as an older worker nears retirement, their risk of loss of principal is greater because they will be withdrawing the funds in the near future, and 2) an older worker does not have as much time to make up for losses in a broad market decline as compared to a younger worker.  A simple Google search will produce a number of links to investment allocation calculators where you can input your age, how long until you retire, and the amount you expect to contribute, and the calculator will suggest an investment allocation for you.  One of my favorites is from CNN Money, and can be found here.

Contributions

Another aspect of a retirement account to consider is how much to contribute.  The common response to this is 10% of gross wages, but that figure is debatable given certain circumstances.  First, a young worker might not be able to contribute 10% because they have other liabilities such as student or car loans that must be serviced.  A young worker just starting out, living on their own and providing for themselves might also not have the cash flow to put away 10%.  In this case the worker should put away something that they are comfortable with.  On the other hand, take an older worker (55) that makes a very high wage, let's say $250,000/year.  The 2014 contribution limits to a 401(k) are $17,500, and workers over the age of 50 can defer an additional $5,500 as catch-up contributions.  In this case, if the older worker put away 10%, they would exceed the allowable amount of contributions.  One other consideration is the employer match.  If your employer matches all contributions made by the employee up to 3% of their income, then it is beneficial for the worker to defer at least 3%.  This way, the worker will be saving something, and will be getting full benefit from their employer.  The match is in effect free money and should not be passed up.    

Company stock

I live in Little Rock, and we have a handful of publicly traded companies located here, one of which is Windstream Communications.  Dividend investors love Windstream because, even with a stock price below $10, they pay a $1 per share annual dividend.  This is a pretty good return, especially on common stock.  But every once in a while I will hear a friend of mine that works at Windstream say "I dumped all of my 401(k) into Windstream stock...can't beat that dividend!"  Although this mindset seems smart, ("I work there, it's a great company, and it's a great dividend) it is a very risky move.  Several employees at Enron did the same thing, and ended up with no retirement savings after the company went belly-up.  I'm in no way suggesting that Windstream will have a similar fate, but the lesson is investing all of your retirement account in one asset, including company stock, is very risky.  The key to having a retirement account that grows and can weather the ups and downs of the market is diversification, and investing all of your contributions in one asset prevents even the smallest form of diversification.  

In conclusion, take some time this month to look over your retirement account statement.  Calculate how much you have invested in each asset class, and if there is too much or too little consider rebalancing the account.  Because the assets are in a retirement account, you won't be taxed on any gains or losses generated transferring funds between investments.  During this process, consider how much you have invested in stock of the company where you work, and take some off the table if it seems too high.  Also look at your contributions and see if they are too high or too low.  If you find yourself having excess funds each month, it might be wise to up your contributions, but if you are struggling to make ends meet or have other obligations it's okay to lower the contributions, as long as you don't sacrifice your company's matching provision in the process.  

What is myRA?

After President Obama's State of the Union address this past week, there has been quite a buzz about "myRA" accounts.  More details were released in a press release from the White House the following day.  But, with 401(k)'s, 403(b)'s, and IRA's already in existence, why do we need another retirement savings vehicle?

In simple terms, the myRA is essentially a Roth IRA offered by an employer that has very low initial investment requirements and where the principal is guaranteed.  Here's how it would work in practice: an employer that does not currently have a plan in place can offer a myRA to their employees.  The employees make after-tax contributions to the account, as low as $5 to $25.  These contributions are deposited to the same government securities investment fund that only federal employees had access to before, meaning the principal is backed by the US Treasury.  The employer has no cost because they will not administer or contribute to the accounts.  

Married couples making up to $191,000/year and single individuals making up to $129,000/year can contribute to a myRA account.  Fittingly, these are the same income limits to make contributions to a Roth IRA for 2014.  Another catch is that the account only exists for a finite amount of time - the earlier of when contributions reach $15,000, or 30 years.  Once these are reached, the account holder will be required to roll their money to a "private sector retirement account", i.e. a real IRA.  

The pros of this approach are 1) employees that work somewhere without a retirement plan now will have an option, 2) contributions are guaranteed by the US government, which eliminates the majority of the investment risk, and 3) with very low initial investments, people in middle and lower income brackets will find it easier to participate.  The cons are, well, only one: the 1-year return on the government securities investment fund last year was 1.47%.  

The President has urged the Treasury to start making these accounts available to the public by December 31, 2014.  

Retirement plans

Saving for retirement should be an important financial goal for everyone, no matter their age or income. Everyone has dreams for retirement, whether it is soaking up the sun on a beach somewhere or traveling the country in an RV, and saving for retirement is the key to making those dreams come true. One struggle that people face, especially younger workers, is that retirement is so far away that it's hard to acknowledge the benefit of saving for retirement now, which is why it helps to view a retirement account as both a savings account and a tax reduction tool. In the world of retirement plans, there are a variety of options available for everyone, whether you are an employer, employee, or self-employed.

401(k) plan

This is probably the most common retirement vehicle out there. The 401(k) plan is typically offered by employers, and allows employees to contribute a portion of their wages to an account. The contributions are "pre-tax" meaning that they go in before payroll and income taxes are calculated. The employee usually can direct the investment of the funds within the account, either by buying individual investments or selecting an allocation between mutual funds / ETFs offered within the plan. Employers also have the option (but not the obligation) to make profit-sharing or matching contributions (i.e. free money). The catch is that employee contributions are limited to $17,500 for 2013, and catch-up contributions of $5,500 for employees 50 years old and over.

Individual retirement account (IRA)

The traditional IRA is a useful product for many reasons, but does not carry the same tax deduction characteristics as other retirement accounts. An IRA can be opened by anyone at a participating institution and contributions can be made at any time during the year up to a maximum of $5,500 or taxable compensation for the year. The catch to an IRA is that distributions are almost always taxable, but contributions are not always tax deductible.  In other words, the contributions have the potential to be taxed twice.  For example, for a married filing joint taxpayer that is covered by a retirement plan at work with AGI in excess of $115,000 gets no deduction.  Limits can be found on the IRS website  here.

Roth IRA

The Roth has grown in popularity in recent years due to its tax deferral attributes. The Roth functions almost entirely the opposite as a traditional IRA in that contributions are made "after-tax" i.e. they are still included in your taxable income, but the distributions in future years are not taxable. This is a great resource for someone with the ability to make contributions and still pay the taxes currently such as a young worker with a higher level of disposable income. There are two catches to a Roth, 1) the contribution limit is the maximum of $5,500 or taxable compensation for one year (2013) and 2) taxpayer's with AGI in excess of $188,000 MFJ / $10,000 MFS / $127,000 S cannot make a contribution to a Roth.

All of the options above are also available to self-employed individuals depending on the income level of the business and whether or not it has employees.

The 401(k) and IRA plans can be useful tools in reducing taxable income.  By making higher contributions to a 401(k) plan, an employee's W-2 taxable income will decrease.  Also, if a taxpayer's income is in a certain range, IRA contributions can also help reduce taxable income.  Contributions to a Roth IRA have a different benefit.  Although current contributions are not deductible, distributions from the plan in the future are not taxable, meaning that a taxpayer can experience years of tax free growth for their retirement.