3/24/2011 4:15 PM ET|
No 401k? Save for retirement anyway
You don't need a boost from your employer to take charge of your retirement. These 6 tips can help you craft an after-work life that's even more golden.
Only about half of the workforce participates in a pension, 401k, or similar type of retirement account at work. When you don't have help from your employer, you have to save and invest for retirement completely on your own. Here's how to build a nest egg without any help from your company:
1. Take advantage of tax breaks. You can contribute up to $5,000, ($6,000 if you are age 50 or older) to an IRA, a Roth IRA, or a combination of the two accounts. Traditional IRAs give you a tax break in the year you make a contribution to the account, but you'll have to pay income taxes on that money and the earnings upon withdrawal. You contribute after-tax dollars to a Roth IRA; distributions that are made after age 59-1/2 from those accounts that are at least five years old are tax-free.
To decide which type of retirement account is better for you, compare your current income tax rate to what you expect your tax rate to be in retirement. If you expect to be in a higher tax bracket when you reach retirement than the bracket you are in now, it's often best to pay the taxes upfront using a Roth account. But if you expect your tax rate to drop in retirement, consider saving in a traditional IRA and taking the tax break now. Investing in both types of retirement accounts allows you to hedge your bets against future tax increases.
2. Consider flexibility. Traditional IRA account owners are required to take distributions from their retirement accounts and pay the resulting income tax each year after age 70-1/2. Those who fail to withdraw the correct amount must pay a 50% tax penalty on the amount that should have been withdrawn. Roth IRA account owners are not required to take annual distributions, which gives them more flexibility to time withdrawals or pass on tax-free money to heirs. Roth IRAs also give you easier access to your money before retirement.
While traditional IRAs levy a 10% penalty on distributions before age 59-1/2, the early withdrawal penalty on Roth IRA distributions applies only to the portion of the withdrawal that comes from earnings. Penalty-free early withdrawals are also allowed from both types of accounts for a variety of reasons, including first-time homeownership costs, health insurance premiums after losing your job, significant unreimbursed medical expenses and college costs.
3. Set up automatic deposits. Just because you don't have a 401k doesn't mean you can't set up a direct deposit from your paychecks to an IRA.
"By segregating those dollars into an IRA, you are less likely to use them for short-term needs, since there are some penalties associated with early withdrawals," says James Miller, a certified financial planner and president of Woodward Financial Advisors in Chapel Hill, N.C. Once you have maxed out your IRA contributions, consider redirecting a portion of each paycheck into an investment or brokerage account.
4. Hold equities outside of your IRA. Regular income tax is due on withdrawals from traditional IRAs, but equities held outside of retirement accounts can be taxed at the typically lower long-term capital gains tax rate. To minimize taxes on your savings, consider holding equities outside of your IRA and investments that are taxed at regular income tax rates inside your IRA. "Things like bond funds or investments that would pay out on a regular basis, you want to put those inside the IRA, and funds that don't have cash distributions or low cash distributions should be in a brokerage account," says John Deyeso, a certified financial planner for Financial Filosophy in New York, N.Y.
5. Aim for low costs. While you can't control the return you will get on your investments, you do have some control over how much you pay in fees. Make sure you compare the expense ratios of similar funds before selecting a long-term investment. "We've gone the rout of using ETFs (exchange-traded funds) as opposed to actively managed mutual funds because you can cut the fees dramatically by doing this," says Chip Addis, a certified financial planner for Addis and Hill Financial Advisors in Wayne, Penn. "A 1% difference in fees can add up to tens of thousands of dollars more that you will have when you retire."
6. Maximize Social Security. Almost all Americans are saving for retirement through the Social Security program. The amount you get is calculated based on your 35 highest-earning years in the workforce, and it varies based on the age you first sign up. "In general, you are better off waiting, because every year you wait past your full retirement age you get about an 8% bump in your benefit by waiting to collect," says Miller. "If you can wait until age 70, you can get a pretty significant bump." After age 70, there is no additional advantage to further delaying claiming your benefits.
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Get your emergency fund together now if you want to avoid stumbling over costly surprises in the future.
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