Maxing out your 401K too early every year can cost you over a million dollars!

Your 401K is often your biggest retirement nest egg, and maxing it out is a fantastic way to boost your retirement savings, however many people make very costly mistakes when trying to save for retirement.

The mistake that we will discuss today primarily affects people who have very good income, as well as good 401K match programs from their employers.  In my example, Mr. X will make $120,000/year salary, and he is going to get a $40,000 bonus in 2014, for a total 2014 income of $160,000, and his company matches 7% on his 401K contributions.  Mr. X always tries to max out his 401K as early in the year as possible, so that he can enjoy larger paychecks at the end of the year (because once you hit the 401K maximum, your total net pay goes way up due to that deduction stopping in your monthly paychecks).  In 2014, Mr. X decides that he will put 25% of his April bonus into the 401K and 15% of each paycheck into his 401K until he hits the maximum contribution level ($17,500/year).

After 5 months, Mr. X has invested $17,500 into his 401K, maxing out his annual contribution, and he enjoys much higher take-home pay for the next 7 months.

Congratulations Mr. X, you just cost yourself almost $5,000 in free money…

In a more severe example, where Mr. X makes $180,000/year salary, and gets a $70,000 bonus, he would have cost himself over $9,000 in free money…

How does this happen?

Well, in this case, Mr. X’s company matches the first 7% that he contributes from each paycheck.  However, his company no longer has to match once he hits the maximum contribution, therefore when he hit his maximum contribution after 5 months (in the first scenario), the company matched the first 7% of those 5 paychecks (and the bonus), but the company did not match anything in the last 7 months of the year.  Had he just put in 11% of his paychecks and bonus, instead of front-loading the contributions, he would have received an additional $4,900 in company contributions.  In the more severe example, let’s say that Mr. X lost $9,000/year in free money for 10 straight years between age 35 and 44, his 401K would end up being over $1,000,000 lower as a result when he retires.  So, we are not talking about chump change here…

The moral of this story is that maxing out your 401K is good, but maxing out your company contribution is even more important.  Your company is offering you (and your family) free money, so please make sure to spend a few extra minutes this year determining what percentage you should contribute so that you maximize your company’s match each month, and on your annual bonus, while hitting the maximum contribution at the very end of the year.  Your kids, and grandkids, will thank you for the extra million dollars decades from now…

 

NOTE:  Some companies DO provide catch-up contributions in these situations.  These rules are company and plan-specific, so it is always good to either check with the 401K provider, or check your final paycheck of the year to confirm that you got the catch-up contribution before assuming that you did.  It is worth noting that companies can change providers, or rules inside the 401K, at will. So, my advice would be to check the status of that rule each year prior to setting up your contribution strategy for the year.

Could a provision in the Fiscal Cliff deal help you retire with more money?

Money (Photo credit: 401(K) 2013)

I will, for the moment, stay away from the politics of the Fiscal Cliff deal and focus solely on one unexpected upside that arose from the recently negotiated bill – The Roth 401(k) provision.

Opportunity

The new Fiscal Cliff bill allows employees to make a one-time, large transfer from a traditional 401(k) to a Roth 401(k).  This could be a huge advantage to certain people during retirement, and it is something that we all should be evaluating whether or not to take advantage of in the wake of the contentious Fiscal Cliff debate.

Warning To All Readers

This article is not meant for your enjoyment, it is hard to write about financial things and make it fun.  However, if you invest the next five boring minutes into reading and evaluating this article, you may save yourself hundreds of thousands of dollars during retirement.

Traditional 401(k) vs. Roth 401(k)

For those of you who are not familiar, your 401(k) are pre-tax dollars, which means you don’t pay taxes on them now, but you do pay taxes on them during retirement.  A Roth 401(k) allows you to invest after-tax dollars.  This means that you don’t get the tax benefits now, but you will get to withdraw the money tax-free during retirement, which can be an enormous advantage in your later years.

Who Should Take Advantage Of This?

The first step is to find out if your company offers a Roth 401(k) option.  Almost 50% of companies offer one, though only around 5% of employees take advantage in this phenomenal savings tool.  After you confirm that your company does offer a Roth 401(k), you need to determine if you fall into one of these three groups:

1)      Younger workers with cash on hand

2)       People who are in lower tax brackets and have extra cash on hand

3)      People with cash on hand who believe their tax rate will be higher in retirement than it is today

You may have caught on to the “cash on hand” requirement in each group.  The reason that is important is that you will be required to pay the taxes on the converted amount this year, which means this option is only right for people who have some savings that can be used to pay for those extra 2013 tax dollars.

Major Upside To Converting To a Roth 401(k)

In almost every scenario, the Roth 401(k) makes more sense in the long-run.  The only scenario where it typically will not work out is if you are in a very high tax bracket today, and an extremely low tax bracket during retirement.  Take a look at this example:

Jimmy is 35 years old, he is in the 28% tax bracket, and he puts 10K/year into his 401(k) each year.

Scenario 1)  Jimmy is in the 15% tax bracket today, and will retire in the 25% tax bracket at 65

Outcome:  The Roth 401(k) option will net Jimmy $368,500 more during Retirement

Scenario 2) Jimmy is in the 25% tax bracket today, and will retire in the 25% tax bracket at 65

Outcome:  The Roth 401(k) option will net Jimmy $257,740 more during Retirement

 

Scenario 3)  Jimmy is in the 25% tax bracket today, and will retire in the 15% tax bracket at 65

Outcome:  The Traditional 401(k) option will net Jimmy$15,560 more during Retirement

As you can see, the only scenario where Jimmy comes out worse-off after choosing the Roth 401(k) is if he is in a high tax bracket today, and he retires in a low tax-bracket.  The truth is that most people who are ready for retirement will retire in a similar tax bracket as they are in right now, because they will become used to living off of that same amount of money.  In addition, taxes are historically low at this point, and with our National Debt rising with no end in sight, it is almost impossible to foresee a scenario where our tax rates will be lower in 30 years than they are right now (I promise that will be my only political comment in this article).

Major Downside To Converting To a Roth 401(k)

If you convert your Traditional 401(k) dollars into a Roth 401(k), you are responsible for the taxes during that year.  For example, if you have $50,000 saved up in your 401(k), here is what it could look like:

Scenario 1:  Tim is in the 15% tax bracket and converts $50,000.  Tim owes $7,500 in taxes in 2013.

Scenario 2:  Sally is in the 25% tax bracket and converts $50,000.  Sally owes $12,500 in taxes in 2013.

Conclusion

The math is not nearly as simple as I made it in this article, but it is directionally-correct.  For the most part, converting your Traditional 401(k) to a Roth 401(k) will benefit you in the long run.  It is always a huge decision to part with cash on hand now in order to avoid paying more taxes later, but these are the types of decisions that financially successful people make every single day.  If you are interested in executing one of these conversions, please do your own research, do your own math, and make your own decisions.  Financial decisions are never easy, but when an opportunity presents itself that could save you hundreds of thousands of dollars throughout your lifetime, you owe it to yourself to spend some time looking into it.  Please feel free to reach out to me with any questions or comments.  Good Luck!

Related articles

• Roth 401k options after ‘cliff’ deal (kypost.com)
• IRA, Roth IRA, Roth 401K Guide (infolific.com)

Should I Invest In My Own Company’s Stock?

Should I Invest In My Own Company’s Stock?

You will get many different answers on this question from your friends and co-workers. Here is the bottom-line: You already have an enormous portion of your retirement linked to your current employer. Your income, and future income, are all linked to your current employer’s well-being. Think, for a moment, what would happen if your company went out of business. You would instantly lose your income, your future income, along with any stock options you held at the company. Isn’t that enough of an investment? Now, if someone were to have 50% of their 401K in their own company’s stock, they would also lose 50% of their retirement nest egg immediately. In my personal opinion, you have enough invested in your own company the day you begin working there, so you should not invest in your own company within your 401K.

NOTE: The one exception, that I would make sure to point out, is when you are offered a match on your company’s stock (and not on other investments), or when you have an opportunity to purchase the company’s stock at a discount to the current stock price. In these unique scenarios, it makes a lot of sense to temporarily hold your company’s stock for the duration required to obtain the benefit.

Retirement Junkie is a website that the Hagopian Institute put together as a source for free information to help people prepare for retirement.  Please visit retirementjunkie.com, and follow MrEmergingMedia on Twitter for more retirement tips, along with other fun offerings from Todd Hagopian and the Hagopian Institute.

Should I Pay Off My Mortgage Before Retirement?

Should I Pay Off My Mortgage Before Retirement?

This is a question that is frequently asked during retirement planning sessions. All of our parents believed that it was important to retire without a house payment. Certainly, not having a house payment makes retirement much easier, but one must be very careful about how much they are willing to spend to make that happen. Becoming “House Poor” is a very real concern. This is a term that describes someone who puts all of their money into their home, and has no cash savings outside of the home to utilize. The reason this is a bad thing is that if you are retired and you own a $300,000 home that is completely paid off, but you have no savings, it is nearly impossible for you to access the equity in your home. It is hard to get a loan if you don’t have significant income, and while their are certain mortgage tools you can use to extract value from your home, this is not an ideal situation to be in. Becoming “House Poor” is something that you definitely want to avoid during retirement. If you read between the lines, I am basically saying that you should not pay off your house while neglecting your other retirement accounts (such as your 401K or IRA accounts). If you can afford to build up your retirement accounts and pay down your mortgage, then this can be an excellent strategy. If you can afford to do only one of these, please focus on building your retirement nest egg. You can always pay off your house with the money later, and you will have much more flexibility in your future finances. Not to mention, you will continue to get years of tax-deductible mortgage interest, tax-deductible 401K contributions, and tax-deferred 401K growth. When you add all of this up, you will be very glad that you took this advice.

Retirement Junkie is a website that the Hagopian Institute put together as a source for free information to help people prepare for retirement.  Please visit retirementjunkie.com, and follow MrEmergingMedia on Twitter for more retirement tips, along with other fun offerings from Todd Hagopian and the Hagopian Institute.

What Is A Traditional IRA?

What Is A Traditional IRA?

This type of account has contribution limits (under the 2010 rules, you could invest $5K/year if you are 49 or younger, and $6K/year if you are 50 or over). This type of account also has income limits, so you should check to see if you make too much money to qualify (2010 limits ranged between $56K – $66K for single filers, and between $167K – 177K for joint filers, meaning that if you made less money than the low-end of the range you could invest fully in the account, and if you fall somewhere in the range you may be able to invest a portion of the limits into the account).

There are two major benefits of this type of account: Tax-Deferred Gains, and the contributions are Tax-Deductible. Tax-Deferred means is that if your $3,000 contribution grew at 10% for 20 years, you would then have just over $20,000 without ever paying a dime of taxes. You will only be taxed on the income when you withdraw the money during retirement. By not paying taxes throughout your working years, the money accumulates much quicker, and your retirement pot grows more rapidly. Tax Deductible contributions mean that if you put in $3,000 dollars, you will actually get to write off $3,000 off of your taxable income for the current tax year. For example, if you are in the 15% tax bracket, you would owe approximately $450 less in taxes if you made a $3,000 contribution. Between these two advantages, this account is generally a great match for anyone who qualifies for this account.

Retirement Junkie is a website that the Hagopian Institute put together as a source for free information to help people prepare for retirement.  Please visit retirementjunkie.com, and follow MrEmergingMedia on Twitter for more retirement tips, along with other fun offerings from Todd Hagopian and the Hagopian Institute.

How Should You Pick Your 401K Investments?

How Should You Pick Your 401K Investments?

First, I will state unequivocally, there is no easy 1-page answer to this question. That being said, In this article, I will do my best to give you the tools you need to make the proper choices in your 401K.

Should I Invest In My Company?

You will get many different answers on this question from your friends and co-workers. Here is the bottom-line: You already have an enormous portion of your retirement linked to your current employer. Your income, and future income, are all linked to your current employer’s well-being. Think, for a moment, what would happen if your company went out of business. You would instantly lose your income, your future income, along with any stock options you held at the company. Isn’t that enough of an investment? Now, if someone were to have 50% of their 401K in their own company’s stock, they would also lose 50% of their retirement nest egg immediately. In my personal opinion, you have enough invested in your own company the day you begin working there, so you should not invest in your own company within your 401K.

NOTE: The one exception, that I would make sure to point out, is when you are offered a match on your company’s stock (and not on other investments), or when you have an opportunity to purchase the company’s stock at a discount to the current stock price. In these unique scenarios, it makes a lot of sense to temporarily hold your company’s stock for the duration required to obtain the benefit.

What Mutual Funds Should I Pick?

Again, this is not a one-size-fits-all kind of question. I will say that there are a variety of 401K plans that offer “Funds-of-Funds”. A few examples of funds like this are “Fidelity Freedom 2040” or “Vanguard Target Retirement 2025”. Basically, these funds hold a variety of other mutual funds on the inside. Their aim is to put together a balanced portfolio with the goal of retiring in the year that is stated. For example, the “Vanguard Target Retirement 2025” fund is for people who are aiming to retire in, or around, the year 2025. It will be comprised of a more conservative investment portfolio than the “Vanguard Target Retirement 2045” Fund. This is because as you grow older, you should slowly make your retirement fund more conservative to protect against large swings in the stock market. These funds will actually slowly rebalance their holdings in order to slowly get more and more conservative as you approach retirement. I am a huge fan of these funds for the average 401K investor. If you choose this route, you will probably want to invest 100% of your portfolio in one of these funds. Most of you probably have been told to never, ever invest “all of your eggs in one basket”. The difference here is that each of these funds holds approximately 10 mutual funds (or thousands of total stocks), so you are probably more diversified than you would be if you were to assemble your own portfolio.

If you would much rather construct your own portfolio, then you should diversify your portfolio according to your risk tolerance. Regardless of your asset class, you should invest a percentage of your 401K across all asset classes, including Large-Cap, Mid-Cap, Small-Cap, International, and Bonds. I am going to give very broad-based guidelines here so that you can begin to construct your own portfolio if you wish. I am going to split the suggestions into 5 age groups and risk tolerances. Please note that the age groups and risk tolerances do not necessarily fit together (as some people are more or less risky than others), but you should choose either the age bracket, or risk tolerance to make your decisions.

Aggressive Portfolio – Typical Age Range: 18 – 35
25% Small-Cap, 25% Mid-Cap, 35% International, 15% Large-Cap, 0% Bonds

Moderately Aggressive Portfolio – Typical Age Range: 35 – 45
15% Small-Cap, 15% Mid-Cap, 20% International, 30% Large-Cap, 20% Bonds

Moderately Conservative Portfolio – Typical Age Range: 45 – 55
10% Small-Cap, 10% Mid-Cap, 10% International, 40% Large-Cap, 30% Bonds

Conservative Portfolio – Typical Age Range: 55+
5% Small-Cap, 5% Mid-Cap, 5% International, 40% Large-Cap, 45% Bonds

Retirement Junkie is a website that the Hagopian Institute put together as a source for free information to help people prepare for retirement.  Please visit retirementjunkie.com, and follow MrEmergingMedia on Twitter for more retirement tips, along with other fun offerings from Todd Hagopian and the Hagopian Institute.

What Should I Do With My Old 401K?

What Should I Do With My Old 401K?

If you have left a former company, you should always move your old 401K into an IRA (Individual Retirement Account). There are many reasons for this, but the most important one is that your old company retains the power in your old 401K. By that, I mean that your old company can decide that suddenly your investments must change from Fidelity to Vanguard or vice-versa. They can also freeze your asset movements with little/no notice during blackout periods. In addition, you may only invest in the asset choices that your company allows you to, whereas in an IRA you have none of these aforementioned issues.

How Should I Do It?

First, find a financial advisor if you don’t have one already. If you are completely adverse to hiring a financial advisor, then look for a free or cheap account on E-Trade or Fidelity, but this will require more information than I will provide on this site. Basically, once you have a financial advisor, who you trust, they will be able to very easily set you up with the transfer paperwork necessary to move your money into an IRA. They will also be able to give you more information than I am about to provide on the type of IRA options that you have. More importantly, your 401K will likely be liquidated and put into your IRA in cash, therefore you will need to buy investments when you begin your IRA, and your new financial advisor can help you make those choices.

What Types of IRAs Are There To Choose From?

The first type is a traditional IRA. This IRA is taxed almost identically as your 401K (although there are some states where it gets slightly advantaged tax benefits, please contact a tax attorney or financial advisor for specifics in your state). If you move your old 401K into a traditional IRA, there will be no tax event that year, meaning it will not cost you anything, you will not pay any immediate taxes, and you will not begin paying taxes until you begin withdrawing the money (just as you would have in the 401K). This is the type of IRA that over 90% of people will wind up using in this scenario, but there are valid reasons for looking at the second type, which I am about to talk about.

The second option you have is rollover the old 401K into a Roth IRA. Roth IRAs are taxed at the time of the rollover. This means that if you rolled over a $20,000 401K into a Roth IRA, and your tax bracket was 15%, you would theoretically pay $3,000 of taxes in the current tax year. The reason you might want to do this is because the Roth IRA will then grow tax free rather than tax-deferred. Please take a look at the “Retirement Tools” Section where I discuss this in further detail, so that I do not provide a lot of repeat data on this site. To make a long story short, two main types of people should be interested in rolling over their 401K into a Roth IRA instead of a traditional IRA:

1. If you are younger than 40, you have the money to pay the taxes, you are not planning on removing the funds early, and you believe that your income will continue to rise throughout your working career.

2. If you will earn an unusually low amount of money in a particular year (e.g. if you got laid off, started a new business, or took a year off), you might decide to roll over the 401K and pay the taxes at a very low tax bracket, rather than waiting until retirement when tax rates or your income may rise from today’s date.

Retirement Junkie is a website that the Hagopian Institute put together as a source for free information to help people prepare for retirement.  Please visit retirementjunkie.com, and follow MrEmergingMedia on Twitter for more retirement tips, along with other fun offerings from Todd Hagopian and the Hagopian Institute.

Which IRA Is Best For Me?

Which IRA Is Best For Me?

What Is An IRA?

Generally speaking, an IRA is an Individual Retirement Account. The two I will speak about in this section are the Traditional IRA and the Roth IRA. These two IRAs have both income limits, and contribution limits (outlined below). In general, you can make contributions into these accounts while you are earning income (provided you meet the requirements below), and you cannot take out the money until you are at least 59 years old (there are certain circumstances where you can get to the money early). People typically invest in these accounts as a retirement tool because they offer certain tax advantages that other normal stock, mutual fund, or cash accounts do not offer. In general, these accounts are a part of nearly every retirement plan provided that you qualify for the funds, you have enough money to invest in them, and you don’t need the money until retirement.

Traditional IRA
This type of account has contribution limits (under the 2010 rules, you could invest $5K/year if you are 49 or younger, and $6K/year if you are 50 or over). This type of account also has income limits, so you should check to see if you make too much money to qualify (2010 limits ranged between $56K – $66K for single filers, and between $167K – 177K for joint filers, meaning that if you made less money than the low-end of the range you could invest fully in the account, and if you fall somewhere in the range you may be able to invest a portion of the limits into the account).

There are two major benefits of this type of account: Tax-Deferred Gains, and the contributions are Tax-Deductible. Tax-Deferred means is that if your $3,000 contribution grew at 10% for 20 years, you would then have just over $20,000 without ever paying a dime of taxes. You will only be taxed on the income when you withdraw the money during retirement. By not paying taxes throughout your working years, the money accumulates much quicker, and your retirement pot grows more rapidly. Tax Deductible contributions mean that if you put in $3,000 dollars, you will actually get to write off $3,000 off of your taxable income for the current tax year. For example, if you are in the 15% tax bracket, you would owe approximately $450 less in taxes if you made a $3,000 contribution. Between these two advantages, this account is generally a great match for anyone who qualifies for this account.

Roth IRA
This type of account has contribution limits (under the 2010 rules, you could invest $5K/year if you are 49 or younger, and $6K/year if you are 50 or over). This type of account also has income limits, so you should check to see if you make too much money to qualify (2010 limits ranged between $105K – $120K for single filers, and between $167K – 177K for joint filers, meaning that if you made less money than the low-end of the range you could invest fully in the account, and if you fall somewhere in the range you may be able to invest a portion of the limits into the account).

There are two main differences between the Roth IRA and the Traditional IRA: The Roth IRA grows Tax-Free, and the contributions are not Tax-Deductible. Tax-Free means is that if your $3,000 contribution grew at 10% for 20 years, you would then have just over $20,000 without ever paying a dime of taxes. You will then not be taxed at all on the income when you withdraw the money during retirement. By not paying taxes throughout your working years, the money accumulates much quicker, and your retirement pot grows more rapidly. By not paying taxes when you withdraw the money, you save an enormous amount of money during retirement. Since the contributions are not Tax Deductible, this means that if you put in $3,000 dollars, you will not be able to write off any tax dollars for the current tax year.

Which One Is Best For Me?

Speaking in general terms, if you are under 45 and you qualify for a Roth IRA, then it is usually a better long-term investment. This is because you have enough time left before retirement to make the tax-free growth worth more than the tax-deduction you would get if you were to write off a contribution to your traditional IRA. The exception to this would be if you are in need of a tax deduction or have another reason to lower your overall tax liability.

If you are above 45, you may want to consider the Traditional IRA, take the tax-deduction in the current tax year, and pay the taxes on the withdrawals later on during retirement. The exception to this would be if you are not planning on withdrawing the money until deep into retirement, in which case you can still look at a Roth IRA for the benefits mentioned above.

Retirement Junkie is a website that the Hagopian Institute put together as a source for free information to help people prepare for retirement.  Please visit retirementjunkie.com, and follow MrEmergingMedia on Twitter for more retirement tips, along with other fun offerings from Todd Hagopian and the Hagopian Institute.

Who Is The Retirement Junkie?

Who is RetirementJunkie?

I was blessed to have a grandfather who, while managing a stock brokerage office, taught me how to evaluate stocks at the age of 10. From that point on, I was completely hooked on the stock market.

Over the years, I have spent time at AG Edwards, American Express Financial Advisors, Ameriprise Financial, and Comerica Bank throughout my career. In the past, I have held a multiple Securities Licenses, including my Series 7, Series 66, as well as multiple Life and Disability Licenses across multiple states.

I also have an MBA with a Dual-Major in Finance & Marketing from the Eli Broad School of Management at Michigan State University.

My mission is to provide free, impactful advice on how to plan for a better retirement for you and your family.

Retirement Junkie is a website that the Hagopian Institute put together as a source for free information to help people prepare for retirement.  Please visit retirementjunkie.com, and follow MrEmergingMedia on Twitter for more retirement tips, along with other fun offerings from Todd Hagopian and the Hagopian Institute.