CHAPTER
6

Finding Money to Invest

In This Chapter

• Understanding your workplace retirement plan
• Choosing the right amount to contribute
• Surveying investment possibilities
• Supplementing your income
• Investing windfalls and savings to build wealth

For many people, the biggest stash of money they will accumulate in any single account will be their workplace retirement account. Because these accounts can build up significantly over time, and may be the basis for how well-funded you will be at retirement, you should understand how these work.

In this chapter, we’ll look at understanding and investing your current employer’s plan, as well as survey ways to supplement your retirement savings with individual tax-sheltered accounts. Finally, we’ll look at other steps you can take on your own to fund your investments.

401(k)s, 403(b)s, and 457 Plans

Your workplace retirement plan is probably the best deal you’re going to get in investing. Employers benefit from them too—such plans have enabled them to get rid of the old pension plans that your parents or grandparents depended on. Their “generous” employer match to your own savings costs them far less than providing you with a pension. If you don’t contribute at all, they don’t have to match anything, and since a lot of people don’t, the employer is home free. You get to assume all the risk. If the investments you choose don’t do well and don’t pay you enough in retirement, well, that’s your problem.

On the other hand, you can’t beat the return. If your employer contributes 3 percent of your salary, and you kick in 3 percent, you’ve just gotten a 100 percent return on your money.

But wait, we haven’t even looked at the tax benefit. Contributions to a 401(k), 403(b), or 457 plan directly reduce your taxable income, so depending on your tax bracket, your cost to contribute (your return on investment) is that much higher. And even if your employer only matches part of your contribution, you still receive the tax benefit.

For many people, their 401(k) is the largest investment they will ever make.

How Much Should You Contribute?

I hope I’ve convinced you of the benefits of contributing to a workplace retirement plan. But how much should you contribute?

As of this writing you can contribute up to $18,000 of earnings, with an additional “catch-up” contribution of $6,000 if you’re over 50. Your employer is probably not going to match these maximum-allowed contributions 100 percent, but the tax reduction alone suggests that you should do everything you can to contribute.

If your earnings are less than or equal to the maximum contribution, you can contribute up to 100 percent of your earnings—a worthwhile strategy if you can live on earnings from another source (like a spouse).

At a minimum, try to contribute enough to get the full employer match, whether it’s 3 percent, 5 percent, 8 percent, or some other number. Next, as soon as possible, you want to up your contribution to at least 10 percent of salary (your retirement savings budget amount, discussed in Chapter 1). As soon as possible means once you have an emergency fund of at least $1,000 to $5,000. It does not mean once you’ve paid off your student loan, bought a house, and so on. The earlier you start contributing to retirement funding, the less you’ll have to play catch-up later. In fact, if you begin in your 20s or early 30s, and keep pace with any salary increases, you may never have to worry about retirement income—you’ll have enough.

If you can, try to increase your contribution to the maximum allowed by law. When you get a raise, direct at least some of it into increased contributions to your retirement plan. No one has ever sat in my office for financial planning and said they were sorry they saved too much.

If you’re in a high tax bracket, the savings from salary reduction becomes more and more worthwhile. If you have limited ability to save, you should prioritize: first, contribute to the account to the maximum match. Next, perhaps choose to contribute to a Roth or traditional IRA (see “Supplementing Your Workplace Plan with IRAs”), up to your maximum entitlement—this gives you a retirement account in which you can choose your own investments and keep the costs low. After that bucket is filled, you can go back and contribute whatever you can to the workplace account.

The Drawbacks

Now that I’ve (hopefully) convinced you that your workplace account should be your first- and highest-priority investment, you should know the drawbacks.

First, you probably have mediocre to terrible investment options in your account. Very few workplace accounts allow you to invest in stocks or exchange-traded funds (ETFs), for example.

Second, your choices of mutual funds will be, for the most part, limited. Your employer may have chosen an account provider who offers only high-cost or poorly performing funds (at least compared to the no-load fund you might have purchased on your own). You’re stuck with the offerings, but do everything you can to convince the powers that be to add low-cost funds in a variety of asset classes.

Even with good offerings, many employees make not-so-good choices; employers have moved to making target date funds the default choice. Still, many employees have no idea what they’ve selected, much less what their target date fund actually invests in.

Generally, target date funds (see Chapter 4) give you a lot of diversity and offer a pretty steady performance over time—neither gaining nor losing dramatically. You pick the year you plan to retire and select the target date fund nearest that date. It will automatically become more conservative as you age. Theoretically, you make one choice and it’s set for your entire career.

But that may not be right for you. If you have a large amount of money outside the retirement fund, you may be more interested in higher returns than in a fund that gets more and more conservative. If so, you can pick a target fund with a later retirement date, which will be more heavily invested in stocks. So if you think you’ll be retiring in 2040 but know you will inherit some money before then, you might want to choose a 2045 or 2050 fund for the possibility of higher return.

Another drawback of workplace retirement funds is that they can have high costs. This can happen in a few ways:

• Only funds with high management costs or (worse) sales charges (loads) are offered to you.
• You may be charged a yearly fee for having the account.

If you change jobs and want to transfer your account to your new employer or an IRA, you may be socked with a huge transfer fee. Usually the charge is minimal ($0 to $25), but I’ve seen clients who were dinged as much as $4,000 to move their accounts.

Luckily, the federal government now requires that employees invested in private sector plans be provided with information regarding the costs of those plans. These costs should be reasonable. A fee of 1 percent or less is probably acceptable. More than that, and you should talk with your employer about getting a better plan.

Given the tax impact and your employer match, it’s still worth investing in workplace retirement funds, despite these drawbacks. But you’ll need to balance your workplace portfolio with some extracurricular alternatives.

Supplementing Your Workplace Plan with IRAs

If you’ve maxed out your contributions and still have money to invest, or if you earn outside income, you can enhance your wealth in years to come by establishing an individual retirement account, or IRA.

These are the three types of IRAs worth considering:

• Traditional IRAs
• Roth IRAs
• SEP-IRAs

Traditional IRA

Traditional IRA contributions, like contributions to a 401(k), are deducted from your income before taxes and therefore directly reduce your taxable income. However, your income limit for deducting contributions is $61,000 (single) and $98,000 (married filing jointly). Earnings in the account grow tax-free until you begin withdrawals. Then, all withdrawals are taxed as ordinary income. You can withdraw from a traditional IRA for college expenses, medical disability, and up to $10,000 to purchase a first home, but you must pay income tax on the entire withdrawal. If you withdraw for any other reasons before 59½ you will pay tax on the entire withdrawal, plus a 10 percent penalty.

Traditional IRAs work very much like a 401(k): you contribute from your income before taxes, and the contribution reduces your taxable income. The difference is that these accounts are entirely under your control and you choose the investments. You can choose mutual funds, target date funds, bonds, cash, or individual stocks. Your contributions and all earnings grow tax-free until you withdraw them in retirement, at which point withdrawals are taxed as ordinary income.

The Feds really want you to leave this money alone until retirement, and you should. At 70½ you must begin required minimum distributions (RMD), whether you need the money or not. After all, the government has been giving you a tax break all these years, and now it’s time to pay the piper. The RMD is based on your age and the value of your account on the previous December 31. Wherever your account is housed, the institution should be able to calculate your RMD. Remember, there’s no obligation to spend the money; you just have to move the distribution to a taxable account and pay income tax on it.

In order for traditional IRA contributions to be tax-deductible, you must be under certain income limits. This program was originally intended to help the middle class, not help the wealthy shelter assets. You can always contribute to an IRA, it just won’t be deductible (but it will still grow tax-free until retirement). You can also contribute for a nonworking spouse.

The following table lists IRA contribution limits.

Roth IRA

A Roth IRA is a retirement account into which you can contribute up to $5,500 a year (currently) with an additional $1,000 catch-up contribution if you’re over 50. Because you’ve already paid taxes on your deposit, you don’t get a tax deduction up front as you do with a traditional IRA. However, earnings in the account grow tax-free, and when you retire and withdraw it, you pay no taxes on those withdrawals. You can contribute to a Roth account as long as your income is below $117,000 (single) or $184,000 (married filing jointly).

You are not legally required to make withdrawals from a Roth as you are from a traditional IRA, so you could leave the entire amount for your heirs, or begin withdrawals at any point after you turn 59½ years old. As with a traditional IRA, you can legally withdraw from a Roth for college expenses, medical disability, and to purchase a first home (up to $10,000). For any other withdrawals before 59½, you must pay a 10 percent penalty and a tax on the earnings (not on what you contributed). After 59½, you can make withdrawals at any time, as long as the account has been open for 5 years.

As with a traditional IRA, a Roth IRA grows tax-free, but there are several important differences. One big drawback is that you don’t get a tax deduction for your contribution. It’s kind of ironic, because the higher your income, the more valuable a tax deduction is to you. When your income is under the limits for a traditional IRA, you’re probably going to have a harder time contributing to an IRA at all, and the tax deduction won’t be as much of a benefit in a lower tax bracket. If you can’t save at all without the tax deduction help, then go for the traditional IRA—it’s better than not saving at all.

If you can swing it, the Roth IRA offers several advantages. You can always withdraw your principal tax-free. Once you reach 59½ (as long as the account has been open for 5 years) you can withdraw principal and earnings tax-free and penalty free. (See Chapter 17 for a discussion of how the Roth can be used for college savings.)

You can also withdraw earnings for heavy medical expenses, disability, or health insurance premiums while unemployed, without penalty. For all other withdrawals before 59½, you’ll be socked with a 10 percent penalty on earnings. But remember, you can always withdraw your contributions, so a Roth can be a dire-emergency fund. However, you should plan to leave it untouched until you retire.

The biggest downside of a Roth is the limited amount you can contribute, and the income limits. Try to contribute as early in your career as you can, particularly if there’s a possibility that your future earnings will rise too high for you to get this tax-free benefit. The Roth has higher income limits, but once you reach them, you can’t contribute.

The following table lists Roth contribution limits.

It is possible (currently) to contribute to a nondeductible traditional IRA if your income exceeds the limits, then immediately convert it to a Roth. However, Congress is looking at eliminating that loophole, and there are some tax implications if you also have other amounts in a traditional IRA. See an accountant before you attempt this tactic.

The IRA world changes frequently. It’s a fertile area for political manipulation, and contribution and income limits can change in any year. Be sure to check with irs.gov for each year’s current rules and dollar limits.

If you don’t earn anything due to business expense write-offs, you can’t contribute to an IRA until you actually can pay yourself something.

You owe it to yourself to consider retirement contributions a necessary business expense and benefit. Even if you can’t afford to contribute the full amount, contribute something.

Brokerage Accounts

At some point in your life, or for some goals, you’re going to want investments you can access before retirement. Or maybe you want to retire before 59½ and would like to avoid tax penalties.

Tax-sheltered retirement plans allow your earnings to grow tax-free, but all except Roth accounts tax your withdrawals (including all gains and earnings) as ordinary income. However, capital gains in regular brokerage accounts (from selling investments) are taxed at a lower capital gains rate, currently 0 or 15 percent depending on income. If your tax bracket in retirement is higher than 15 percent, you’ll pay a higher tax on 401(k) or traditional IRA withdrawals than you would by extracting the same sum from a taxable brokerage account through sales.

A brokerage account allows you to access your money at any time, and there are no minimum withdrawals as may be required by some types of retirement accounts such as your 401(k) or traditional IRA. Brokerage accounts give you the maximum flexibility for any type of savings program, but earnings are not tax-sheltered. Brokerage accounts allow you to purchase mutual funds, stocks, and bonds. (See Chapter 7 for more discussion of brokerage accounts.)

Dealing with Past Employers’ Plans

If you’ve worked for a while, you’ve probably had several employers. At each of them, you may also have had a retirement plan. Generally speaking, you have three choices: leave it where it is, cash it out, or roll it over.

Leave it where it is When you leave an employer, you aren’t obligated to move your retirement account. But you might forget you have it. People lose these things. I’ve had plenty of clients who come to me for financial planning, and in the course of a deep dive into their files, discover (sometimes several) small employer retirement plans they’ve forgotten they have. Sometimes they get lucky and the investments have grown. Sometimes the money has been parked in cash and they’ve earned nothing for years. If you leave it where it is, be sure you keep good records and review the account on a regular basis to monitor its activity and returns.

Cash it out The most likely thing people do when they leave an employer is to cash out the retirement funds. Please think carefully before doing this. True story: when I quit a job in my late 20s, I had $2,000 in a retirement plan. Not knowing what to do with it, I rolled it over into a mutual fund. I then proceeded to totally ignore it for another 20 years. Sure, I’d get statements in the mail but I was busy with other things, and used to just toss out the envelopes as so much more paper clutter. When I finally got interested and opened one, that $2,000 had grown to nearly $80,000. Glad I didn’t spend it at the time.

If you do decide to cash it out, that’s considered a distribution and you’ll be liable for both income taxes and a 10 percent penalty, depending on your age.

Roll it over People leaving jobs may feel they could use the money, or there’s not enough there to be worthwhile, but they’re not thinking about how much that money could grow if properly reinvested. My advice in most cases is to open up an IRA and roll that money over into it. You’ll probably change jobs several times in your career. Keep rolling over your 401(k)s into that IRA. A self-managed IRA is going to offer you lots of opportunities to invest—in fact, it may be the first place you start to make real investment choices. Choose a low-cost brokerage firm or a mutual fund company, so you’ll have maximum freedom to choose investments. Don’t plunk it in a bank—you won’t make any money over the long term.

Other Investing Considerations

As you progress in your investing career, and build accounts outside of the tax-sheltered ones, the best management of your accounts also means you will consider asset location—housing your investments with an eye on paying the least amount of taxes.

If you’ve maxed out your contributions and have money to invest in a regular old brokerage account where you can choose a variety of investments, you generally want to put the ones that pay dividends or large payouts (like bonds and real estate investment trusts, or REITs) where they will be tax-sheltered.

Investments from which you primarily profit by capital gains can be parked in taxable accounts, because capital gains are taxed at a lower rate.

And if you hope to retire early, having some money available that won’t be penalized by early withdrawal (before traditional retirement age) can be a great idea.

Augmenting Your Investment Money Through Your Own Efforts

The simple truth about accumulating investment money is that you have to save (or earn) more, spend less, and wisely invest the difference. You can also help yourself by selling any assets you aren’t using, getting a part-time job, and being prepared to deal with windfalls.

Selling Your Junk

Do you have unused or excess assets? That’s otherwise known as junk. Get rid of it—learn to use eBay, craigslist, hold a yard sale, trade it off to friends. Even a few hundred dollars can help you begin your investing program. Not only can you scare up some capital, selling off your unwanted possessions can also show you the sins of your ways. If it slows down your spending and causes you to more carefully consider future purchases, all the better. Remember, the $100 you spent on that thing you no longer want could have doubled in value as an investment.

It can be a no-brainer type of job, or you can use that time to try out and grow a business idea that might allow you to quit your job someday. As long as you pick something that doesn’t require a lot of money up front, it’s almost all upside. And if you ever get fired, at least you have some money coming in. Just don’t use the extra to, er, enhance your lifestyle. Generating an extra $6,000 to $12,000 won’t support you, but it’s a pretty nice chunk of change to build your investments.

Money from Windfalls

People generally have one of two reactions to big windfalls: I can spend it (all) on something I always wanted, or I can’t spend a penny of this because I’ll never get this much money again.

I’ll lean toward the second as my preference, but it doesn’t really have to be either. When you get any amount of money, ask yourself what it can do for the plan you’ve developed. If your goal is to buy a house, and this will get you there, I give you my permission. In debt? Put at least some of it to paying it down. Or let it give you a jump on the long-term investment program you’ve planned, and maybe you can retire early, or at least have the choice. (See Chapter 19 for more on dealing with windfalls.)

Gifts, Rebates, Refunds, and Other Relatively Small Amounts

Work your plan. You can put the money into your vacation fund, your get-a-new-bike fund, or whatever. Even if it’s so small that all it will do is take you out to dinner, choose a cheaper place and spend only half. Remember, wealth isn’t what flows through your fingers; it’s what you hold on to.

Settlements

Depends on what kind—if you’ve been injured and it’s a big one, they’re probably going to want to pay it out in structured payments. You need professional accounting and financial planning help before you agree to anything.

But what if it’s a smaller settlement—maybe a couple thousand from a complaint about a product that gave you a minor injury? I really want you to save this once you pay off any medical or legal costs. It’s money you never expected to have anyway. Luck has put it in your hands, now invest it and turn it into an even bigger bonanza. You’ve just received a mini-endowment of your investment portfolio.

The next problem is that it may be more money than you’ve ever seen before, and you may not feel experienced enough to make investing decisions with so much. There’s absolutely no harm in going slow. Better to forgo some short-term gain than plunge in and take big losses. See Chapter 7 for ideas on where to park it while you’re thinking things through.

Finally, you may have a sentimental attachment to the investments Dad or Grandma purchased. Stop! Investments have no sentimental value. The investments don’t care anything about you. And any single investment isn’t a good one forever.

Whenever you can, attempt to prioritize savings into tax-deferred or tax-free accounts like your 401(k), a traditional IRA, or a Roth IRA. Well-funded retirement accounts are the basis for your future retirement income and the underpinning for financial security. But to improve your wealth, build investments beyond retirement accounts. Try to hold on to as much as you can, and put it to work for you in your investment plan.

The Least You Need to Know

• Contribute enough to your workplace retirement account to get the employer match.
• Contribute as much as you can afford to tax-favored retirement accounts, up to their legal maximum.
• If you’re self-employed or have side income, establish a retirement plan—you owe it to yourself.
• Use strategies to earn and save more and spend less.
• Try to hold on to as much of a windfall as you possibly can. Don’t rush into investing it, but don’t let it sit idle forever.