Money Book for the Young, Fabulous & Broke: Retirement Rules
March 27, 2008, 10:28 am
Filed under: Books, Money Basics | Tags: ,

This is the sixth installment of my review of Suze Orman’s The Money Book for the Young, Fabulous & Broke. The previous installment, Save Up, covered ways you can save money.

The whole reason behind Orman writing chapter 6, “Retirement Rules,” is that 20somethings cannot safely rely on social security to take care of us when we retire. There is very little chance that the system will still be running when we reach that point in our lives and, even if it is, the amount we will get from it will not be enough to live off of. In short, we must fund our own retirement. Luckily, we have the power of compound interest on our side because of the sheer amount of time we have until we retire.

There are two basic flavors of retirement accounts: 401(k)s and Roth IRAs.

Here’s a nice trivia fact: the name 401(k) comes from the part of the federal tax code that deals with these plans. The contributions you make into your account are taken out of your paycheck and invested into mutual funds, stocks, and or bonds. There are limits to the amount of money you can put into your 401(k) every year. For 2008, the federally imposed limit is $15,500, but your employer could have a lower limit. Give HR a call and check it out.

The neat thing about 401(k)s is that your employer probably offers a company match where they match a certain percentage of your contributions up to a specific amount. This is free money! Do not pass up this opportunity! Any plan where you get a company match is top priority. Orman is very clear on this point: you must enroll and invest enough in your 401(k) to get the maximum company match each and every year.

There is such a thing as a vesting schedule that applies to your company match (not your contributions). Each year, a little more of the company match becomes yours- typically 20-25% a year until it is all yours- in order to ensure that your employer is not wasting their money on an employee who won’t be sticking around with the company for very long. Therefore, skip contributing to a 401(k) if you are not planning on staying long enough with the company to collect the match.

The money put into your 401(k) is taken out of your paycheck pretax. Another term for this is tax deferred. You pay the taxes when you take the money out of your account when you are at least 59 1/2. The amount you pay in taxes is based on your income tax bracket at the time you withdraw the money. If you make a withdrawal before you turn 59 1/2, you not only owe tax, but must also pay a 10% early withdrawal penalty.

Unlike a 401(k), a Roth IRA is completely separate from any employer. You must set up an account yourself. In a Roth IRA, the money you put in has already been taxed and will not be taxed again when you take it out (unless your account is less that 5 years old or you’re under 59 1/2 when you withdraw your earnings). Orman highly recommends concentrating on a Roth if you can’t get a company match or if you’ve already gotten the maximum company match.

Orman is absolutely wild about Roth IRAs because, when you make withdrawals in 40 years, your tax rate will be higher since you will more than likely be making more money than you do right now. So it makes much more sense to be taxed now with a Roth IRA then later with a 401(k).

Just like a 401(k), the money you contribute to a Roth is invested in mutual funds, stocks, and or bonds and there is a limit to the amount you can contribute to your Roth IRA every year. For 2008, it’s $5,000. You must also make less than $101,000 if single or $159,000 if married. You can withdraw your contributions anytime without penalty or taxes from a Roth, but your earnings can only be taken out tax- and penalty-free once you hit 59 1/2. In this way, a Roth can double as an emergency cash fund. Orman recommends opening up a Roth account with either a discount brokerage or a no load mutual fund company because of their lower fees.

Another advantage to having a Roth IRA is that you can withdraw your earnings penalty-free, up to $10,000, to use for the down payment on your first house. Again, your account must be more than 5 years old in order to cash in the waived taxes and fees. For a 401(k), you can also use your earnings for a down payment, but you must pay the taxes even though the 10% fee will be waived. 

Since I don’t have a full time job, I do not have any sort of 401(k) account. I would absolutely love to have a Roth IRA and plan to open up an account once I can afford to set aside the minimum balance and monthly transfer requirements, not to mention any fees I’ll need to pay on the account. Once I do get a full time job, I plan on maxing out the company match. Jake has a 401(k) through his employer, but they do not offer a match, instead they just give a plain percentage regardless of if you personally contribute any money or not. He’s currently contributing 3%, but I’m hoping that he’ll be able to set up a Roth soon and contribute that money to the Roth instead.

Next up for my Money Book for YF&B review is investing principles.

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