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NEXT TIME you see your boss walking by your cubicle and you find yourself fighting the urge to trip him, take a deep breath and keep this one thought in mind: Your employer is probably making you rich.
Got a 401(k) plan at the office? Is there employer matching? Then all this should add up to a very comfortable retirement, one that you'd be hard-pressed to match without the tax-deferred compounding a 401(k) offers.
This section features interactive tools and guidance that will help you make the most of your 401(k). But step No. 1 is simple: Put at least as much into your plan as your employer will match each year. Think of it this way: What other investment gives you the equivalent of a 25% or 50% return on the first day?
But don't stop there. To lock-in a comfy retirement, you need to save a lot more than that. Our research shows that you should follow this pattern:
- Roth IRAs: After you've maxed out the company match, turn to a Roth IRA — if you qualify. (Your adjusted gross income must be less than $95,000 or less than $150,000 if you're married.) That's a better option than putting it in the 401(k) without the match. It's true that you won't get a tax deduction on Roth investments this year, but the eventual tax-free status of your Roth returns outweighs any immediate gain you'd get from a tax deduction. (See our Which IRA Is Right for You? for more on Roth accounts.)
Step No. 1: Max out. Put as much into your plan as your employer will match each year. What other investment gives you the equivalent of a 25% or 50% return on the very first day?
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- Unmatched 401(k): Keep putting your excess savings into the Roth until you've used up the $4,000 that you're allowed to contribute each year. (If you'll be age 50 or older by the end of the year, you can contribute an extra $500 annually. The limits for 2004 were $3,000 and $3,500, respectively.) Then, if you want to save even more than that, make whatever unmatched contributions you are allowed to your 401(k). For 2005, the government caps contributions at $14,000, although the limit is $18,000 for those age 50 or older.
- Taxable Investments: If you plan to invest in equities, a taxable investment account with your friendly brokerage firm is probably the next best thing. The key to choosing taxable investments for your retirement savings, however, is to keep your expenses down and get the most benefit from the lower capital gains break. That means holding your stocks for more than 12 months — longer, if possible — and choosing mutual funds with a low annual turnover (the rate at which the fund manager buys and sells holdings). Since the law requires that gains from selling stocks be distributed to mutual fund investors, the higher the turnover rate, the greater the amount of your return each year that will be subject to taxation — and that amount may be taxed at higher rates.
- Nondeductible IRA: Here the annual limit is $4,000 ($4,500 if you are 50 or older. For 2004, the limits were $3,000 and $3,500). Unlike a deductible IRA, anyone with earned income from a job or self-employment can open one. And since these accounts grow tax deferred, if you have a long investment horizon, the tax-savings can be significant. That said, withdrawals are taxed as ordinary income, rather than at the lower long-term capital gains rates applied to taxable accounts. Given the current 15% maximum federal rate on long-term capital gains and qualified dividends, these accounts aren't as attractive for those with a relatively short investment horizon.
- Variable Annuities: Forget them. Their exceptionally high expenses often counteract the tax-deferred aspects of these contracts. Variable annuities make sense only for a fixed-income asset such as bonds or cash, and only if you are saving for many years. In that case, the gains from compounding your interest free of income tax eventually outweigh the drag created by higher fees. The exact number of years necessary to come out ahead depends on your tax bracket and the income yield of your investments.
Once you've got your savings placed in your 401(k) and other accounts, of course, you then have to choose the most appropriate investments. Our Picking Investments section will walk you through the issues involved.
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