The 9 Steps to Financial Freedom (23 page)

Your situation might be a little different, depending on what tax bracket you are in or whether the state you live in imposes an income tax, but the concept always holds true.

Finally I convinced her, and she promised to up her contribution to the maximum that very week, which she did. She called me a few days later: the very day she raised her contribution, her boss had called her into her office to give her a midyear raise. This was the first time in all these years she had been given a raise before the end of the year. She was stunned.

I wasn’t. This sort of occurrence, however you want to explain it, is not uncommon; I’ve seen it happen many times. I attribute it to the second law of financial freedom:
Respect attracts money
.

Judy had decided to respect herself, chosen to put the creed into action and take the steps to nurture her money. And by doing the right things with her money, she attracts more money.

If you are covered at work by a 401(k), 403(b), or SIMPLE plan, I want you to go into your human resources office and up your contribution. You must contribute at least enough to qualify for the maximum matching employer contribution. That match is a free bonus you do not want to pass up. After you have achieved that, your focus should be on also funding a Roth IRA. Then, if you have the ability to save even more, you can increase your work-based contributions even higher. The absolute best move is if you can fully fund your work retirement plan as well as a Roth IRA. If you have not signed up for your retirement plan, please do so now. If you are self-employed or your place of employment doesn’t offer a 401(k) or similar plan, please read on and take the actions that are right for you. Once you’ve done this, write down the date you took the action and begin to keep track,
and see what happens in your financial life that never would have happened before. For Judy, it was a midyear raise. Soon you will see that there is a direct correlation between taking a step toward financial freedom yourself and watching your money take a step right back toward you.

You need not feel afraid about increasing your contributions. None of these changes is cast in stone, and you could always change back if you felt you had to. Among all the people I’ve had do this, by the way, not one single person has ever regretted it—or changed his or her contribution back to where it was. You cannot afford not to try this out. There will be a day, you know, when you won’t be able to bring in a paycheck, and you must prepare for that day now.

Companies are offering 401(k) plans because most of them do not offer pensions anymore. When many of our parents retired, things were different. Back then, many received a monthly paycheck from their longtime employers after retirement—that’s why retired people were called pensioners. Also, even a generation ago people were not living to ripe old ages, the way we are now, and retirement was a shorter-term eventuality. For most of us, the pension check is a relic of the past.

If you’re counting on Social Security to see you through retirement, count again. That is not the most secure bet you could make. When Social Security was first created, the average life expectancy was sixty-two. The architects of Social Security expected that very few Americans would live long enough to collect it. Surprise! Now that the average life expectancy extends well into the eighties, most of us will spend more years in retirement than we ever did working. This is placing a tremendous
strain on the Social Security system, so much so that recently the government has changed the ages as to when you can collect your full Social Security benefit. Starting with people born in 1938, the normal Social Security eligibility age will rise by two months for each year, until it reaches sixty-six if you were born in 1943. It then stays at sixty-six for everyone born through the end of 1954. If you were born after the year 1954, then the age to receive full benefits starts to climb again by two months a year until it is finally capped at sixty-seven for those born in 1960 or later.

Not only does the change affect when you start collecting your full benefit amount, but it also affects you if you decide to take your Social Security payment before your full benefit eligibility age. For instance, if your full benefit eligibility age is now sixty-six but you wanted to take your Social Security benefits at age sixty-two, your benefits will be 25 percent lower. People whose normal retirement age is now sixty-seven will see a 30 percent benefit reduction if they choose to take their Social Security at age sixty-two.

The way it used to work was you could get your full benefits at age sixty-five, but if you did take them at sixty-two you only had a 20 percent reduction. But now, not only do you have to wait longer to get your full benefit if you were born after 1938, but if you take your Social Security at sixty-two, you get less as well.

On the bright side, the yearly rate of increase in benefits for those who wait past their full eligibility age to start collecting Social Security will gradually rise, up to 8 percent for those born in 1943 or later. This incentive is not offered beyond age seventy, however.

The current eligibility age of 65 for Medicare, the nation’s health insurance program for the elderly, is not affected by the Social Security changes.

If all this is confusing, take a look at the chart above. The figures on the left refer to the year you were born and the figures in the second column refer to your actual full benefit age calculated by the SSA. The last three columns show you what will happen if you decide to start taking Social Security before reaching your full retirement age.

You can obtain an estimate of your Social Security benefits at the SSA website at
http://www.ssa.gov
.

So, as you can see, the government has the ability to make changes whenever they want; in my opinion, if you are counting solely on Social Security, you could be in danger. It is so very important to also save for retirement outside of your Social Security payroll deductions. For most of the people I have come in contact with, their saving grace is their 401(k) or other retirement plan. Almost certainly it will be for you, too.

The employer-sponsored plans known as 401(k) and 403(b) allow you to contribute a portion of your salary. A 401(k), which takes its exciting name from a section in the tax code, is an all-around plan that almost any employee of any company can enter into. A 403(b) plan is what you have if you work for a nonprofit organization, such as a hospital, university, or research organization. The 401(k) and 403(b) plans work in much the same way; if I refer to a 401(k) plan here, it will also apply to you if you have a 403(b) plan.

How Much Can I Put into My Plan?

The percentage and the amount you can contribute may vary from employer to employer; some employers limit the percentage of your salary you can contribute. Regardless of the percentage your company allows, the maximum dollar amount the government generally allows as of the year 2012 is $17,000 per year for 401(k) plans and 403(b) plans. That contribution limit is adjusted for inflation annually.

Individuals who are at least 50 years old by the end of the year can make an additional contribution to their plan. For 2012, the additional 401(k)/403(b) contribution limit is $5,500 and will be indexed for inflation in later years.

In addition, with a 401(k) the government has interesting regulations that affect how much you can contribute if you are making a lot, $115,000 or more, in 2012. (This figure also changes for inflation.) When you earn this kind of money, the government considers you to be a “highly compensated employee,” and out of fairness to all employees it does not want the average percentage for those earning $115,000 or more and putting the maximum into the plan to be far greater than the average percentage of all other employees who are not as highly compensated. The term “highly compensated employee” means any employee who, during the current year, made at least $115,000, or your salary is in the top 20 percent at your firm. A plan where the more-highly-paid individuals contribute much more than the less well-paid is called “top-heavy.”

This means that if you are highly compensated in the government’s eyes, you might not even be able to contribute the full $17,000 to your 401(k). In fact, if employees at your company who are less well paid are not putting in anything at all, you may not be eligible to contribute anything whatsoever. Make sure your plan administrator has addressed this potential problem. Otherwise, if you are highly compensated and have put too much in your plan, they’ll have to give the money back to you, and it will be taxed as ordinary income.

How Do I Put Money into My Plan? What Happens to the Money?

The percentage that you decide to contribute, once okayed by the company, will be taken from your paycheck.

The company administering the plan then invests your money for you. You will usually have a choice of several investment vehicles, which might include mutual funds, bond funds,
or individual equities such as the stock of your own company. Typically, the choices will offer a range of risks and returns. Some investments are highly predictable, such as bonds, which produce steady income at minimum risk. The stock market is more variable, and the most aggressive growth funds may swing up and down considerably in value, while they offer a higher return over time.

Usually you will be given extensive information about your investment options, and you can divide your contributions as you see fit among the different investments.

Plans today allow you to transfer money within the plan from one investment to another or to change how you want future contributions to be allocated among the investments. All it usually takes is a phone call. So if you have invested all your money in a stock fund, for instance, and the stock skyrockets and you sell your shares within the plan because you made 30 percent on your money, you will not owe a penny at that time in taxes. While the money sits in the plan you do not have to pay taxes on it.

Should I Invest All My 401(k) Money in My Company’s Stock?

It’s never wise to put all your eggs in one basket, particularly in stocks. The stock market has ups and downs, and individual companies may fall on hard times very quickly, due to management mistakes, changes in the economy, or sheer bad luck.

This doesn’t mean your company is a bad investment or that you shouldn’t express your loyalty by being a shareholder. But even great companies can see frightening declines in their stock. By all means, invest in your own firm, but spread your money around so that you’re protected if the unexpected happens.
Diversification
should be your watchword. I recommend
you limit investments in one company to 10 percent or less of your assets.

When Do I Owe Taxes on a Retirement Plan?

The taxes on a traditional 401(k) will be deferred until you take your money out, at which time it will be taxed as ordinary income. But if you withdraw funds from a retirement account before the age of fifty-nine and a half, you will pay ordinary income tax as well as a 10 percent penalty. You will also pay a state tax and penalty, if applicable. With a SIMPLE, it works the same way after the first two years. But if you take out the money within the first two years you participate in the plan, an early withdrawal tax of 25 percent will apply.

However, there are exceptions.

Getting Around the 10 Percent Early Withdrawal Penalty

Very few people know about this, but it’s true.

If you’re fifty-five or older in the year of retirement from your company, you can withdraw whatever you like from what’s known as a
qualified employer retirement account
without any tax penalty whatsoever.

You will pay tax on this money as if it were ordinary income. The tax will be withheld from your withdrawal off the top in the form of a 20 percent withholding tax. You’ll get a refund of this withholding tax if when you file your return you owe less than was withheld. If you owe more, you’ll have to pay the balance.

This holds true only for employer-sponsored retirement plans such as the 401(k)and 403(b). If you take your money out of your 401(k) and put it (without you touching it) into, for example, an IRA rollover, this 20 percent withholding rule won’t apply to you.

What If I Leave My Present Employer?

When you leave your place of employment, many times you can leave your 401(k) right there and not have to take it out until much later. Other times you might want to withdraw your money, and some companies may encourage you highly to take it out when you leave, although if you have more than $5,000 in the plan, they can’t force you to do so. In any case, there might come a time when you need a place to which you can transfer the money.

You usually have two choices. If you’re merely changing jobs, you may be allowed to move it to the 401(k) plan at the new company. The other option is to arrange for a trustee-to-trustee transfer of the money from your current plan into an
IRA rollover account
which is often called a direct rollover. If you do this, you can continue to shelter all the money from taxes and invest it for your retirement. You can open an IRA rollover at a bank, a mutual fund company, an insurance company, or a brokerage firm. I prefer discount brokerages or low-cost mutual fund firms. IRA rollovers are governed by the same regulations as an IRA account (described later in this chapter).