Self-Employed? Here’s How to Plan for Retirement

Don't forget to include retirement savings in your plan to build a successful business.

When you’re hard at work as a self-employed entrepreneur or freelancer, retirement can seem like something that’s miles away. It can not only feel less important than getting your business or trade off the ground, but also seem like you won’t have spare money to set aside for a good, long time. You can save for your future, however. Here are some steps self-employed individuals can take to plan for their retirement.

1. Enroll in a Retirement Plan

Yes, there are retirement plan options out there for self-employed people like you. These include:

One-Participant 401K Plan: The one-participant or “solo” 401K is essentially the same as a traditional 401K designed to cover a business owner with no employees. (Note: You can hire your spouse and include them in this plan as well.) According to the IRS, you can contribute elective deferrals up to 100% of your earned income and employer non-elective contributions (determined by a special computation). Contributions are made pre-tax (you’ll be taxed when you withdraw the money, which you typically can’t do without a penalty until age 59½) and give you great flexibility in how much (or how little) you contribute. The contribution limits for 2017 are $18,000 and 25% of compensation up to the amount that’s defined in your plan, respectively, according to the IRS.

Traditional Individual Retirement Account (IRA): Many self-employed people can see immediate rewards from contributing to a traditional IRA, as these are tax-deductible in certain situations, giving you an immediate break on your taxable income. For example, if your income is $60,000, and you contribute $4,000 to a traditional IRA, you’ll only be taxed on $56,000 for that year. Keep in mind, however, that you’ll have to pay taxes when withdrawing the money and tax penalties can arise if you withdraw your retirement dollars early.

Simplified Employee Pension (SEP) IRA: To set this plan up, you simply fill out a form — no annual reporting to the IRS is required. The IRS notes that you can open a SEP IRA through your bank or other financial institution and can contribute up to 25% of your net earnings from self-employment. This type of plan is generally best if your business has no employees, or very few, because you have to include all employees in the plan — and everyone has to receive the same amount, which can get pricey if you have a lot of people working for you.

Savings Incentive Match Plan for Employees (SIMPLE) IRA: Per the IRS, a SIMPLE IRA plan is best suited as a start-up retirement savings plan for small employers. Under this plan, both employees and employers can contribute to traditional IRAs.

You can read more about the retirement plan options available to self-employed individuals on the IRS’s website and check out our glossary of common retirement terms you’ll want to know.

2. Budget By Percentages, Not Dollars

As a self-employed person, your income likely fluctuates from month to month, meaning you can’t budget the same way that a non-self-employed person would. It can help to think about budgeting for non-fixed expenses in percentages, instead of dollars, personal finance expert AJ Smith suggested in a blog post on Credit.com.

“If, for example, you want to save for retirement, try putting aside a certain percentage of your income rather than a certain dollar amount,” Smith wrote. “A dollar amount can lead you to save too little in high-income months and more than you can realistically afford in low-income ones.”

3. Be Vigilant About Your Taxes

Paying taxes can be a lot more complicated when you’re self-employed. For instance, throughout the year, you’ll have to estimate how much you owe for Medicare, Social Security and income tax and pay it in quarterly installments — and face penalties if you do so incorrectly. Plus, you’ll have to a pay a self-employment (SE) tax, which is essentially a combination of the Social Security and Medicare tax.

It’s important to properly work your tax payments into your budget, so you don’t wind up spending dollars you don’t really have. You may also want to consult with a tax accountant or other financial expert about your taxes, so you don’t miss out on important deductions or credits that could drive more money to your bottom line — and subsequently your retirement plans.

4. Stay on Top of Your Credit

Similarly, you’ll want to monitor your credit scores to make sure they’re in good shape and that you don’t wind up paying extra in interest on personal and business financing. Those dollars can severely hamper your ability to save for your eventual happy golden years. (You can see how your credit is doing by getting two free credit scores every 14 days on Credit.com.)

Remember, too, many business lines of credit require a personal guarantee, meaning you’ll be personally liable for any debts your business has that go unpaid. As such, you’ll want to carefully consider all loans you’re thinking of taking on to finance your business. Overextending yourself can make it harder to save not just for retirement, but also for future bills and/or emergencies that may come your way.

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4 Ways to Boost Your 401K

boost-your-401K

Millions of Americans are having difficulty saving for retirement. Student loan debt, increased food and housing costs, and stagnant wages are contributing factors.

If you have an employer-sponsored retirement plan, there are several steps you can take to boost your 401K.

1. Maximize Your Contributions

Once you establish your 401K account, you may want to increase your contributions. Usually the default contribution rate is between 3% and 5%. It is recommended that you should save at least 10% of your income. If you can afford to do so, I would recommend maximizing your contributions. In 2016, you can make a maximum contribution of $18,000. If you are 50 or older, the IRS allows you to make a catch-up contribution of $6,000 for a total of $24,000.

2. Take Advantage of Your Employer Match

Many employers offer to match your 401K contributions by a percentage or dollar amount. An employer may offer a 100% match up to 5% of your contribution. For example, if you contribute 5% of your salary to your 401K, the employer will match your 5% for a total of 10%. The employer may or may not offer additional matching beyond this 5% but it is an incentive for you to save. If you do not take advantage of the match, it is money that you are leaving on the table.

3. Minimize Expenses

While a 401K plan allows you to defer taxes, there may be fees associated with the investment vehicles offered by the plan. Choosing an index fund or an exchange-traded fund with low expense ratios will minimize your expenses while adding to your long-term returns. Sales loads can also take a bite out of your returns. Sales charges are paid to the broker who sold you the mutual fund. Consider choosing a no-load mutual fund as an alternative. Another set of fees that you may notice are commissions or transaction fees. If your plan offers a brokerage account, you may be paying a commission on each trade.

4. Consolidate Your 401K Plans

Nowadays, it is not uncommon for someone to have had several jobs. We may have contributed to several different 401K plans with our former employers. Rolling over these balances into your existing employer’s plan would give you full control over your retirement assets. If you are in transition or self-employed, you can consolidate your retirement plans at a brokerage firm or a bank.

The federal government has developed a retirement vehicle, myRA, to help people without a retirement plan save for their future. Several states are planning or implementing their own retirement plans. Although these efforts are commendable, they are limited in their scope. Ultimately, we must be responsible for our own retirement planning.

[Editor’s Note: You can monitor your financial goals, like building a good credit score, for free every 14 days on Credit.com.]

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How to Get the Most From Your 401K

how-to-build-your-401k

Perhaps you’ve heard of 401Ks or already contribute to one, and you’re intrigued about how you can use them to fund your retirement. These employer-sponsored plans are there to help you do just that, so it’s in your best interest to take advantage of one, especially if your company offers saving incentives, like a company match. We asked Robert Dowling, a financial planner with Modera Wealth Management in Westwood, New Jersey, who’s worked with high net worth individuals for 18 years, for tips on getting the most from your 401K. Here’s what he said.

1. Contribute More Than 3%

Most people who sign up for a 401K start out by contributing 3% of their salary, Dowling said. But if your budget can handle it, it wouldn’t hurt to raise that percentage, even just a bit. “Try to participate as much as you can without putting yourself in dire straits,” he said, noting the danger of overspending. Over time, your savings will thank you. (Concerned that your spending is out of control? You can get a sense of where your debts stand by viewing two of your free credit scores on Credit.com.) “We suggest every year to work it into your expectations to increase your contributions by 1%,” Dowling said. Some plans even allow you to fill out paperwork so your contributions rise automatically.

2. Enroll in Your Company’s Match 

“Take advantage of your company match to maximize company contributions,” said Dowling. “It can be quite powerful.” And besides, it’s free money!

3. Know Your Company’s Vesting Schedule 

While taking advantage of your company match can help you boost contributions, you won’t get far if you leave the company before they’ve vested — i.e., the company’s given you ownership. “What a company will say is, We will reward you with matching contributions, however, we want you to work for us for a certain period of time,” Dowling explained. So it’s important to know what that schedule is, especially if you’ve got one foot out the door. With the schedule in mind, you’ll be able to ask yourself if it makes sense to forfeit the company’s share of your savings rather than stick it out.

4. Play Catch-Up With Your Contributions

Those under 50 can contribute a maximum amount of $18,000 to their 401K every year, said Dowling. However, if you’re 50 or older, that maximum jumps to $24,000, meaning you can contribute an extra $6,000. “Sometimes folks aren’t aware of that,” he said, so “we remind clients to start their catch-up contributions,” as the provision is called, “early.”

5. Sock Away Your Bonus  

When someone says “bonus,” we can’t help but think of steak and fancy nights on the town. But the fact is, the more you can contribute to your 401K early on, the better prepared you’ll be for whatever life throws your way later, Dowling said. Also, if you’re having a hard time making those weekly, bi-weekly or monthly contributions, what better way to get a leg up than by throwing your bonus right into retirement savings? Bonus points if you tell HR that’s your plan, Dowling said, since companies tend to view this as a longterm benefit. You can even ask to have the bonus direct deposited into your account.

6. Take Out a Loan 

Though we’d never recommend borrowing money you can’t afford to pay back, it is helpful to know you have the option to borrow against your 401K. According to Dowling, some programs allow this, and you can take out up to $50,000. Rather than pay interest to a creditor, with a 401K you pay it back to yourself by putting the money in the plan, Dowling said. There can be penalties for defaulting on these loans, so make sure to do your research before choosing this option.

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The Critical Money Choices You Should Make in Your 70s

money-choices-in-your-70s

You’ve reached 70, and you’ve got it all figured out. You’ve finally said goodbye to having to work for income, you’re in an easy routine and everything is going well. Then you hit 70½, and the IRS requires you to start taking distributions from your retirement plan, even if you don’t need the money. The agency slaps a hefty penalty on any amount not taken. So, no matter how comfortable you feel, your 70s are not the decade to take your eye off the ball.

Required minimum distributions, or RMDs, begin in the year you turn 70½. Technically, you have until April 1 of the year following the year you turn 70½ to take your first distribution. This is the point at which the federal government no longer lets you kick the tax can down the road. Pushing your first distribution into the following year means you’ll have to take two RMDs in one year, which may have adverse tax consequences. You’ll be responsible for adding the values of your retirement accounts and dividing them by your age factor on what’s called the “uniform lifetime table.” Essentially you are required to take 3.65% of your retirement account balances as of December 31 of the previous year. Each year, that percentage will increase slightly.

As always, there are exceptions to the rules. Often, the way you take RMDs from IRAs will differ from how you take them from employer-based plans. With IRAs you are in complete control of when during the year you take your RMD. You also can choose which account you take it from, as long as the total distribution is the correct percentage for your age. With employer-based plans, you typically must choose between a monthly and annual distribution schedule. The checks come automatically. While this can help you avoid missing the deadline, it usually prevents you from controlling what you sell.

There are exceptions for those still working. If you are employed at 70½ and don’t own 5% or more of the company, you are not required to take a distribution from that employer’s retirement account.

What if you’re sitting on a beach and miss your distribution? The IRS can slap you with a heavy penalty: 50% of the amount you were supposed to take. Let’s say you have $1 million in your various IRAs. Your first RMD will be 3.65% ($36,500). If you miss that distribution, the IRS penalty will be $18,250. You read that right: $18,250.

The good news is that the IRS may let you slide once. If you’re reading this a little too late, you should take the distribution, file Form 5329 and beg for forgiveness. I’d also recommend bringing on a Certified Public Accountant (CPA) for assistance. By the way, the beach may not be a good enough excuse.

How to Avoid Mistakes 

Now that we have outlined a few of the mistakes you can make, let’s highlight some of the ways to avoid those mistakes. The first is consolidation. If you’re 70 years old with five traditional IRAs, it’s time to consider consolidation. Not only will this make it easier for you to figure out your RMDs, it will also make your money easier to manage. If you want to adjust your portfolio, you can do it in one shot rather than riding around town or spending all day on hold with fund companies to make sure all accounts have been adjusted. The final benefit of consolidation is more of a benefit to your heirs because the more accounts you have, the longer and, usually the more expensive, it is for your personal representatives to sort everything out.

I believe, as do most estate planning attorneys, that everyone over the age of 18 should have at least a basic estate plan. Once you have kids, it’s time to get serious with a will or trust package. Unfortunately, half of the folks I meet with (who are all 55 or older) have not adjusted their estate plan since their children were born. You should be checking with your attorney at least every five years to make sure your documents are sound. If you’ve moved to a different state, you’ll almost certainly have to have your documents redrafted by a local attorney.

Part of that estate plan is making sure your accounts are properly titled and your named beneficiaries are aligned with your goals. In order to minimize your probate estate and pass assets directly to beneficiaries at your death, you should consider trust ownership, certain types of joint ownership or Pay On Death/ Transfer On Death designations. You should update your beneficiaries annually as part of your financial plan.

Gifting, whether it be to a charity you care about or to a younger generation, can be one of the most fulfilling financial moves you make. Remember (I know you weren’t paying attention) when the flight attendant told you to secure your own oxygen mask before assisting others? The advice is the same for gifting. You must be absolutely sure that your own financial needs are taken care of before you start distribution. You can accomplish this through a financial plan. Federal law allows you to give $14,000 a year to anyone you want to without filing a gift tax return. If you’re married, you can do twice that through what’s called a split gift. Section 529 plans are a great way to help fund education, and they come with many tax advantages. Charitable giving is a great way not only to fulfill philanthropic goals but to lessen the tax sting. Have your financial planner, CPA and estate attorney work together if you have complex goals. (Full disclosure: I am a CFP.)

Now that you’ve checked your planning boxes, it’s time to start talking about them. The sad reality is that every day you come closer to your life expectancy and someone else taking over your financial affairs. Being private about your money is no longer wise. I urge you to talk to your spouse, children and anyone else who may handle your estate when your time comes. Introduce them to your planner, attorney and accountant if there is complexity. Oh yeah, and enjoy your retirement; 70 is the new 40!

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The Critical Money Considerations You Should Make in Your 60s

finances-in-your-60's

The average retirement age in the United States is 63, according to U.S. Census Bureau data. If you are part of that trend, get ready to have your financial world turned upside down in your 60s.

As you trade in your office keys and a steady paycheck for a pension (if you’re lucky), investment income and Social Security, you shift from an accumulation phase to a distribution phase. Once you do, many of the engrained investment lessons you learned no longer apply. While the most important retirement-based IRS rules come into play during your 50s and 70s, in your 60s you must learn about (and try to understand) government programs, such as Social Security and Medicare.

As you shift from accumulation to distribution, volatility becomes trouble. While market turmoil is tough to stomach whether you’re in your working years or retired, those wild swings can actually be beneficial for employees. If you participate in an employer-based retirement plan, you have a forced discipline to buy securities even when the market is down. You are practicing dollar-cost averaging, which, over long periods of time, can help you buy at a lower cost per share. The day you turn on that “income” switch, that volatility exposes you to sequence-of-return risk. In other words, the average return of your investments is not the only factor anymore. When you are living off your investments, the timing of returns is also critical. The earlier in retirement you take a big hit, the worse off you’ll be.

Financing Life After Retirement 

Now that we know we want to reduce volatility as well as sequence-of-return risk, we must think about solutions. Not to sound like a broken record, but the first step is to diversify. Imagine retiring in 2000 with large tech holdings or 2008 with large amounts of real estate. To spread the risk, cut your pie into many pieces.

Once you have a diversified, retirement-appropriate portfolio, you must decide which pieces and how much to sell in order to make your money last. Here are two out-of-date strategies that I wouldn’t fully depend on.

1. Living Off Dividends

Living completely off your dividends is probably unrealistic and irresponsible, unless you are very wealthy. In today’s low-yield environment, you are likely to get a dividend around 2%. If you’re invested 100% in stocks (also irresponsible for many), that means you’ll need a $5 million portfolio to draw $100,000 a year before taxes are taken out. The other risk is that if you are properly diversified, you are drawing only from the stock side, which means the bonds will become too heavily weighted. A better strategy is to sell by rebalancing. Every year decide how much money you will need and sell from the portion of the portfolio that has gone up. This will bring your portfolio back into balance and help you avoid selling at a loss.

2. Using the 4% Rule of Thumb

The 4% rule — often used to determine how much money you withdraw from a retirement account each year — was created for much less healthy people in a much healthier market. The amount you can safely pull out of your portfolio depends on the return you are earning and your life expectancy, which should make you skeptical of any one-size-fits-all strategy.

When to Take Government Retirement Benefits

Now that we have handled the complexities of investing as a retiree, we can dip a toe into the murky, complex waters of government programs. Regardless of your birth year, you can claim Social Security retirement benefits early at age 62. However, you will be permanently penalized for doing so. If your full retirement age is 66 (if you were born in 1943-1954), you will receive 25% less in benefits every month if you claim at 62. The opposite is true if you wait. You will get delayed retirement credits (income increases) of 8% per year until age 70.

The first step to figuring out Social Security is to learn the language (PIA, AIME, DRC, FICA, etc.). Next, find an advocate. Whether they’re a financial planner or not, you need someone sitting on the same side of the table as you when you make the very important decision about when to claim. Lastly, if you’re married, you must plan as a couple. Survivor benefits can be permanently reduced or increased depending on when your spouse claims benefits. Social Security should be simple — in fact, it’s anything but.

It used to be that Social Security’s full retirement age and Medicare eligibility aligned at age 65 and you could knock out both benefit applications at once. However, now you’re eligible to apply for Medicare up to 3 months before you turn 65, and that enrollment period is open for 7 months. You should apply ASAP, at least for Part A, in order for your coverage to begin the first day of the month of your 65th birthday. If you are still working, you’ll need to decide whether it’s worth picking up parts B and D or whether you have adequate, affordable coverage through your employer. Once you retire, you’ll have 8 months to get full Medicare coverage before your premiums are increased by penalties.

While traditional Medicare will likely cover the expenses of many of your medical needs in retirement, it will not cover long-term care expenses, except for short stays in a skilled nursing facility. According to the U.S. Department of Health and Human Services, 70% of those turning 65 will need some type of long-term care (LTC) services during their lifetime. Therefore, it’s a good idea to stress-test your financial plan to help ensure that you can afford a LTC service if needed. If you choose to buy long-term care insurance, you must factor that into your monthly or annual expenses to see if you can afford what are likely to be increasing premiums. If you decide to roll the dice, you want to be sure you have enough in assets and/or income to cover the cost.

Don’t Forget About Taxes

You’ve heard the saying that in life only two things are certain: death and taxes. While we don’t know when the former will come, we know that the tax man comes every year. That’s true even in retirement. The common assumption — and sometimes misconception — is that you will pay less in taxes once you have retired. That is another belief that depends totally on you, where you live and fiscal policy at the time. Your Federal Insurance Contributions Act (FICA) taxes will likely disappear in retirement, but so will many of your work-related deductions, including your 401K, health savings accounts, etc. My advice: Plan conservatively. You don’t want a tax hike in retirement to change your lifestyle.

There are many things to think about as you transition from your working years to your fun retirement years. Planning is advised; rolling the dice is not.

Remember, the opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

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Retirement Planning Tips for 50 Year Olds

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Odds are, if you are in your 50s, you have thought about retirement one time or another. Regardless of whether this is your final decade of working for the man — or being the man — it is important that you start to create a retirement vision. This means putting your 3 p.m. daydreams, at least the realistic ones, on paper.

Write Down Your Goals

When creating a retirement vision, start with location and lifestyle: Where do you want to be, and what do you want to be doing? Many retirement moves are based on family members who haven’t hatched. That said, it is important to narrow down locations based not only on family but the things that are important to you and your spouse.

The financial considerations of your lifestyle and location are wide-ranging and important. Luckily, there is plenty of research to guide you. Kiplinger, for instance, has an interactive map detailing the least and most tax-friendly states for retirees. CNN Money has a calculator that shows what your salary in your current town is equivalent to elsewhere. (Retirees can just replace salary with expenses.)

According to a Dominican University study, you are 42% more likely to achieve your goals just by writing them down. Your takeaway: Write down when you want to retire, where you want to retire and what you want to do.

If you haven’t already, create a written financial plan and update it each year. In its simplest form, the plan will show you where you are, where you are going and what it will take to get there. If you are going to outsource this activity, I recommend using a Certified Financial Planner (full disclosure: I am one). If you are a do-it-yourselfer, make sure you are using software that runs Monte Carlo simulations to stress-test market volatility. (Unless you have written your own algorithm, simple spreadsheet programs generally won’t cut it.)

Think About Expenses

The first and most important part of your financial plan will always be expenses. If you don’t have a handle on what you’re spending on a monthly basis, now is the time to get one. You can use the current figure paired with your lifestyle and location goals to estimate what you will need in your retirement years. Make sure your plan accounts for inflation and taxes in these figures. Once you are within 10 years of retirement, I encourage you to ignore the retirement ratios, (e.g., you need 75% of your pre-retirement income in retirement). These are averages, and everyone’s retirement goals will be different. Figure out yours. (Remember, recommendations here are for general information only and are not intended to provide specific advice for any individual.)

At this point, you are probably in your highest-earning years. I implore you to save that extra income rather than adjusting your lifestyle. Start, if possible, by maxing employer-based retirement plans. It is also especially important in this pre-retirement phase that your portfolio is aligned with your risk tolerance. According to Dalbar, over the last 20 years, ending December 31, 2015, the stock market has returned 8.19% on an annual basis. The average investor has earned a measly 2.11% over the same period, not even keeping up with inflation. There are many reasons for this gap, but perhaps the biggest is the fact that individuals invest with their hearts instead of their brains. Investing within your risk tolerance will help you avoid bad decisions if and when the market next turns bear.

Tax Considerations

The first of the IRS’ age-based retirement rules take effect in your 50s. At age 50, you are allowed to make what are called catch-up contributions to IRAs and employer-based plans. This takes the maximum contributions from $18,000 to $24,000/year for employer plans and from $5,500 to $6,500 for IRAs (in 2016).

Most of us are familiar with the significance of age 59½. That’s when we can withdraw penalty-free from our IRAs and employer-based retirement plans. Remember, you will still owe income taxes unless it’s a Roth account.

The age folks aren’t generally aware of is 55, which is important for early retirees. If you are 55 and separated from service with your employer, you can pull money from your employer-based retirement plan, without penalty. (Again, this information is not intended to be a substitute for specific individualized tax advice; it’s a good idea to discuss your specific tax issues with a qualified tax adviser.)

Regardless of whether you plan to retire in your 50s, it is critical that you start to put together a plan. According to a 2014 survey from the Employee Benefit Research Institute (EBRI), 49% of retirees leave the workforce earlier than they planned, often due to a disability, layoff or buy-out. So whether or not you plan to hand in your keys in your 50s, make sure you know what you want to be doing the first day the alarm clock doesn’t go off.

More Money-Saving Reads:

Image: Aldo Murillo

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Retirement Planning Tips for 50 Year Olds

retirement-planning-tips

Odds are, if you are in your 50s, you have thought about retirement one time or another. Regardless of whether this is your final decade of working for the man — or being the man — it is important that you start to create a retirement vision. This means putting your 3 p.m. daydreams, at least the realistic ones, on paper.

Write Down Your Goals

When creating a retirement vision, start with location and lifestyle: Where do you want to be, and what do you want to be doing? Many retirement moves are based on family members who haven’t hatched. That said, it is important to narrow down locations based not only on family but the things that are important to you and your spouse.

The financial considerations of your lifestyle and location are wide-ranging and important. Luckily, there is plenty of research to guide you. Kiplinger, for instance, has an interactive map detailing the least and most tax-friendly states for retirees. CNN Money has a calculator that shows what your salary in your current town is equivalent to elsewhere. (Retirees can just replace salary with expenses.)

According to a Dominican University study, you are 42% more likely to achieve your goals just by writing them down. Your takeaway: Write down when you want to retire, where you want to retire and what you want to do.

If you haven’t already, create a written financial plan and update it each year. In its simplest form, the plan will show you where you are, where you are going and what it will take to get there. If you are going to outsource this activity, I recommend using a Certified Financial Planner (full disclosure: I am one). If you are a do-it-yourselfer, make sure you are using software that runs Monte Carlo simulations to stress-test market volatility. (Unless you have written your own algorithm, simple spreadsheet programs generally won’t cut it.)

Think About Expenses

The first and most important part of your financial plan will always be expenses. If you don’t have a handle on what you’re spending on a monthly basis, now is the time to get one. You can use the current figure paired with your lifestyle and location goals to estimate what you will need in your retirement years. Make sure your plan accounts for inflation and taxes in these figures. Once you are within 10 years of retirement, I encourage you to ignore the retirement ratios, (e.g., you need 75% of your pre-retirement income in retirement). These are averages, and everyone’s retirement goals will be different. Figure out yours. (Remember, recommendations here are for general information only and are not intended to provide specific advice for any individual.)

At this point, you are probably in your highest-earning years. I implore you to save that extra income rather than adjusting your lifestyle. Start, if possible, by maxing employer-based retirement plans. It is also especially important in this pre-retirement phase that your portfolio is aligned with your risk tolerance. According to Dalbar, over the last 20 years, ending December 31, 2015, the stock market has returned 8.19% on an annual basis. The average investor has earned a measly 2.11% over the same period, not even keeping up with inflation. There are many reasons for this gap, but perhaps the biggest is the fact that individuals invest with their hearts instead of their brains. Investing within your risk tolerance will help you avoid bad decisions if and when the market next turns bear.

Tax Considerations

The first of the IRS’ age-based retirement rules take effect in your 50s. At age 50, you are allowed to make what are called catch-up contributions to IRAs and employer-based plans. This takes the maximum contributions from $18,000 to $24,000/year for employer plans and from $5,500 to $6,500 for IRAs (in 2016).

Most of us are familiar with the significance of age 59½. That’s when we can withdraw penalty-free from our IRAs and employer-based retirement plans. Remember, you will still owe income taxes unless it’s a Roth account.

The age folks aren’t generally aware of is 55, which is important for early retirees. If you are 55 and separated from service with your employer, you can pull money from your employer-based retirement plan, without penalty. (Again, this information is not intended to be a substitute for specific individualized tax advice; it’s a good idea to discuss your specific tax issues with a qualified tax adviser.)

Regardless of whether you plan to retire in your 50s, it is critical that you start to put together a plan. According to a 2014 survey from the Employee Benefit Research Institute (EBRI), 49% of retirees leave the workforce earlier than they planned, often due to a disability, layoff or buy-out. So whether or not you plan to hand in your keys in your 50s, make sure you know what you want to be doing the first day the alarm clock doesn’t go off.

More Money-Saving Reads:

Image: Aldo Murillo

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Retirement Accounts: What You Need to Understand

Finances

With mounting concerns over Social Security, and a languishing number pensions, it’s more important than ever to start investing for retirement. Tax advantaged retirement accounts offer investors the best opportunities to see their investments grow, but the accounts come with fine print. These are the things you need to know before you start investing.

What are employer sponsored retirement accounts?

Employee sponsored retirement accounts often allows you to invest pre-tax dollars in an account that grows tax-free until a person takes a distribution. In some cases, you may have access to a Roth retirement account which allows you to contribute post-tax dollars. Contributions to employer sponsored retirement accounts come directly from your paycheck.

The most common employee sponsored retirement accounts are defined contribution plans including a 401(k), 403(b), 457, and Government Thrift Savings Plan (TSP). Private sector companies operate 401(k)s, public schools and certain non-profit organizations offer 403(b)s, state and local governments offer 457 plans, and the Federal government offers a TSP. Despite the variety of names, these plans operate the same way.

According to the Bureau of Labor Statistics, 61% of people employed in the private sector had access to a retirement plan, but just 71% of eligible employees participated.

How much can I contribute? 

If you’re enrolled in a 401(k), 403(b), 457, or TSP, then you can invest up to $18,000 dollars to your employer sponsored retirement accounts per year in 2016. If you qualify for multiple employer sponsored plans, then you may invest a maximum of $18,000 across all your defined contribution plans. People over age 50 may contribute an additional $6,000 in “catch-up” contributions or $3,000 to a SIMPLE 401(k).

In addition to your contributions, some employers match contributions up to a certain percentage of an employee’s salary. Visit your human resources department to learn about your company’s plan details including whether or not they offer a match.

What are the benefits of investing in an employer sponsored retirement plan?

For employees that receive a matching contribution, investing enough to receive the full match offers unparalleled wealth building power, but even without a match, employer sponsored plans make it easy to build wealth through investing. The funds to invest come directly out of your paycheck, and the plan invests them right away.

However, there are fees associated with these accounts. Specific fees vary from plan to plan, so check your company’s fee structure to understand the details, especially if you aren’t receiving a match. If you don’t have an employer match, then it may make more sense to contribute to your own IRA in lieu of the employer-sponsored plan.

Investing in an employer sponsored means getting to defer taxes until you withdraw your investment. Selling investments in a retirement plan does not trigger a taxable event, nor does receiving dividends. These tax benefits provide an important boost for you to maximize your net worth.

In addition to tax deferred growth, low income investors qualify for a tax credit when they contribute to a retirement plan. Single filers who earn less than $41,625 or married couples who earn less than $61,500 qualify for a Saver’s Tax Credit worth 10-50% of elective contributions up to $2000 ($4000 for married filers).

What are the drawbacks to investing in an employer sponsored retirement plan?

Investing in an employer sponsored retirement plan reduces the accessibility of the invested money. The IRS punishes distributions before the age of 59 ½ with a 10% early withdrawal penalty. These penalties come on top of the income taxes that you must pay the year you take a distribution. In most cases, if you withdraw money early pay so much in penalties and increased income tax rates (during the year you take the distribution) that you would have been better off not investing in the first place.

Additionally, investing in an employee sponsored retirement plan reduces investment choices. You may not be able to find investment options that fit your investing style through their company’s plan.

Should I take a loan against my 401(k) balance?

Since money in 401(k) plans isn’t liquid, some companies allow you  to take a loan against your 401(k). These loans tend to be low interest and convenient to obtain, but the loans come with risks that traditional loans do not have. If your job is terminated, most plans offer just 60-90 days to pay off the loan balance, or the loan becomes a taxable distribution that is subject to the 10% early withdrawal penalty and income tax.

It is best to only consider a 401(k) loan for a short term liquidity need or to avoid them altogether.

What if I don’t qualify for an employer sponsored retirement plan?

If you’re an employee, and you don’t have access to an employer sponsored retirement plan you have to forgo the tax savings and other benefits associated with the accounts, but you may still qualify for an Individual Retirement Account (IRA).

However, if you pay self-employment taxes then you can create your own retirement plan. Self-employed people (including people who are both self-employed and traditionally employed) can start either a Solo 401(k) or a SEP-IRA.

A Solo 401(k) allows an elective contribution limit of 100% of self-employment income up to $18,000 (plus an additional $6000 in catch up contributions for people over age 50) plus if your self-employed, then you can contribute 20% of your operating income after deducting your elective contributions and half of your self-employment tax deductions (up to an additional $35,000).

If you qualify for both a Solo 401(k) and other employer sponsored retirement plan, then you cannot contribute more than $18,000 in elective contributions among your various plans.

A SEP-IRA allows you to contribute 25% of your self-employed operating income into a pre-tax account up to $53,000.

What are Individual Retirement Accounts?

Individual Retirement Accounts (IRAs) allow you to invest in tax advantaged accounts. Traditional IRAs allows you to deduct your investments from your income, and your investments grow tax free until they are withdrawn (at which point they are subject to income tax). You can contribute after-tax money to Roth IRAs, but investments grow tax free, and the investments are not subject to income tax when they are withdrawn in retirement. There are income restrictions on being eligible for deductions and these vary based on household income and if an employer-sponsored retirement plan is available to you (and/or your spouse).

What are the rules for contributing to an IRA?

In order to contribute to an individual retirement account, you must meet income thresholds in a given year, and you may not contribute more than you earn in a given year. The maximum contribution to an IRA is $5500 ($6500 for people over age 50).

A traditional IRA allows you to defer income taxes until you take a distribution. Single filers who earn less than $61,000 are eligible deduct one hundred percent of deductions, and single filers who earn between $61,000 and $71,00 may partially deduct the contributions. Couples who are married filing jointly may make contribute the maximum if they earn less than $98,000, and they may make partial contributions if they earn between $98,000 and $118,000.

Roth IRAs allow participants to invest after tax dollars that are not subject to taxes again. The tax free growth and distributions can be especially beneficial for those who expect to earn a high income (from investments, pensions or work) during retirement. Single filers who earn less than $117,000 can contribute the full $5,500, and those who earn between $117,000 and $132,000 can make partial contributions. Couples who are married filing jointly who earn less than $184,000 may contribute up to $5500 each to Roth IRAs, and couples who earn between $184,000 and $194,000 are eligible for partial contributions.

What are the benefits to investing in an IRA?

The primary benefits to investing in an IRA are tax related. Traditional IRAs allow you to avoid paying income taxes on your investments until you are retired. Most people fall into a lower income tax bracket in retirement than during their working years, so the tax savings can be significant.  Roth IRA contributions are subject to taxes the year they are contributed, but the IRS never taxes them again. Investments within an IRA grow tax free, and buying and selling investments within an IRA does not trigger a taxable event.

Additionally, low income investors also qualify for a tax credit when they contribute to a retirement plan. Single filers who earn less than $41,625 or married couples who earn less than $61,500 qualify for a Saver’s Tax Credit worth 10-50% of elective contributions up to $2000 ($4000 for married filers).

IRAs also allow individuals to choose any investments that fit their strategy.

What are the drawbacks to investing in an IRA? 

Investing in an IRA reduces the accessibility of money. Though it is possible to withdraw contribution money for some qualified expenses, many distributions are to be subject to a 10% early withdrawal tax penalty when a person takes a distribution before the age of 59 ½. In addition to the penalty, the IRS levies income tax on distributions the year that you take a distribution from a Traditional IRA.

Should I withdraw money from my IRA?

Taking a distribution from an IRA means less money growing for retirement, but many people use distributions from IRAs to meet medium term goals or to resolve short term financial crises. The IRS publishes a complete list of qualified exceptions to the early withdrawal penalty.

If you have to pay the penalty, withdrawing from an IRA is not likely to be the right choice. Once the money is withdrawn from an IRA it can’t be contributed again. For short term needs, taking out a loan usually comes out ahead.

What’s the smartest way to invest?

Investing between 15-20% of your gross income for 30 years often yields a reasonable retirement nest egg, but even if you can’t invest that much right now, it’s important to get started. The smartest place to invest for retirement is within a tax advantaged retirement account.

If you don’t have access to an employer sponsored plan the best place to start is by investing in an IRA. On the other hand, if you have access to both an employer sponsored plan and an IRA, the answer is not as clear. Anyone who has an employer with a matching policy should aim to invest enough to take full advantage of any matching plan that your company has in place.

After taking advantage of a match, the next best option depends on your personal situation.

Employer sponsored plans and Traditional IRAs offer immediate tax benefits that can be advantageous for high income earners. However, investing in a Roth IRA keeps money more liquid than either an employer sponsored plan or a traditional IRA.

Of course, the best possible scenario for your retirement is to maximize contributions to both an employer sponsored account and an individual retirement account, but you should carefully weigh how investing in these accounts affects your whole financial picture and not just your retirement goals.

The post Retirement Accounts: What You Need to Understand appeared first on MagnifyMoney.

What Should I Do With My Old 401K?

old-401K

Q. I will be changing jobs and I have a small 401K. Should I leave it there or move it to my new employer’s plan?
— Working

A. You have several options for your 401K.

It will partly depend on the balance in the account.

If the account has less than $1,000, your employer is permitted to cash out the account when you leave the company, said Marnie Aznar, a certified financial planner with Aznar Financial Advisors in Morris Plains, New Jersey.

She said you should be sure to fill out the necessary paperwork to roll the account over and avoid having it cashed out prior to your departure.

If the balance of your account is large enough — typically at least $5,000 — you may be able to leave the 401K with your old company, she said.

But there are two other good options to consider.

Aznar said you can either roll the balance into your new company’s 401K plan or roll the 401K into an IRA rollover with the custodian of your choosing. (This guide to common retirement lingo might be helpful as you navigate this decision.)

You also have one bad option: Take the money and run. That choice would mean the money is taxed at ordinary income tax rates and would probably be subject to penalties.

Not a good choice, Aznar said.

She said if you think that the investment options in your new company’s 401K plans are good and the cost structure of the new plan is competitive, that would be the simplest and most efficient approach.

If, however, you do not think that the investment options in the new 401K plan are very good and/or you believe that the underlying expenses in the new plan are high, it would be worth considering doing a trustee-to-trustee transfer of your old 401K plan into an IRA rollover, Aznar said.

“When you opt for a trustee-to-trustee transfer, there are no income tax consequences associated with making the move and you are able to choose any investment options available to you at the new custodian,” she said. “This option would give you the most flexibility from an investment perspective.”

[Editor’s note: Sound retirement planning can help you avoid costly debt, and potential credit damage, later in life. You can manage your financial goals, like keeping tabs on your credit scores, for free on Credit.com.]

More Money-Saving Reads:

Image: AleksandarNakic

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3 Situations in Which a 401k Loan Can Be a Good Idea

Man Paying Bills With Laptop

If you hear the words “401(k) loan” and immediately think to yourself “ooh, that sounds like a bad idea”, good for you! You’re on the right track.

In most cases borrowing from your savings isn’t a smart move, particularly when it’s from an investment account like your 401(k) that’s meant to sit untouched for decades so that it can grow and eventually allow you to retire.

But a 401(k) loan is unique. We covered the ins and outs of how it works in a previous post, but here are the basics:

  • The loan comes directly out of your 401(k) investments.
  • Repayment is made through automatic payroll deductions.
  • Both the principal and interest are paid back into your 401(k), so you truly are borrowing money from yourself.
  • The loan is typically easy and quick to get.

The fact that you pay the interest back to yourself is especially unique and makes 401(k) loans attractive in certain situations.

So while you should proceed with extreme caution when considering a 401(k) loan, and while in most cases there are better options available to you, here are three situations in which a 401(k) loan can be a good idea.

1. Increase Your Investment Return

There are certain situations where you can use a 401(k) loan to increase your overall investment return. Here’s a hypothetical example showing how it can work.

Let’s say that the following things are true:

Given that scenario, here are the steps you could take to increase your expected investment return while only adding a small amount of risk:

  1. Take out a 401(k) loan, borrowing money from the bond portion of your account.
  2. Put the loan proceeds into a taxable investment account and invest it in the exact same bond fund (or something similar).
  3. You will earn the exact same return on the bond fund as you would have in the 401(k), less the cost of taxes you have to pay on any gains.
  4. As you pay back your 401(k) loan, the 4.5% interest is essentially a 4.5% return since it’s going right back into your 401(k).

In other words, you’re getting essentially the same return on your bond fund in the taxable account, minus the tax cost. But you get a higher return in your 401(k) because the interest rate is higher than the expected return on the bond fund.

And since your bond investment is unlikely to fluctuate too much (though it can certainly fluctuate some), in a worst-case scenario where you lose your job and have to pay the loan back in full within 60 days, you will likely to have the money available to do so.

Here are a few things to keep in mind as you consider this approach:

  • The more expensive your 401(k) is, the more likely this is to work out in your favor. That’s because you can choose a lower cost bond fund in your taxable account and save yourself some fees over the life of the loan.
  • The higher your tax bracket, the less advantageous this is since the tax cost in the taxable investment account will be higher.
  • Make sure you’re not sacrificing your ability to contribute to your 401(k), and definitely make sure you’re not missing out on any employer match.

2. Paying off High-Interest Debt

If you have high-interest debt, taking a 401(k) loan to pay it off could be a good idea.

Before you do so, make sure you’ve exhausted all other options. Do you have savings you could use to pay it off? Are there any expenses you could cut back on so you could put that money towards your debt? Are there any creative ways you could make a little extra money on the side?

Any of those options are better than a 401(k) loan simply because they don’t require you to borrow against your retirement and they don’t come with the risks that a 401(k) loan presents.

But if you’ve exhausted those other options, paying off high-interest debt with a 401(k) loan has two big benefits:

  1. Your 401(k) loan interest rate is likely lower than the rate on your other debt.
  2. You pay the 401(k) loan interest to yourself, not someone else.

The big risk you run with this strategy is the possibility of losing your job and having to pay the entire 401(k) loan balance back within 60 days. If that happens and you’re not able to pay it back, the remaining balance will be taxed and subject to a 10% penalty. That outcome is likely much more costly than your high-interest debt.

3. Financial Emergency

If you’re in a situation where you absolutely need money for something and you don’t have the savings to handle it, a 401(k) loan may be your best option.

Here’s why:

  • It’s quick. You can often get the loan with just a few clicks online.
  • There’s no credit check. You’ll be able to get it even if you don’t have a great credit history.
  • It likely has a relatively low interest rate and you pay the interest back to yourself.

In an ideal world this is exactly what your emergency fund would be there for. But of course life happens and a 401(k) loan can be a good backup plan.

Be Careful

A 401(k) loan should almost never be your first choice. Other than situation #1 above, which should only be done very carefully, in most cases there’s another route that would be better.

But in the right situations a 401(k) loan can be helpful and may even lead to better returns. As long as you proceed with caution, it can be a valuable tool in your financial arsenal.

The post 3 Situations in Which a 401k Loan Can Be a Good Idea appeared first on MagnifyMoney.