How to Save with a Retirement Plan

In a universe where sure things are almost unheard of, a retirement plans is as close to a financial slam dunk as you will likely get. The benefits are manifold and include generous contribution limits and tax advantages.

Things You'll Need

• Appropriate accounts

Instructions

1. Know what your choices are. There are three primary kinds of retirement plans--employer-sponsored plans (401(k) and Simple IRA), personal savings plans (conventional and Roth IRA), and plans for self-employed people (SEP IRA).

2. Employer-sponsored plans: Plans like 401(k)s and Simple IRAs are retirement plans offered by the company you work for. The contributions grow, tax-free, until you withdraw them after retirement. Depending on the plan, you make regular tax-deferred contributions, and sometimes your employer may match some or even all of your contribution. In 2003, the maximum contribution for a 401(k) is $12,000 of your compensation. For a Simple IRA, it's $8,000.

3. Personal savings plans: These are plans you set up yourself in addition to the plans offered at work. Conventional IRAs let you contribute as much as $3,000 a year. The contribution may be tax-deductible, depending on your income and other factors. The Roth operates differently. Your contributions to a Roth--up to $3,000 a year--are not tax-deductible. However, you may withdraw proceeds from a Roth tax-free after you retire. Both a conventional IRA and a Roth let your deposits grow tax-free.

4. Self-employment plans: These are plans for people who work for themselves. They are self-administered, and allow you to take a portion of your income and direct it to a tax-deferred savings plan. Many participants also contribute to an IRA at the same time. For a SEP IRA, you can contribute 25 percent of your self-employment income or $40,000, whichever is less.

5. Determine your eligibility. Employer-sponsored plans may have a waiting period after your hire date. Individual plans are open to everyone, though conventional and Roth IRAs have income limits. Self-employment plans are usually open to all people.

6. Sign up. If you have a plan offered at work, specify how much of your salary you want deposited into your account. For selfdirected and self-employment plans, check with large institutions like Charles Schwab (schwab.com) and Fidelity (fidelity.com). These companies let you sign up online in minutes.

7. Choose where your money goes. Most retirement plans offer a dizzying array of options to invest in. The key to long-term gains is proper diversification. Strive for a blend of stocks (including small and large cap, and international), bonds and cash. Your exact mix depends on when you want to retire and your tolerance for risk. Many financial Web sites and financial planners offer portfolio diversification advice.

8. Ask about matching contributions on 401(k)s and Simple IRAs. Company matches are literally free money. Some companies are generous enough to contribute a dollar for every dollar you deposit yourself, although the most common match is 50 cents per dollar invested by an employee.

9. For employer-sponsored plans, find out how long the vesting period is, which refers to the amount of time before any company contributions become your property. It can take several years before you're fully vested, although employee contributions are 100 percent vested at the outset.

10. Understand the tax advantage. Most money that you deposit into the majority of plans is considered tax-free income by the IRS. That's an immediate payback--you're paying no taxes on money that's still yours. That money and any gains from its investment remains tax-deferred until you retire and begin to withdraw it.

11. Reexamine your tax withholdings on your paycheck. Since a retirement plan leaves a portion of your income untaxed, you may be withholding too much money from each paycheck (and giving the government an interest-free loan). Calculate your real tax liability for the entire year, divide it by the number of paychecks, and set your withholding accordingly. Talk to your accountant for more information.

12. Avoid early withdrawals. You may be liable for the tax on any money you withdraw before you reach age 59 1/2 and also have to pay an additional penalty.

13. Use your nest egg for emergencies if you must. Many plans let you borrow against some retirement plans in situations of hardship or for a first-time home purchase, sometimes up to half the money in the account. But penalties and taxes may be extreme, so check the details before you tap into your retirement account.

14. If you have a 401(k) or other employer-sponsored retirement plan and you leave that company, roll this money into an IRA. Some companies will let you keep your funds in their plan after you leave, but you have much more control and a much greater range of investment choices in an IRA.

Tips & Warnings

• While stocks can give solid long-term gains, they may be volatile over the short term. If you've got a long time until your retirement, you can afford to be more aggressive in your investment choices. If you're closer to retirement, consider less volatile investments, like bonds or cash.

• Contribution limits usually increase every year. Most savvy investors are sure to contribute the maximum amount they can, so adjust your contribution schedule at the beginning of every year to max out your plan.

• For holders age 50 or older, there are catch-up provisions that allow you to contribute an amount in excess of the basic annual contribution. For 2003, the catch-up amount for a 401(k) is $2,000, $500 for a conventional IRA, and $1,000 for a Simple IRA.

• Look carefully at how much of your money goes into the stock of the company you work for. As any Enron employee will tell you, having the majority of your money in one asset can leave you dangerously undiversified.

• Consider commissions and fees when choosing a broker to handle your plan. Most retirement accounts will hold stocks and mutual funds, and different brokers have different trading fees. It pays to shop around.