Monday, February 06, 2006

Preparing for retirement without a 401K.

Businessweek had a great article the other day on life without a 401K. It is bad enough that most young people cannot depend on social security or a pension fund to help fund their retirement. Just over a 1/3rd of the employees between 21 and 30 don't even have access to a company sponsored 401K. So if you are a freelancer, temporary work, or contractor and find yourself without the benefits of a 401K here are some top 5 ideas from to prepare for your retirement.

Five ways to save for retirement without having a 401k:

  1. Open an Individual Retirement Account (IRA). A 401(k) isn't the only way to get tax-preferred savings. IRAs provide tax benefits of their own, and come in two distinct flavors, traditional and Roth. Both are available from most mutual fund companies. Many financial advisors recommend Roth IRAs, especially for young people. Investors can't put pretax funds into a Roth IRA, but qualified withdrawals are tax-free. The after-tax nature of the accounts makes them ideal for anyone who is presumably in a lower income-tax bracket now than they will be at retirement. However, if you currently earn $110,000 or more per year, you can't use a Roth IRA. Some young workers may prefer a traditional IRA, which defers taxes until withdrawal. In other words, money goes into these IRAs on a before-tax basis, as with a 401(k). Depending on annual income, assets going into a traditional IRA may be tax-deductible, too. Contribute by Apr. 15 to take deductions for the 2005 tax year. For savers below age 50, the annual contribution limit for either type of IRA is $4,000, enough for most young professionals. In 2008, the limit rises to $5,000. Most experts recommend leaving contributions in an IRA until retirement. Early withdrawals typically carry a tax penalty, but there are exceptions for medical expenses, higher education costs, or a down payment on a first home.
  2. Explore other savings options. Plenty of young people worry about locking up their money in the long run. After all, they might need to crack their nest egg for weddings, children, or rainy days. So contributions to an IRA can be supplemented with savings outside a tax-favored retirement plan. Meanwhile, self-employed individuals have access to a wider array of retirement-plan options (see BW 12/05/05, "A Perfect Match"). A Simple IRA allows contributions of up to $10,000 a year and can be established anytime between Jan. 1 and Oct. 1 by visiting a financial institution. "They're very easy to use, and you can put a ton of money away," says Terry Balding, a certified financial planner at Terry Balding & Associates. The self-employed have access to the same types of plans used by big corporations. A one-person 401(k) or pension plan could make sense for those with high income. But the cost and hassle of maintaining these complex programs will be too much for most young professionals.
  3. Make savings and investments automatic. Once workers start saving, the best way to keep up the momentum is to ensure that it happens by default. "The biggest piece of advice, beyond 'start now,' is to use a 'set it and forget it' approach," says John Curry, managing director of retirement management with FundQuest. Most mutual fund companies allow deposits into IRAs or taxable accounts to be made directly from another account via bank draft. Like contributing to a 401(k), setting up a systematic bank draft allows savings to pile up in the background, without requiring any further effort. These days the details of investing can be automatic, too. Mutual funds called lifecycle funds aim to take out the legwork, and they're growing in popularity (see BW 07/26/04, "Funds That Adjust As The Years Go By"). These funds shift their asset allocation from stocks to bonds as they approach a certain retirement date. Assets in the funds have more than doubled since 2003, according to Financial Research. Products like the T. Rowe Price Retirement 2040 Fund (TRRDX ) and Vanguard Target Retirement 2045 Fund (VTIVX ) have earned praise for low fees and ease of use.
  4. Investigate index fund: Then again, fees are usually even lower for an index fund. Young investors are widely encouraged to invest primarily in equities, because of their longer time horizon. An index fund lets them reduce management costs while they do it. A fund tracking an index like the big-cap Standard & Poor's 500 gives exposure to a broad array of U.S. companies. Fidelity Spartan 500 Fund (FSMKX ) has a low expense ratio of 0.1%, while the Vanguard 500 Index Fund (VFINX ) costs only 0.18% (see BW Online 2/8/06, "How to Kick a Fund's Tires"). S&P 500 funds are also tax-efficient, so they can be relatively painless even outside a tax-favored account like an IRA. "The last thing you have to worry about at this point in your life is asset allocation, because you don't have a lot of money," says Patrick Doland, a financial adviser in Northbrook, Ill. "So let's get you in an investment vehicle to start out, and let's not overcomplicate it." Index funds make sense for young people who are confident they'll remember to give their portfolio a tune-up once it reaches $10,000. Indexes can be volatile, so the risk-averse should either be prepared or consider other options.
  5. Follow the 10% rule. Financial advisers suggest workers save 10% of what they earn. That may sound steep, especially since the national savings rate sank into negative territory last year for the first time since the Great Depression. But it is possible. On after-tax earnings of $30,000 a year, saving 10% would mean setting aside less than $60 a week. So give up a night on the town, or start packing your lunches and skipping Starbucks in favor of the office coffeepot. The trick is to get your house in order first. Keep paying off those student loans, but don't necessarily pay them ahead of schedule. In many cases, if a student secures a low, fixed interest rate, it may be better to invest that money. On the other hand, it's almost always smart to pay off credit card debt first. Only extremely risky investments would have a chance of overcoming the high interest rates credit card companies typically charge. Better yet, avoid racking up debt in the first place.

Other resources:

Get out of Debt
Making Money online with Google Adsense
Investing with Mutual Funds
investment calculator

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