What is a Roth IRA?

An IRA (Individual Retirement Account) is an investment plan that allows you to put away money for your eventual retirement. Tax breaks make this investing method attractive to many people, but it can still be a confusing concept. Of course, there are many different ways to invest in an IRA. Having a Roth IRA differentiates from a traditional IRA mostly by when the taxes are paid. Traditional IRA accounts allow tax-deductible contributions; however, when you begin to take money out of this IRA it is taxable at the then-current rate. And rates will most definitely change between now and then.

When you have a Roth IRA, you contribute after-tax dollars as you fund the account. Unlike a traditional IRA, when you take money from your Roth IRA it will generally not be taxed. What you really need to understand about any kind of IRA is that it is not a type of investment itself, but it is the place where you store investments for the future and can take advantage of the tax benefits.

What are the benefits of a Roth IRA?

There are quite a few benefits of having a Roth IRA as a part of your retirement savings plan. Since Roth IRA contributions are made after tax, you generally don’t have to pay taxes on them in later years when you take money out of the accounts, in retirement. This allows you to sidestep higher taxes in the future if you anticipate that you will be taxed higher in retirement than you are now of if you continue to work after you retire. The ability to have tax-free growth really makes a Roth IRA shine. Also, a Roth IRA allows you to withdraw up to $10,000 and put it towards purchasing your first house without penalty.

Are there any limits or restrictions?

There are a few limits and restrictions that you should know about before opening a Roth IRA. First of all, any contributions made to your Roth IRA are not tax deductible like the contributions made to your 401(K) or traditional IRA. There is an income limit, which will exclude you from being able to have a Roth IRA if you make more than the specified amount in that tax year. Finally, there are potential penalties and taxes involved if you decide to cash out your Roth IRA early, so it should be used only for money that you don’t plan on using until retirement.

If having a Roth IRA seems like a good idea for you consider opening a Roth IRA with a low-cost investment company such as Scottrade or TradeKing. Enlist tax help if it still looks like a great idea, even if now it’s a little confusing. A Roth IRA is an excellent way to save money for retirement and know that you won’t have to fuss with tax deductions and higher rates if you are eligible.

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First, we need a quick refresher on what a 401k plan is because most people know very little about them other than the fact that their employer may offer one. To be specific, a 401k is simply a type of account provided by individual employers to accept salary deferrals from employees while taking advantage of the tax benefits outlined in the tax code. In fact, the reason it’s called a 401k is because of the part of the tax code where the plans are outlined.

The 401k isn’t a government plan, there are no requirements for employers to provide them, and there is not a single company or administrator that handles all plans. It is simply an optional benefit that many employers provide which allows employees to set part of their income aside, before tax and tax-deferred, for retirement. Aside from the specific instructions within the tax code and throughout some regulations in the financial industry, every plan is a little different. Unfortunately, this means not all plans are necessarily created equal.

The Perceived Risk of 401ks

Everybody loves to point to stories about workers who were just a few short years from retirement in 2007 only to soon find half their nest egg wiped out. These are true stories. I know because it was during this time I was still working as a retirement plan consultant and I was helping employees manage their 401k/403b plans. I saw it happen right before my eyes. But what’s really at fault here?

Even though the 401k has come into existence thanks to the government and its tax code, they are still largely individual plans when it comes to how you participate. As the employee, you are responsible for determining how much to contribute and selecting how your money is invested, at least from the options provided by your plan. According to recent data, the average 401k offered 24 investment options. While there are some plans that offer only a handful of choices, the thing to keep in mind here is that your employer isn’t holding a gun to your head and saying you must put your entire retirement nest egg into a large-cap stock fund and to just pray for the best. You have options between stock funds, bond funds, and often many other investment choices.

While a small company 401k may not have the best, most, or cheapest investment options out there, there’s absolutely no excuse for hearing stories about how the 401k is too risky because 65 year olds were invested nearly 100 percent in stocks and now have to put off retirement because the stock market took a dive. The 401k didn’t tell that person to invest their money that way. And you certainly won’t find that advice coming from a professional, or even anywhere else for that matter. As unfortunate as situations like these are, it’s all too easy to make the plan itself the scapegoat rather than question why the investor felt the need to risk their money in such a way.

This isn’t to say the 401k is without faults, because that is clearly not true. We’ve got a long way to go before leveling the playing field. The nature of how these plans are set up inherently means some plans will be better than others. But if you have a 60 year old invested in Plan A, which only has six investment choices and 1.5% annual expenses, and a 60 year old invested in Plan B, which has 30 investment choices and 0.5% annual expenses, if both of these investors wanted to retire early at 62 and were betting heavily on stocks when the market suddenly drops 30 percent they are both screwed equally. It wasn’t the fees that put their retirement on hold (although over the long run they certainly don’t help) and it wasn’t the lack of investment choices. Ultimately it comes down to how they invested their money. You can blame the 401k all you want for their misfortune, but if the same person had all of their money in a Vanguard IRA invested in an inexpensive stock index fund they would be in pretty much the same boat.

The Real Risk of 401ks

The nature of the 401k itself isn’t responsible for putting someone’s retirement in jeopardy. Instead, there are two big risks that fall on the shoulders of the individual. The first is simply not saving enough for retirement. Ask almost anyone if they are maxing out their annual contributions and you’ll find that they aren’t. In fact, most people struggle to set aside just $5,000 a year, which is less than a third of what’s typically allowed. While saving a few thousand a year will go a long way toward building a retirement nest egg, it will almost certainly not be enough to fully fund the retirement of your dreams.

The second big risk comes from making poor investment decisions. Even if you are able to put aside a large sum every year into the plan, if you don’t know how to manage this money you could find yourself in the headlines when you’re a year or two away from retirement and you’ve just lost most of it because you were not invested appropriately.

The only way a 401k plan works is if you start saving early and if you save enough that you can reach a realistic sum of money upon retirement. In addition to saving enough you then have to be smart with the money and invest it appropriately for your risk tolerance, time frame, and the stage of life you’re in. If you’re able to save enough and put the money to work in a suitable manner, you’ll almost certainly bid your working life farewell with a comfortable nest egg that will allow you to coast through retirement. But if you spend thirty years just putting 100 bucks a money into the account and let it all ride on stocks (or similarly park it in the fixed account that doesn’t even earn one percent interest) you’ll have a pretty dismal retirement party, if you’re ever able to retire at all.

Again, this failure has nothing to do with the 401k itself. Even if you didn’t use a 401k and you put 100 bucks a month into an IRA or another investment account and then invested the money foolishly, you’d end up with the same outcome.

There’s No Free Lunch

As pension plans fade away we’re left with the burden of saving for our own retirement. Unfortunately, some people feel that it should be up to the government to provide this benefit, either through Social Security or some new program. That’s not going to happen. For one, Social Security was never intended to be a retirement plan. It was created in the 1930s as a safety net that provided something in old age. And you must remember that back when Social Security came into existence, the average life expectancy was only about 62 years. Today it’s nearly 80. As you can see, the program was never designed to provide a few decades worth of comfortable retirement income, and it never will be. When you finally ignore Social Security, even though you’ll probably get some sort of benefit from it or whatever the program evolves into, you must recognize that the only person who can ensure you have a comfortable retirement is yourself.

It doesn’t matter if you contribute to a 401k, a Traditional IRA, Roth IRA, buy real estate, or keep money in savings bonds or in CDs at the bank, the bottom line is you need to be responsible for setting aside the money for later. The government isn’t going to do it for you and unless you’re fortunate enough to work for a company that provides a pension benefit, nobody else is going to either.

What You Can Do to Ensure Retirement

Since the ball is in your court, it’s up to you to put a plan in place to ensure you’ll be able to retire on your own terms. You can complain about the government wasting money or about Social Security going bankrupt, but that won’t solve your retirement problems. So your best bet is to put your head down and get to work.

First, it’s important to recognize that something is always better than nothing. It’s easy to feel defeated when you realize you can’t max out your contributions or save what it will take to reach your magic number. So if you can only afford to save $50 from every paycheck, that’s fine. Just be sure to actually put that $50 toward retirement instead of feeling bad about how it’s less than you need to save. Again, doing something in this case will always be better than doing nothing. The best part is that you can always increase this amount later. Over time you may have more cash flow and can contribute more, or maybe you end up streamlining your budget which allows for larger contributions. Either way, do what you can now and work on increasing that as time goes on.

Next, make sure you’re investing the funds appropriately. Especially when you’re younger, you may feel like swinging for the fences by taking on a lot of risk with stock funds. While that can work out since you have time on your side, it’s still a good idea to create a solid diversified portfolio that’s suitable for your age and your ability to stomach market swings. Slow and steady often wins the race, especially if it means you aren’t constantly getting spooked out of the market whenever things turn south for a while. And of course, stay on top of your investments and adjust your holdings as you age. Don’t become media fodder when you’re 65 and now find yourself needing to work the rest of your life because you were still invested in all risky stock funds just months before your retirement date.

Finally, examine your 401k carefully. As mentioned earlier, not all plans are created equally and there are some plans out there that downright stink when you look at the fees and investment choices. So if you find that you can’t invest in anything with less than a 2 percent annual fee, it’s fine to turn your attention to other options. If you’re still eligible to contribute to a Traditional IRA and deduct the contributions you can always go that route. Or maybe you’ll open a Roth IRA. Or maybe you have a side business and can open up a self-employed retirement plan. Either way, if your 401k plan is truly bad it might be a good idea to look at alternatives.

So, is the 401k too risky for retirement like the media often says? Not at all. The real risk is that since we’re all largely responsible for our own retirement, the fact of the matter is most of us aren’t saving nearly enough, or when we do save we’re making poor decisions with the money. These mistakes are made regardless of the investment vehicle used. I can understand the arguments people often make when pointing out that 401ks don’t work because even those who do utilize them often come up short, but this would be true for any investment vehicle that’s 100 percent optional. Just imagine how many people wouldn’t contribute to Social Security if it was optional, yet demand benefits when they need them later. Until there’s a way to force people to save I’m afraid it’s up to us to make good decisions with our money and stop thinking somebody else is going to step in and take care of it for us.

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The calendar may have flipped to the new year, which means most tax tricks, tips, and deductions have closed the book on last year’s taxes, but that isn’t the case for your IRAs. Individual Retirement Accounts are unique in that they give you up until when you file your taxes on or before the April 16th tax deadline. That means you have a full three and a half extra months in the new year to catch up on an entire year of Roth IRA or Traditional IRA contributions if you choose to.

This is good news for many people because it’s easy to forget to miss a contribution during the year and the first instinct is to expect that once the calendar year is up you’re out of luck. There also may be situations where the new year means a new job, a pay raise, or bonus that could be applied to a contribution and catch up on what you missed out on. Whatever the situation, you have over three months to do something good for your retirement nest egg, and if you contribute to a Traditional IRA, lower your tax burden.

Get a Late Tax Break

As mentioned above, if you have a Traditional IRA account those contributions generally count as a tax deduction. If you’re like me and typically get your taxes done early you’ll be able to see your possible tax liability before you officially file, and before the deadline. If you notice you’ll be on the hook for a few hundred, or even a few thousand dollars you can use the time before filing to make a Traditional IRA contribution to offset part or all of that liability. That is of course assuming you haven’t already maxed out your IRA for the tax year. But consider this: if you’re at the 25 percent tax rate and haven’t contributed anything to your Traditional IRA yet, a quick $5,000 contribution before April 15th (April 16th in 2012) you’re basically cutting $1,250 from your tax burden. Of course the tax break is nice, but you’re doing something even more important by putting more money aside for retirement and giving it more time to grow.

Spread Out the Contributions

Say you’ve found yourself in the new year and want to make up the IRA contributions you missed, but you don’t have a large chunk of cash available to do so. Don’t worry. Nothing says you have to make that prior contribution all at once. In most years you’ll have around 15 weeks from January 1st through the tax deadline. So think about it in small chunks. If you want to max out the IRA contributions you have 15 weeks in the new year to contribute $5,000. That means you could achieve that by just contributing $333 per week until the deadline. If you did make some contributions last year and just want to put in enough to reach the limit, just take what you have left to contribute and divide it by the number of weeks left before the tax deadline. Then you can make small weekly contributions or double the weekly amount and set up direct deposit or create an automatic contribution that coincides with your bi-weekly paycheck.

Whatever you do, don’t stop making those contributions once the tax deadline passes. Now is the time to adjust your weekly, bi-weekly, or monthly contributions so that you can max out your current year’s contributions. It’s a lot easier to contribute slowly throughout the year than play catch up every January through April. After the April tax deadline you’ll generally have 37 weeks, give or take a week, to make current year IRA contributions. So, take $5,000 and divide it by 37 and now you only have to contribute $135 per week to hit the maximum limit, or $270 every two weeks if you’d rather contribute directly from each paycheck. This is obviously far more manageable than trying to cram it all into a few short months. And here’s the best part. Once you do this and make your maximum contribution within the calendar year you can start fresh next year and have a full 52 weeks to spread the contributions out across. That is less than $100 a week, or less than $200 from each bi-weekly paycheck. Suddenly, saving for retirement has never seemed to easy.

Getting Started

If you haven’t opened an IRA yet, Roth or Traditional, you can still open one this year and make prior year contributions. If you’re contributing money electronically the brokerage will ask which year you’d like to make the contribution for. If you’re depositing via paper check you will want to make sure you write on the check which year the contribution is for, or use a special deposit form provided by the broker that allows you to specify. Otherwise they may assume that any money coming in after January 1st is for current year contributions.

If you’re looking for a good cheap place to get started with your IRA I’d recommend either Scottrade or TradeKing. Accounts at either of these providers allow you to invest in stocks, bonds, mutual funds, index funds, ETFs, and almost anything else. And commissions are about as cheap as they get in the business. And remember, you’re never stuck with a single company. You’re always free to do an IRA rollover or transfer the funds to any other brokerage or fund company in the future. The most important thing is to get an account open and put that money to work before the deadline passes.

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After listening to a conversation about how this is a great strategy in this recession, I had to set the record straight and educate my friends at work.  Someone has to do it right?  Well, to sum up the multiple conversations I’ve had, here are five of the reasons why you should never tap into money from your 401k.

If you do borrow, time is no longer your best friend

Money grows over time, everyone knows that.  And if you are investing regularly, time is truly your best friend.  I’ll take a known statistic for example.  Most of the time, your money doubles every eight years on average. For someone who is investing and not tapping into their 401k plans like a savings account, this is great news.  However, if you withdraw money from your 401k plan you are missing out on serious growth opportunities.  There are many reasons people take 401k loans, but many Americans take out money for a mortgage.  401k rules allow for these loans to be taken out for up to 5 years, and up to 15 years for a home purchase.  If you borrow from your 401k, you are missing out on opportunities for your money to grow among other things.  Over the long haul, this could mean the difference between $50,000 and $500,000.  I don’t know about you, but I don’t want to miss out on the potential long-term growth prospects for my retirement money.

Losing money is not fun

You wouldn’t throw money out your car window, now would you?  Yeah, didn’t think so.  So why do it with your 401k money?  Because that’s essentially what you’re doing when you borrow from your retirement account.  And don’t use the excuse that paying yourself back the interest is boosting your savings.  The long term return on your money makes the average interest rates today look like chump change.  Don’t buy into this and avoid borrowing from your 401k.  And don’t let me get into tax implications.  To repay a 401k loan, you are using after tax money from your paycheck, which means anything above and beyond the principal repayment will be taxed a second time when you make a distribution from your account. That’s a bum deal.

Like a bird in tar, you are trapped

While speaking with my coworkers, many did not realize that a 401k loan stipulates that if you quit or lose your current job, the 401k must be repaid almost immediately.  In effect, this is a type of leash that could force you to stay at your job and prevent you from seeking other higher paying opportunities.  I can’t imagine having this freedom taken away from me. Even worse, if you unexpectedly lose your job after borrowing a large chunk of your retirement plan you’re stuck with the bill. And if you can’t repay the loan you get stuck with then a big tax bill for the early distribution. Talk about making a bad financial situation even worse. Borrow from your 401k and you are at the mercy of your employment.

Makes you look like you are chasing the Jones’s

If you can’t live within your means and need take out a 401k loan for anything other than an absolute financial crisis, what does that say about your character and spending habits?  This is a huge wake-up call.  Are you managing your money well?  Are you keeping track of costs?  These are questions you need to ask yourself if you find yourself borrowing from your 401k for frivolous purchases.  Is that LED TV or kitchen remodel really worth the sacrifice of potentially a hundred thousand extra dollars in retirement?

Don’t listen to Nike, just DON’T do it!

Look, is it really worth it?  There are plenty of sources of income and savings.  You could even open up a zero interest credit card if you needed a short-term influx of cash.  Sacrificing future gains to make a purchase today is not wise and I highly advise against it.  Instead, look at your lifestyle and evaluate your choices and decisions.  Are you making bad ones?  If so, seek out help.  You will be glad you did.  If you want to be living on a beach at 65, you will NOT tap into your 401k account.

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So what’s a scared American to do?  Well, that’s where individual Roth IRAs are king. The combination of a private retirement fund and tax free growth is music to anyone’s ears.  I’ve said it time and time before that a Roth IRA is the fastest way to a million dollars for the average American.  The biggest factor contributing to this is that your money is taxed from day one through your paycheck and is never taxed again with a Roth IRA.

A Roth IRA is truly the “king” of retirement accounts.  Even 401k plans often pale in comparison.  One of the only reasons why a 401k makes sense is because many employers contribute to your account.  Let’s take a look at the tax benefit of a Roth IRA and why you should open one today.

ZERO taxation when you withdraw at retirement

This is the kicker for choosing a Roth IRA.  Not having to pay tax on withdrawals like you would with a 401k is simply astonishing to me.  As long as you are 59 1/2 years old and the account is five years old, you can withdraw any or all of your retirement savings tax free during your “golden years.”  This means all money in will stay in and will utilize the magic of compound interest.  With the uncertain economy a Roth IRA is a clear winner because who knows how high taxes will be 30, 40, 50 years from now…

You can remove your money invested at any time

If you are regularly putting money into your Roth IRA, you are able to withdraw your money invested without any penalty!  Most people don’t realize this, but it’s a huge selling point.  However, I don’t recommend doing this because you’re taking money away from your retirement account.  But, at the end of the day, it’s nice knowing your principal is accessible unlike money in a 401k.  what you’re NOT allowed to take out is the interest on your money. With a 401k you’re usually only left with a hardship withdrawal or a 401k loan. So, as long as you only take out money that you originally put it, you don’t get dinged with a tax penalty.

You can take it all out or leave it all in

No more worries about having to take out a portion of your money because of federal regulations.  Now, with a Roth IRA, you can leave your money in your account and let it keep gaining interest during your retirement.  This is a much appreciated feature because most people’s retirements last 15+ years.  You don’t even have to spend the money if you don’t need it! Unlike a 401k or traditional IRA, you are required to make minimum distributions once you reach 70 1/2.  If you have saved more than you had to, you can just leave the money in the accounts for your kids or whoever is set as your beneficiary.  This is huge for out of the blue deaths or just giving your grand kids a gift of money.

No age limit, no problem

I love that anyone can open a Roth IRA and contribute as long as they have some sort of income.  I first found out about them when I was 18 years old.  Boy, am I glad I found out about them then!  It’s great because you can open a Roth IRA for your kids and help the start investing at a young age and encourage stewardship habits early on.  At any age, it’s easier than ever to convert your traditional investment vehicles to a Roth.  If you’re young and in a relatively low current tax bracket I recommend switching and start enjoying tax free growth for life. Although there are potential pitfalls in converting, so make sure you understand the tax implications of doing a Roth IRA conversion.

Now that you know about the amazing tax benefits of a Roth-IRA, what are you waiting for? If you don’t have one, open one today. Here are a few great places to set up a free account:

• Scottrade
• Tradeking

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Money management is the main driving goal during retirement and, for starters, it’s recommended that you withdraw 4 to 5 percent from your overall savings and no more than that. On average, people put money into various accounts like a 401(k), IRA, and if you’re lucky, a pension. Minimizing what you’re withdrawing is the key so you’re not faced with dwindling finances the older you get. Plan out what you have and factor in what you need to live on. This doesn’t mean you should live poorly, just wisely. There’s a lot of savings and retirement information on the web, like RetirementCalculator.com, that helps people with some of the myriad issues that come along with retirement.

You’ll also want to begin to minimize the taxes that are hitting you. Simply put, if you have money invested in a 401(k) or a traditional IRA, you have to pay taxes on the money when you withdraw it. more money you leave in you accounts, the more they will grow. With a lager balance your interest for that account will compound much faster. Now, eventually, you’ll have to withdraw the money but you want to minimize the hit you’ll take in taxes and waiting can often prove a very handy approach. This is why retirement planning is more than just thinking about putting money away for retirement. It’s also about managing that income in retirement so you don’t pay any unnecessary taxes.

Finding the right mix in your accounts isn’t impossible. If you think you’ll be withdrawing money at an earlier age then there are certain accounts that you should look at. Roth IRA’s, as stated above, are perfect for early withdraws. The difference with this type of IRA is that you’ve already paid all of the taxes on contributions. Everything was taken out when you put your money in so when it comes time to withdraw, you’re not caught off guard and hit with huge penalties and taxes.

Much of this information is about building your savings and having a low impact but it’s also important to note one of the worst mistakes retirees often make. It’s essential that you, under no circumstances, treat your 401(k) or other retirement accounts like it’s a savings account. Constant withdraws, penalties, and taxes will decimate your savings. Don’t touch it unless you absolutely need to and only withdraw after the account’s term limit.

Managing your money today is easier than every. With tools like the Internet and Retirement Apps that help you plan and manage your spending, you can have a much better idea of what you can and can’t afford. You want to stretch your money as far as you can and make the most from your retirement savings and accounts.

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If retirement seems like it is a lifetime away, planning for how you’ll spend that time may  be difficult. But one thing is certain: you’ll need to have money in retirement. If you don’t plan on working in retirement, where will this money come from? Most people have three sources of income that work together to fund retirement: Social Security, pensions, and personal savings.

Retirement Planning Problems

Even with three potential income streams there are some problems to consider. First, we aren’t certain what the future holds for Social Security. Even in the best-case scenario where you receive your full Social Security benefits, the average person only receives 40% of their pre-retirement income. That can certainly help, but with increased costs on things like health care in retirement that money doesn’t go very far.

The next problem has to do with pensions. These employer-sponsored plans not very common today, and even if you are lucky enough to receive a pension benefit, the amount you receive in retirement will likely only supplement around 25% of your pre-retirement income. Younger generations have all but written off pensions as a source of retirement income, so if you have one, count your lucky stars.

With all of the uncertainty and limited payouts of Social Security and pension plans you’re left with finding ways to save some of your current income for retirement. Thankfully, the government realizes the importance of saving for retirement, so they have created tax incentives to encourage you to save for retirement. The problem is that most people simply aren’t saving enough for retirement.

Time is Your Greatest Asset

The most important component of retirement savings is to start as soon as you can. The power of compound interest requires time to work its magic, so the more time you have, the more your money will grow. If you have a 401(k) plan at work or a traditional IRA, begin saving as much as you can, even if it is only fifty dollars a month. Every little bit helps. In addition to saving money for retirement, by making these contributions you’ll also be reducing your taxable income today. That means less money in Uncle Sam’s pocket and more for you when you retire.

In addition to the common pre-tax plans like a 401(k) or traditional IRA, you should also consider a Roth IRA. While you don’t receive an immediate tax deduction from contributions into a Roth, the benefit here is that your money will grow tax-deferred and can be withdrawn in retirement tax free.

Investing for Retirement

Aside from starting early, the biggest obstacle in saving for retirement comes down to the investments. Where should you invest? How do you know if your investments are appropriate? Investing doesn’t have to be complicated as long as you follow the golden rule�’don’t put all of your eggs into one basket. You’ve probably heard that before, but it is worth mentioning again. As long as you spread your investments out across many investment types and asset classes you will maximize your returns while minimizing risk. There’s no way to completely eliminate risk, but diversification works. Take a look at how diversification generated positive returns during the “lost decade” of investing.

If you are primarily saving in a retirement plan through your employer, check to see if your plan offers any asset allocation investment funds. These are funds that automatically invest your money in a way that is appropriate for your age or investment objective. If you do a lot of investing on your own and aren’t comfortable making any drastic changes, you may want to seek professional help to ensure you’re doing what’s best. Working with a financial planner can help you make the most of your current investments and work with you to create a plan to reach your retirement goals.

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What is probably more shocking is that many of the people coming in looking to take money out of their retirement plan only need a small amount (generally under $1,000) to cover some unexpected expenses and I’ve even seen people take out $500 loans  from their 401(k) on three year terms. With so many people tapping into their employer plans for minor emergencies I think this highlights the importance for keeping a cash emergency savings account available even if it isn’t a significant amount.

Congratulations on Saving for Retirement, but Your Responsibilities Don’t Stop There

I have to applaud those who actually take the time to enroll and begin contributing to their plan, especially if money is tight as it often is. Generally, the people who need to borrow against their 401(k) are earning modest incomes and are just able to make ends meet. There is a lot to be said for someone in such a situation. They understand the importance of saving and have learned to make due without that little extra money coming home in their paycheck.

But taking the step to actually save for retirement is only the first step. That money doesn’t do any good if you’re constantly tapping into your nest egg via loans, premature distributions, or cashing out instead of doing a 401k rollover. Saving is good, but not managing those funds properly can be just as bad as not saving anything at all.

Taking the Next Step

While participating in the plan is a great initial step it is often the only savings many people are taking part in. It is automatically taken out through payroll so it is simple to set up and easy to forget about. The problem is that people stop there and don’t apply the same technique for other savings. If you can spare $50 every two weeks from your paycheck for retirement you should strive to save at least $25 as well for your emergency savings so you don’t have to treat your retirement plan as an emergency fund.

The problem is that this takes additional work and you either need to change your direct deposit to put money into a savings account or you need to manually set up the transfer or deposit. The other big problem is how easy the money can be to access. Most people simply set up their savings account where they do the rest of their banking and more often than not the savings account is linked to the checking or even their ATM card. The ease in accessing this money can make it difficult for some people to keep the money in savings where it belongs and occasionally tap into it for things that aren’t quite emergencies. The benefit of a retirement plan is that the money isn’t as easy to access, so after a few years of constant contributions and no withdrawals people are surprised at how much they have saved and see that as money that can be used for other things.

So, if you can manage to get by saving automatically in your retirement plan, you can just as easily set up an automatic savings plan with a savings account. The best thing to do is to open an high-yield online savings account. Ally Bank currently offers a high APY. The rates are probably better than you’ll get at the bank, and the money will physically be separated from your other cash. Then, all you have to do is establish a regular and automatic transfer to fund the account. Maybe you set the transfer up for payday so you don’t even miss the money. Whatever you do, it has to be automatic and require little action from you. If you have to force yourself to remember to make a deposit every two weeks how long will that last before the habit fades away?

Loans Should Be Your Last Resort

If your 401(k) plan allows you to take a loan it should be treated as a last resort. Some people argue that taking a 401k loan isn’t all that bad of an idea because it is your money and you are simply paying yourself back the interest. While that is true, you are still hurting yourself over the long run. Money that you take out of your plan can no longer earn interest or see capital gains. For some loans this could be a period of five years of foregone compounding interest. Second, most people who take a loan end up stopping their regular contributions as well so that they can afford to make the loan payments. This just compounds the problem of foregone gains and what is even worse are those who end up forgetting to begin contributing again once the loan has been repaid.

Another thing to consider are the tax consequences on the loan. Money you borrow from your plan is pre-tax money, but your loan payments are from after-tax dollars.  This means you are effectively going to be taxed twice on some, not all, of the money that you borrowed. If that isn’t a raw deal I don’t know what is. Finally, in the event you default on your loan because you change jobs and stop making loan payments the IRS will treat that as a premature withdrawal resulting in taxes owed on the distribution with a 10% penalty on top if you were under the age of 59 and a half. You say to yourself it won’t happen, but I have seen people take out $10,000 loans only to find themselves out of work a month later, fail to repay the loan in time, and get hammered with a $10,000 early distribution and all of the taxes that go with it.

Check to See if Your Employer Offers an After-Tax Retirement Account or Christmas Club

If you find it difficult to save money the traditional way and want to avoid the pitfalls of tapping into your qualified retirement account there may be another option available to you in the form of an after-tax portion of your 401(k) or 403(b). Some employers actually offer the option to also contribute after-tax dollars into your retirement account, either within your current plan or through a separate account like a Christmas Club program.

The benefits of doing this are that you can begin saving money easily through payroll deduction just like your current retirement plan and yet you have access to 100% of this money without needing to take a loan or worry about IRS early withdrawal penalties. While you won’t receive the tax benefits of a qualified plan you can at least create a cushion of money that is available without excess penalties or taxes. Most plans allow this money to go into a savings type account or in some sort of fixed fund so your money is usually not at risk.

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In a real practice dealing with real people, the results are even more shocking and really hit home. I’ve worked with people, affluent people such as doctors and lawyers who are nearing age 65 and are looking to retire. When we begin to dig into their investments and retirement plans it was typical to find out that these individuals earning sometimes upwards of $200,000 a year had as little as $50,000 saved up and expected to retire inside three years. On top of that, they still had mortgages, auto loans on luxury cars, and vacation homes, yet they said they couldn’t afford to max out their 401(k).

And these are people you’d think would have it easy and built up a nice nest egg. When you work with the typical middle-class employee the situation wasn’t much better. The real problem is most of these people weren’t saving at all. The good news is that those who were saving typically put a larger percentage of their paycheck away than those who made far more money.

So, the evidence is out there, and for the majority of people they simply aren’t saving nearly enough. But, that hasn’t stopped one man from proclaiming we are actually saving too much for retirement. Too much, too little. How much should you save for retirement?

The Man Behind the Claim

Laurence Kotlikoff is an economics professor at Boston University and he claims that most Americans are saving too much money for retirement while sacrificing spending money today. This is a pretty bold statement that goes against most of what we’ve been taught. But this idea isn’t new. The first time I came across it was in a 2007 Registered Rep article. “The rules of thumb are the rules of dumb,” scoffs Laurence Kotlikoff. Kotlikoff is one of the leading members of what could be termed a school of retirement heretics who question much of the conventional retirement financial-wisdom, and even received truths about the retirement period itself.

It is All About Consumption

Kotlikoff argues that current financial planning doesn’t take into account consumption smoothing. That is, most savings plans revolve around a fixed amount that is put on autopilot and doesn’t change according to what is going on in people’s lives. With major life events such as weddings, college education, career changes, and so on, the amount you need to save will fluctuate and not remain constant.

I can agree with this, and just sticking to the rules of thumb that say you need to save X percent of your income or you need to have X amount of dollars by retirement are just that–rules of thumb. Sure, rules of thumb aren’t supposed to be perfect and exact for everyone, but people need to start somewhere. Especially those who may not have much of a financial background as it can be intimidating to even fathom what kind of numbers should be considered.

To quote Kotlikoff again: “You don’t want to be putting your savings on autopilot, because if you put your saving on autopilot it means that your consumption is going to be disrupted.” And to that I have to say, “so what?” Making retirement savings automatic is the number one thing most people should be doing. The average person isn’t in a position to constantly adjust their savings amount year to year based on every little detail that’s going on in their lives so the best course of action is to set it up and let it happen automatically. So what if consuming (spending money) is affected? I’d argue that it’s better if somebody isn’t blowing a little extra money on Starbucks or a new car and instead keep putting money aside for retirement, which is probably still far short of what needs to be saved anyway.

Striking a Balance

All that being said, there is a hint of truth to this, but I don’t think people saving too much is hardly the problem as he suggests. The key takeaway is that you need to strike a balance between spending money today and planning for the future. Clearly, you don’t want live a life of poverty for 40 years just so you can retire and finally enjoy the fruits of your labor. On the other hand, you don’t want to spend like there’s no tomorrow only to realize you’re going to retire in poverty.

The fact is, most people are not saving enough, and not saving too much as Kotlikoff suggests. Just because people are using rules of thumb as a starting point for retirement savings doesn’t mean they are saving too much. Most people get a late start when it comes to saving, so even using the rules of thumb it may mean too little too late. Either way, people need to save for retirement, and it’s true they also need to be sure to enjoy life today. But I can guarantee you, the typical person making $50,000 a year and who’s putting 10% of their paycheck away (a common rule of thumb) is not going to have enough put aside by the time they retire to have the retirement they want.

Is There a Motive for This?

You bet there is. Kotlikoff has developed software that will help investors and advisors “smooth out” their consumption so that they can take into account the changes in their lives to more appropriately plan for retirement. The software is called the Economic Security Planner. The software starts at $149.00 and goes as high as $750 for the financial planner version.

It is starting to make sense now. If you make an outrageous claim that goes against everything we’ve been taught, you’ll generate a lot of attention in the media. Then, if you have developed a product that can address the concerns you mention, you can stand to make a lot of money. You’ve just created your own market for your new product. While that’s excellent marketing, I’m not so sure it’s good economics.

My Problem With This

Clearly, Kotlikoff has impeccable credentials given his background and academic qualifications, so I’m certain that many of the ideas surrounding this claim are sound. I agree that the typical retirement advice that is dished out by investment companies and many advisors is too simplistic and cookie cutter to be of much use on an individual level. But the claim that many or even most Americans are saving too much, I don’t buy that.

Maybe in the wealthy tier of individuals that Kotlikoff deals with this is true. I can see how those who can afford to save a lot may be dumping a ton of money into retirement while foregoing consuming today, but I simply cannot believe this to be true with the vast majority of your typical working Americans.

If I had to guess, I’d say that 9 out of 10 people I work with are not saving enough for retirement, by a long shot, let alone saving too much. Only between 60-70% of all employees are saving money at all, and the majority of those are saving a couple percent their pay. Virtually nothing. I find it very hard to believe that these working families are sacrificing things in their life today because they are saving $200 a month for retirement.

I do think that the argument about how retirement planning is too general is very true, and this is certainly a wake up call for those who blindly follow these rules of thumb, but the notion that most people are saving too much is a bit much. You should carefully examine your savings and retirement needs before reducing your retirement savings contributions or dropping a few hundred dollars on his software. Instead, start by sitting down and spending some time carefully thinking about your own situation and find out how much you need to save for retirement.

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Employees saving for retirement are not getting any favors from the government this year. The contribution limits for the major employer-sponsored retirement plans: 401(k)s, 403(b)s, and 457(b)s will not get an increase. That means like in 2010, the 2011 limit remains $16,500 for those under age 50. Those who are age 50 and older get the benefit of a catch-up contribution of an additional $5,500.

While this may not seem like a big deal if you don’t max out your contribution anyway, you have to wonder why. They say there isn’t enough inflation to warrant an increase, yet everywhere we look prices are rising. Not only that, but politicians remind us regularly that as a whole we aren’t saving enough and have problems with Social Security, yet no new incentives are ever put in place to encourage people to save more.

Going Beyond the 401(k)

Thankfully, we don’t need to rely on our employer-sponsored 401(k) plan. Don’t get me wrong, they are a great way to save and you should certainly take advantage of any matching contributions they might offer. But instead of relying entirely on an archaic section of the tax code you can put your retirement into your own hands. The ball is in your court.

First of all, do you have an old 401(k) sitting around from a previous employer? It’s time to do a 401(k) rollover into an IRA. Why leave your money tied up in an account that isn’t fully in your control? The plan administrator can change investments, fees, and plan features on a whim and you’re stuck with those changes as long as you’re with that plan. When you roll over your 401(k) you can choose what company to move the funds to and how you want to invest it.

If you don’t have an old 401(k) to roll over, it’s time to focus on your existing IRA. Don’t have one? Open an IRA today. Sure, the government also didn’t increase the IRA contribution limits, but it’s still better than nothing. If you’re looking for a tax break today, the Traditional IRA may be what you’re looking for. But if you’re hedging your bets and expect to have higher taxes or be in a higher tax bracket when you retire you’ll probably be looking at a Roth IRA.

Places to Invest

The options are almost endless. There are many investment companies to choose from and you can invest directly with a fund company, with a discount brokerage, or even a full-service branch. It all depends on what you’re looking to get out of your account and the level of service you need. Personally, I’m a do-it-yourselfer so I typically hold my accounts at discount brokers so I can keep my expenses low. Not only that, but I prefer to go with brokerage companies because within that single account I have the option to invest in individual stocks, bonds, ETFs, mutual funds, index funds, and even options, and do so for virtually free.

So, if you’re looking for flexibility and low transaction costs, here’s what I would recommend:

• Tradeking – Only a few cents more than Zecco, no maintenance fees on IRAs, and a great trading platform.
• Scottrade – 7 dollar trades, but they also have local branches all across the country if you prefer to meet with someone.
• Fidelity – Slightly higher trade commissions, but access to their incredibly low-cost index funds is nice.

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