As you may know by now, the Fool recently launched three new retirement portfolios. Although I've got a number of years to go before I retire, it's certainly a subject that's near and dear to my heart whenever I think about my investment goals. There are a number of different ways that a Fool can save for retirement. Let's review a few of them now.
First, the most lucrative retirement accounts are those that are available through your employer. Most often, this is in the form of a 401(k). (And in case you're wondering, the name comes from the section of the Internal Revenue Code that contains the applicable rules. Also worth noting is that educators use 403(b) accounts instead.) There are a number of advantages to these accounts.
One of the best parts is that it's a snap to invest in a 401(k) as contributions are made through automatic payroll deductions. (After a while, you won't even miss the money!) Another advantage is that the contributions are made with pre-tax dollars. Not only that, but money invested in a 401(k) is able to grow on a tax-deferred basis. In addition, many employers will match at least a portion of your contributions.
The employer match is a very important employee benefit. Companies that I've worked at have matched some percentage of up to 6% of my gross income. The match has ranged from 50% to 100% of my eligible contributions. Sometimes I find that the best way to really understand the advantages of opportunities like this is to work through some numbers. I'll do the calculations, so all you need to do is sit back and follow along.
To make everything work and easier to follow, I'll ignore deductions and exemptions from income. I also won't consider state taxes as the rules can vary from state to state.
As a base-line for comparison, here's our hypothetical $50,000 income individual -- we'll call her Kristin -- with a 28% tax rate:
- Salary: $50,000
- Income Tax @ 28%: $14,000
- After-tax income = $36,000
Now let's say that Jen, who also makes $50,000, adds a 401(k) contribution:
- Salary: $50,000
- 6% 401(k) Contribution: ($ 3,000)
- Taxable income: $47,000
- Income Tax @ 28%: $13,160
- Tax Savings = $840 (that is, $14,000 minus $13,160)
- After-tax, after-401(k) income = $33,840
Okay, so let's compare. Without saving for retirement, Kristin takes home $36,000. Her friend Jen, however, was able to save $3,000 towards her retirement and still take home $33,840 -- only $2,160 less than Kristin. Essentially, Jen achieved an immediate 38.9% return on her money! (The math works like this: ($3,000 / $2,160) -1 = 0.389 or 38.9%)
For fun, let's take this example one step farther. Suppose that Jen also enjoys the benefit of a 50% employer match. That would result in an additional $1,500 of savings. Add up the pieces, and you'll see that even if the 401(k) investments are flat, Jen will get quite a nice return on her 401(k) contribution. For Jen's $3,000 contribution, she gets a matching $1,500 from her company, so that means $4,500 in her 401(k) versus an alternative of $2,160 in after-tax income. Hmmm, which sounds better? The 401(k) with 50% matching gives Jen 108.3% more money than the after-tax alternative.
This is an example of why I believe 401(k) plans are one of the best benefits that companies offer. When I started working, I failed to participate in my company's 401(k) for the first couple of years because I had some school debts to pay off. I also mistakenly thought there was no reason for me to worry about my retirement as that event was so many years away. May I suggest that if you're currently eligible for a 401(k) plan and aren't contributing, then you should strongly consider making such contributions your top resolution for the New Year.
The one disadvantage of many 401(k) accounts is that your investment opportunities are often limited to various mutual funds. Some companies supplement some of the expenses, which helps, but in many cases that doesn't make up for the poor performance that many of the funds generate. However, the tax advantages that I mentioned in the above example helps to overcome that. Personally, I've also made it a practice to transfer my 401(k) to a self-directed IRA whenever I change jobs. If you do this as a fund-to-fund transfer, there are no current tax consequences. This allows me to invest in individual stocks of my choosing.
There's much more to say about 401(k) and other tax-deferred retirement plans, but I'll leave that to the new retirement area's sections on:
- 401(k) Plans
- All about Individual Retirement Accounts (IRAs)
That's enough about retirement accounts for me for one night. Let's now discuss this month's $500 investment. As a logistical matter, we're still in the process of getting a $500 check to our new AmEx account. Last week, Bill suggested that we put our dollars into American Express (NYSE: AXP), and Matt and Rob suggested that we add some more shares of Coca-Cola (NYSE: KO). (Those reports are available in the Rule Maker Archives.)
I've had a bit more time to think about this than the others as I was in Paris on business last week. And no, traveling to places like that to do my work is not as great as it sounds! The amount of work that we had to do didn't leave time for much other than working (though I will admit that we ate well at dinnertime). Plus, it's much nicer to come home to the smiling faces of my family and our two dogs instead of retiring to an empty hotel room.
In his column Matt made reference to this post by markandsusanv about the process used to select our $500 investment picks. I, too, try to limit my choices to the companies that score best using the Rule Maker Ranker. I've also become more sensitive to the fact that our portfolio seems a bit top heavy at the moment. That's made this month's decision a particularly tough one for me. I'd really like to side with Matt and Rob's selection of Coke. But, I just can't do it.
There are two reasons that I don't want to put our money in Coke this month. The first is that while Coke's Ranker score has moved into the second tier for the first time in awhile, I like to see more than one quarter of improved performance to make sure it's not an aberration. The other reason is the pending management change from Douglas Ivester to Douglas Daft. So far, my take is that it was a good move, but I'm not sure yet. I know that Ivester wasn't in the CEO office all that long, but to me his performance showed that he was not the right man for the job.
That leaves me choosing from our tech companies again. I've decided to cast my vote for Intel (Nasdaq: INTC), a company that I've written about many times in the past. One of the factors that led me to choose it this month is this flow ratio comparison for all Rule Makers:
Flow as of % Gain
Company 9/30/99 9/30/98 (Decline)
Intel 0.97 1.19 (18.5)
T. Rowe Price 0.67 0.77 (13.0)
Cisco Systems 1.03 1.13 (8.8)
Yahoo! 0.37 0.40 (7.5)
Coca-Cola 1.00 1.07 (6.5)
Gap Inc. 1.34 1.35 (0.7)
Pfizer 1.82 1.59 14.5
Schering-Plough 1.20 0.98 22.4
Microsoft 0.37 0.27 37.0
I like to reward companies that consistently improve their performance. This is something that Intel has done all year long. In addition, as Matt and I discussed recently (Part 1 and Part 2) the flow ratio is one of our most important tools to evaluate company performance. The fact that Intel showed the most improvement in its flowie for the quarter is just one more reason for me to nominate it for our $500 investment this month.
I hope that all of you have a very Foolish holiday.