401(k) Basics: Laying the Groundwork for a Secure Retirement | Planning for Retirement

Lesson 1: Why Is Planning for Retirement so Important?

What Are You Waiting for?

Procrastination is probably among the more universal of human traits. Whether it is the student cramming before finals or the writer rushing to meet a deadline, examples abound of well-intentioned people waiting until the last moment to tackle something important. It seems that retirement is no different. Why do we tend to postpone a vital step like preparing for retirement?

Maybe it is because it seems so far off, or simply that none of us wants to think about getting old. As a result, the "save what and when I can" philosophy seems popular, along with the assumption that our retirement years will somehow take care of themselves. There's always Social Security to bail us out, right?

Maybe, but then again, maybe not. In an era of longer lives and lower birth rates, some financial and political experts worry about the adequacy of the Social Security fund. Moreover, for those currently receiving Social Security checks each month, few would claim to be overpaid. Most retirees discover that Social Security covers only a very frugal lifestyle. In fact, many seniors find they must continue working well beyond the end of their "first" career to make ends meet.

How can you avoid not having enough money for your retirement (taking nothing away from those who choose to continue working)? The answer is simple. Plan for retirement -- the sooner, the better. This tutorial is designed to help you start planning today. In this lesson you'll learn why planning is so crucial. The next lesson provides some guidance on how to select and establish the right kind of retirement savings plan. When you are done, you'll know what practical and relatively simple steps you can take to start down the road to retirement security.

Retirement Dreams and Financial Reality

It seems that the media bombards you with images of retirees happily enjoying their golden years. Ads for brokerages, insurance companies, and especially retirement communities show their models sailing a yacht or driving a Cadillac off into a beautiful sunset. How realistic are these pictures? Can you possibly attain a worry-free retirement?

Granting that as a nation we have come to expect very little truth in advertising, the media's depiction of retirement is undoubtedly still misleading. More likely, very few people are setting aside enough now to assure a financially secure retirement later.

Not Very Prepared, Are We?

If a recent survey is any indication, Americans are woefully unprepared for retirement. Each year the Employee Benefit Research Institute (EBRI) conducts a Retirement Confidence Survey that polls 1,000 Americans over the age of 25.

In 2002 the EBRI found that the number of Americans who claim to be saving for retirement had fallen to its lowest level since the survey began. Despite that, 70 percent of those polled said they were very or somewhat confident they would be able to live comfortably in retirement, an increase from 63 percent in 2001. Many respondents, especially those under 39, expected to retire early (61 or younger).

Among those who had started saving, only a few had taken the time to estimate how much they'd need in retirement. 17 percent guessed that they would be able to retire on less than 50 percent of their current annual income. However, financial experts peg that figure at closer to 75 percent.

Even more tellingly, the survey discovered that fewer than half had saved more than $50,000 toward retirement, while fully 15 percent had saved nothing. Of those who had saved at least $100,000, almost all expected to live at least 20 years after retirement. That nest egg looks a lot smaller if it has to cover a lengthy post-retirement lifespan.

The Savings Shortfall

The EBRI pollsters concluded that many of us fail to save toward retirement because we cannot control our current spending. Others suffer financial setbacks or refuse to consider the possibility of bad health or the inevitability of aging. The combination of insufficient savings and inflated expectations could cause some serious unhappiness as retirement nears. Over 50 percent in the EBRI survey expected to fund their retirements entirely with Social Security or private pensions.

Clearly, there is a big disconnect between our retirement goals and our discipline in achieving them. As a generation that has never really known financial anxiety, we've come to expect that our needs will somehow always be met. Many view Social Security as that magic provider, which may be why half of today's current retirees report that Social Security makes up most or all of their ongoing financial support. The next section examines the wisdom of that approach.

Isn't Social Security Enough?

There is some good news for all of us procrastinators when it comes to retirement planning: the government is preparing for our golden years even when we aren't. You've probably noticed the deduction on your paycheck captioned FICA. That's the Social Security Administration withholding a percentage of your wages each year, to be returned to you with interest from the time you retire until you die. Seems like a fair deal, doesn't it?

It is certainly helpful. However, the bad news is that the monthly checks you'll be receiving in retirement cover pretty much the bare bones -- necessities only, no luxuries. Before we get into exactly how much we should expect to receive, let's take a quick look at the history of Social Security and discover how it works.

History of Social Security

Before the Twentieth Century, there were few, if any, retirement savings programs for older Americans. What little assistance there was came mostly from churches or other charitable organizations. Senior citizens were expected to live with younger relatives, or possibly receive aid from their neighbors or hometowns. This system, though somewhat harsh, worked reasonably well in a time when people lived much shorter lives on average than we do today.

Various experiments with social insurance programs began in the early 1900s. The first efforts grew out of workers compensation plans designed to protect injured workers. By 1929 almost all of the states had enacted workers compensation legislation. Retirement plans for various specific groups of workers (teachers, civil servants, and those in the armed forces) soon followed.

After the stock market crash of 1929 wiped out Americans' personal savings, few people had enough left to cover their retirement needs. The federal government was forced to step in, first with loans and then with outright grants, to help citizens survive.

A more permanent solution was needed, so in 1935 President Franklin Delano Roosevelt signed the Social Security Act. It provided relief for both retirees (Social Security) and displaced workers (unemployment compensation), the two groups most battered by the Great Depression. By 1939, the first lump-sum checks were paid, and in 1940 the current system of monthly benefits began.

There were few changes in the system until disability insurance was introduced in 1956. Cost-of-living adjustments (called COLAs) were added in 1972, and in 1983 the age for receiving full retirement benefits was upped from 65 to 67, where it stands today. Various types of workers (congressmen, railroad workers, and others) all had separate government plans at one time, but they have now been blended into the Social Security program.

How it Works

When applying for a job or filling out a form, have you ever wondered where your Social Security number came from? Everyone must apply for a Social Security number. Generally, they are handed out at birth or when an immigrant becomes eligible to work in the U.S. All of your Social Security contributions are tracked by this number, so it's an important ID to have.

The numbers are assigned based on where you live at the time of application: The lower numbers start in the East and increase as you move west across the country. For example, residents of New Hampshire are assigned numbers beginning with 001-003, while Hawaiians get numbers starting with 575 or 576. Incidentally, your number is retired when you die. There has been no need to reuse numbers because there are about one billion possible combinations of a nine-digit number. The SSA doesn't rule out doing so in the future, but only 400 million numbers have been used so far so there are 600 million or so left to go before that happens.

At each job, your employers are required to deduct a percentage of your wages and forward it to the government. That deduction is matched with an equal amount paid by your employer. The self-employed, by the way, must also contribute. Future benefits are based on the average earnings over your working lifetime.

Deductions, though designated for your future use, are in reality used to pay out benefits to current retirees. That is why many analysts worry about the future solvency of the Social Security Trust Fund as Americans live longer and more of us leave the work force than join it. However, the plan is designed to be self-supporting and recently had a reserve balance of over $1 trillion. Lifetime payouts since Social Security began are approaching $6 trillion.

Some Figures

How much is deducted from each of your paychecks? The current payroll tax is 7.65 percent of your wages, up to a limit of $84,900. This inflow then supports a maximum monthly payout of $1,660 to current retirees. Because Social Security benefits are indexed for inflation, you can expect to receive a similar amount at retirement as measured in buying power of today's dollar.

You may begin receiving benefits as early as age 62, but if you do, the amount will be reduced for the remainder of your life. To obtain a larger payment, you must wait until age 67 to start receiving checks. Be aware that you may increase the payout further by working until age 70. If you continue working beyond that, your total Social Security payout will be reduced by $1 for every $3 in annual earnings over a target amount ($30,000 in 2002).

Does $1,660 a month look like enough to get by on? Perhaps. Will it cover annual round-the-world cruises? Highly unlikely. That's why we're suggesting that you begin thinking now about ways to supplement your Social Security check with other savings.

Start Early, Contribute Faithfully

In the last section, you learned that Social Security alone will probably not fulfill all of your future financial requirements. That means you'll need to begin planning for one or more additional sources of retirement income. And there's no time like the present to start planning. However, the idea of starting a retirement savings program can seem a little daunting. It's natural to wonder how and where to begin.

Don't worry -- setting up a retirement plan isn't rocket science. In fact, just the opposite is true. The best savings programs are fairly simple and straightforward. Financial planners know that if they become too complicated, no one will want to utilize them.

Some of the younger students in this class may be questioning how much of this applies to them. Won't there be plenty of time to worry about all of this later? What age is best to begin saving for retirement? Ideally, as soon as you begin earning wages. Most retirement plans allow anyone, no matter how young, to contribute a portion of their income.

Some foresighted parents actually want their young children to put a portion of each weekly allowance into savings. The goal, of course, is to establish the discipline of saving a bit from every cash inflow. That habit can pay huge dividends over a lifetime, so it's never too early to get started.

Blueprint for Success

At the most fundamental level, the keys to successfully funding retirement are:

• Establishing a sound program as soon as possible.
• Sticking with it.

Getting these two concepts right goes a long way towards increasing your savings by the time you retire. How can we be so sure? You already know that $1 received today will likely be worth more in the future, say in thirty years. If you invest that $1 and earn a positive return, the longer you invest it, the more it grows.

Conversely, the $1 you receive in the distant future is worth less to you today. If $1 currently pays for a copy of the New York Times, it will presumably buy less (maybe just the sports section) in thirty years. Inflation erodes the value of future wealth.

You know that $1 put into savings today should be worth a good deal more in thirty years. Interestingly, it will also be worth more than $2 (twice the savings contribution) you invest fifteen years from now and hold for the next fifteen. To clarify, let's look at an example.

The Early Saver Catches the Worm

If you invest $1 in 2002 at an average annual return of 5 percent, it will be worth $4.32 in 2032. For comparison, if you invest $2 in 2017 at the same average annual return, it will grow to only $4.16 by 2032.

The gap is even wider at higher rates of return. If you could earn 10 percent on your money, $1 today would grow to $17.45 in thirty years, while the $2 you invest in 2017 at the same return would yield $8.35 in 2032. Clearly, you are much better off the sooner you start your saving plan.

For a more realistic retirement planning example, consider an annual savings contribution of $1,000 that you invest at 8 percent. At the end of thirty years, you'd have $113,283 in total savings. Compare that to investing $2,000 a year beginning ten years from now at the same rate of 8 percent. Twenty years later, you'd have $91,524, even though you socked away twice as much for twenty of the thirty years. In fact, you would have contributed a total of $10,000 more in the second scenario and wound up with almost 20 percent less in the end.

For a further explanation of why it doesn't pay to procrastinate with retirement planning, let's turn to the next and final section of this lesson.

The Power of Compounding and Tax Deferral

Albert Einstein is said to have referred to compound interest as the greatest mathematical discovery of all. He was probably being playful, but there's no doubt that compounding is extremely beneficial to retirement savers.

Let's start with two brief definitions:

• Simple interest is the amount you earn on an original invested principal amount.
• Compound interest is the increase in your investment return from earning interest on the principal combined with any previous interest you earned.

Most financial investments assume payment of compound interest, although simple interest is still used in many situations. An example makes the difference between these two types of interest more clear.

If a 3-year CD promises simple interest at 5 percent, a $10,000 investment will yield $500 annually for a total 3-year return of $1,500 on your original principal of $10,000. However, if the CD promises compound interest at 5 percent on the same $10,000 investment, the 3-year return will total $1,576, or $76 more.

Compounding is the reason all of the "early bird" scenarios in the previous section looked better than the "well-intentioned procrastinator" examples. It's also why we've stressed the need to begin saving for retirement as soon as possible. You don't have to save any more, just start sooner.

Looked at another way, compounding is like earning extra free money just for putting away the same amount now rather than later. That's simply too good a deal to pass up.

Deferred Taxes

As you will see in Lesson 2, several different types of retirement savings plans allow for legally deferring tax payments. At first, that may not seem like such a big deal. Pay taxes now or pay them later, what's the difference? There are two reasons why tax deferral is such a powerful savings catalyst.

1. Whatever you don't pay in taxes now can be put to work earning interest or capital gains until it is taxed. The deferred tax amount is like an interest-free loan from the government that can be invested until coming due later. Yes, you must repay it, but you get to keep everything earned on your investment in the meantime. We just learned that compounding helps increase wealth by earning interest on interest. Just think of the deferred tax as that much more to be compounded each year.
2. Remember from the previous section that $1 received in the future is worth less than $1 received today. Today's $1 can be invested and should be worth more later.

The corollary to this present value rule is that a future outflow or expense is less painful than paying the same amount today. You will make the future payment in dollars that will be worth less due to the constant upward creep of inflation. Financial experts therefore recommend postponing tax payments as long as legally possible, since they'll be made in devalued dollars. As a result, entire financial departments of major corporations are dedicated to finding the best ways to speed up collections and delay payments.

To sum up, invest as much as you can as soon as you can and delay required payments like taxes as long as possible. While it may seem a little underhanded, in fact it's just good financial planning.

Moving Forward

In this lesson, we've taken some first steps toward understanding the importance of planning and saving for the future, along with the need to supplement your future Social Security or private pension benefits with other sources of retirement income. We've also demonstrated the helpful boosts provided by tax deferral and compound interest.

In the next lesson, we'll explore some retirement savings alternatives and conclude with a guide to selecting the best type of program for your personal financial situation.

As a supplement to this tutorial, please read "Part 1: The Retirement Landscape" in the text accompanying the course, A Commonsense Guide to your 401(k), by Mary K. Rowland. This section goes into a bit more detail on the points we've covered so far, especially regarding the wisdom of starting your retirement savings plan as soon and contributing as much as possible. These are valuable insights from one of America's leading writers on personal finance and retirement planning.

Planning for Retirement: Getting a Jump on the Golden Years

Lesson 2: Retirement Planning Programs

Bonds and Stocks

Before mutual funds and tax-advantaged retirement plans, or even Social Security, the traditional savings vehicle for retirement was a mix of stocks and bonds. Many people still invest in stocks and bonds directly today, although they are more frequently included in other types of plans, as we'll see below.

Let's take a look at what makes each attractive. We'll start with bonds, the more conservative of the two savings alternatives.

Bonds

What exactly are bonds (or fixed income vehicles, as they are more formally called)? A bond is basically an IOU from an institution to an investor. Once a company reaches a certain size, it can use the capital markets to raise additional funding, usually at a better rate than from a bank loan. It will offer to pay interest in return for the use of your money for a specific time.

You pay cash now for the promise of periodic interest at a specified rate and return of the principal on a future date. Only very dire circumstances will keep a company or government entity from making its interest payments, since missing them will result in a loss of financial standing and presumably a stock price decline plus many lawsuits. But keep in mind that companies can find themselves in financial straits, leaving perspective bondholders in a bad way when it comes to collecting their money. Look no further than recent news makers Enron, K-mart, and Global Crossing for examples of this unfortunate situation.

The most common issuers of fixed-income securities are:

• The U.S. Government, which issues bills (short-term maturities), notes (intermediate-term maturities), and bonds (long-term maturities -- now being retired).
• Banks, which issue certificates of deposit (CDs, for short).
• Corporations and government agencies, which issue bonds.
• Cities, states and counties, which issue municipal bonds (usually tax-free).

Bonds pay interest quarterly, semi-annually, or in a lump sum at maturity (see the sidebar for more information). They are liquid and may be sold and resold many times between issuance and maturity. The issuer simply pays interest to the owner of the bond on the payment date.

The issuer's creditworthiness depends on its future prospects. Since all predictions are generally less accurate the farther out they go, short-term debt is considered less risky than long-term debt. A lot can happen to a company over time, so you as an investor will generally require a higher interest rate on a longer-term debt (the fundamental risk-return tradeoff). However, even longer-term debt is generally considered safer than company stock, so bonds usually return less than the riskier stock of the same company.

Because bonds tend to do well and stocks poorly as the economy contracts, their gains and losses usually offset each other. When the economy is picking up steam and stocks are riding high, bonds generally lose short-term value due to interest rate increases. Over the long haul, the majority of bonds will make it safely to maturity, providing a measure of certainty in your retirement portfolio that stocks (next section) cannot duplicate.

Stocks

Buying stock (or equity) is another time-honored means of investing for retirement. No doubt you've read about or already invested in the stock market. Every daily TV, radio, or published news report includes some kind of stock market recap.

Why do stocks command so much attention in the press?

• They are easy to understand
• They are potentially very rewarding
• They are just plain fun

Stock market investing is both a potential means of increasing wealth and an enjoyable (albeit challenging) pastime for many.

Stock is nothing more than a method of selling a portion of a company to investors. Eventually, most companies reach a stage in which some outside capital is necessary for the company to grow. The investors who provide capital by purchasing stock actually become the part owners of the company, though few individuals own more than a small percentage of the larger publicly traded firms.

Stocks tend to be much more volatile than bonds. Thus, they can be very nerve-wracking for the beginning investor. Even experienced investors may panic when suffering through the occasional gyrations of the stock market. This normal tendency can prevent stock investors from reaching their long-term retirement needs.

How best then to ride out the market storms that inevitably come along? The worst storms can have you thinking about ditching a long-term retirement investment at just the wrong moment, well short of retirement age. If you know that staying the course is personally difficult, consider working with a broker or financial advisor. The trustworthy ones realize that a big part of the service they provide is making sure you hang in there (and continue investing) when things get rough.

Buy and Hold

As with mutual funds (next section), the classic no-brainer stock investing strategy is called "buy and hold." However, because stocks are inherently riskier than a diversified mutual fund, the stocks you choose to hold until retirement must have superior long-term prospects.

The buy and hold approach is based on the observation that stocks as a whole tend to increase in value over time. In fact, as measured by stock indices like the Dow Jones Average (invented more than 100 years ago), they have done just that. Bonds generally return less, but they also show positive averages over the long term.

Mutual Funds

Direct investment in stocks and bonds, described above, has long been a reliable means of building retirement assets. The unfortunate catch is that unless you adequately diversify your portfolio, a perfectly good retirement plan can be sidetracked by only one or two bad picks. It's very hard to recover savings lost when a company's failure leads to a bond default or stock delisting; the result is total loss of invested principal in either case. This is especially true when the faltering stock represents a large percentage of your total retirement portfolio.

Responding to the need for better methods of diversification (i.e., not putting all your eggs in one basket), mutual funds were first developed in the 1920s. The industry grew rapidly and today represents a significant part of the retirement savings market. In fact, the total number of mutual funds now, amazingly, exceeds the number of stocks traded on the NYSE and NASDAQ combined. The benefits of fund investing have proven irresistible, and more funds are being created every week.

Mutual funds are simply groups of stocks, bonds, or other savings instruments pooled for investment purposes. Mutual funds key on the diversification concept by purchasing large varieties of whatever their charter requires they invest in (for example, one type of stock like growth or value), so that no individual stock or bond predominates.

Note that there can be higher costs to holding mutual funds than individual stocks or bonds. The fund may charge commissions to investors on top of the fund manager's fees (typically 1 to 2 percent) for managing the fund. No-load funds charge only administrative fees while load funds charge one of the following:

• An upfront percentage fee for purchasing shares (called Class A shares).
• A percentage fee for selling shares, which declines over time (Class B shares).
• A continuing "pay as you go" annual fee (called Class C or D shares).

Load funds are usually purchased through brokers, though fund companies may also charge loads for their shares. No-load funds are generally available directly from a mutual fund company or a discount broker like Charles Schwab. There is much debate about which type of fund is best, but if you are reasonably self-reliant and able to withstand market fluctuations, no-load funds have a big cost advantage.

Selecting a Fund

When picking a mutual fund, most experts recommend choosing from among the long-term performance leaders. The idea is that any fund manager can experience a lucky temporary run with eye-popping returns for six to 12 months. However, only the most talented managers can post above-average results for three or more years, which is why we suggest using the three, five, and 10-year mutual fund return tables (carried in all the leading financial publications) to find your candidates. You can also view the current top 25 mutual funds and review the performance of more than 12,000 mutual funds on Bloomberg.com.

WARNING
Remember that past performance of a mutual fund is no guarantee of future success. Mutual funds are subject to the ups and downs of the markets.

For a good overview of the do's and don'ts of mutual funds, read an excerpt from The New Commonsense Guide to Mutual Funds on Bloomberg.com.

Dollar Cost Averaging

Perhaps the best mutual fund investing strategy for retirement planning is dollar cost averaging (DCA), which starts with the buy and hold approach and takes it a step further. The object is still to invest in quality stocks or bonds for the long term. With DCA though, you average into your eventual position by buying on a regular, preset schedule. That means buying the same amount on the same date each month or quarter.

Here's an example: Say you have determined that you can afford to save $100 a month toward retirement. On the first of each month, you'd unfailingly invest $100 in more shares of your favorite mutual fund.

Because the fund's value (called net asset value or NAV) moves up and down throughout the year, you will naturally buy shares at different prices each month. The beauty of DCA is that in months when the NAV is down, you will automatically buy more shares. In months when the NAV is higher, you will buy fewer shares, because you are investing the same fixed $100 each time.

As a result, your average cost of shares purchased will probably be lower than if you purchased them all at once. DCA prevents you from making emotional mistakes like buying extra shares when prices get hot or buying less when stocks are out of favor (the best time to buy, but hard to do).

DCA, like buy and hold, is a passive investing strategy. You may wish to increase your monthly contributions as your income grows, or to stop them temporarily if circumstances require. All that's necessary for DCA to work is the discipline to keep investing on a preset schedule for the long term.

Now let's take a look at the many benefits of saving for retirement via tax deferred accounts like IRAs and 401(k) plans.

IRAs, 401(k)'s and Other Tax-Advantaged Plans

Remember from Lesson 1 how effective tax deferral can be in boosting your investment returns? Congress, which has a stake in getting Americans to save toward retirement, capitalized on that factor by creating the attractive tax deferred savings programs we'll examine next. This section outlines the primary tax-advantaged savings plans, starting with Individual Retirement Accounts (IRAs).

IRAs

Anyone with earned income, no matter how young, can open and fund an IRA. They come in two basic types:

• The traditional IRA
• The relatively new Roth IRA

We won't be covering the other, less common, IRAs like Simplified Employee Pensions (SEPs), but there's plenty of info on them available from Bloomberg.com or the IRS.

In either case, the tax laws allow you to make annual savings contributions of up to $3,000 ($3,500 if you are over 50). Contributions to traditional IRAs reduce your taxable income today, but are taxed as regular income when you make withdrawals. Conversely, Roth contributions are made with after-tax funds now, but can be withdrawn tax-free later. Either way is beneficial; the choice is up to you.

For both types of IRAs, you may purchase a wide variety of different investments within your account, including stocks, bonds, mutual funds, limited partnerships, and even gold coins. Income and capital gains from your investments accumulate tax free within the account, providing a big advantage over investing in the same types of assets outside of an IRA. In fact, most financial advisers recommend fully funding an IRA and/or a 401(k) plan each year before investing directly in other assets.

A Few Rules

There are a large number of special rules governing IRA contributions and their tax deductibility. Traditional IRA contributions are fully deductible if you are not already contributing to a 401(k) plan. If you do contribute to a 401(k) plan, deductibility depends on your adjusted gross income (AGI).

For example, in 2002, if you are covered by a 401(k) or a SEP IRA and are single:

• If your AGI is less than $34,000, then a $3,000 IRA contribution is fully tax-deductible.
• If your AGI is more than $44,000, then your IRA contribution is not tax-deductible at all.
• If your AGI is between $34,000 and $44,000, you are allowed a tax-deductible IRA contribution of less than $3,000 ($3,500 if over 50).

Different limits apply to married filers.

Roth IRA contributions have similar earning caps. However, you are not required to pay any taxes on distributions taken after age 59 (since you paid taxes on the money before it went into the IRA), as long as the account is at least 5 years old.

Once retired, most investors withdraw funds from their IRAs in a series of installments over their remaining lives. In a traditional IRA, should you choose to take a withdrawal before age 59, you will pay income tax on the amount withdrawn and be socked with a 10 percent penalty for early withdrawal. As a result, most advisers recommend postponing withdrawals until after age 59.

Roth IRAs also differ from traditional IRAs in that certain withdrawals you make before the age of 59, primarily for medical emergencies or the purchase of a first home, can be exempt from penalties. Even so, try to exhaust all other possible sources of cash before you remove funds from either type of IRA before age 59, because withdrawals reduce the amount building up in your retirement kitty.

Most IRAs are held at brokerages (full service, discount, or electronic) and mutual fund companies. In some cases, you'll be charged an annual maintenance or account fee on top of any commissions or load charges for purchasing the assets in which you invest.

Both Roth and traditional IRAs are easy to invest in and understand. Congress designed them to be used by everyone. In fact, they are now considered fundamental to saving for retirement, along with 401(k) plans.

401(k) and Other Company-Provided Plans

Today, most large companies offer some kind of retirement plan to their employees. Some even contribute money to the plans on behalf of their workers. This is truly one of the most important employment benefits, one you should consider closely before taking a job or making a career change. It can make a big difference to your retirement nest egg.

Among the most common employer-sponsored plans are:

• 401(k) and 403(b) plans.
• Pensions and Employee Stock Ownership Plans (ESOPs).
• Annuities.

401(k) and 403(b) Plans

The 401(k) plan is a program that Congress improved but only unwittingly created. The founder was an accountant who noticed that tax law changes left a loophole allowing companies to start and help fund retirement plans for their workers. They have now become among the most popular savings programs of all.

The features that make 401(k) plans so attractive include:

• Automatic deductions from employee paychecks.
• Flexible investment options.
• The ability to borrow against your account balance.
• Company matching contributions.

Many employers offer a matching-funds benefit in their 401(k) plans. Typically, for every dollar an individual contributes into a 401(k) plan, the employer matches some portion. There is a limit to company generosity, naturally. Most firms offer a 50 percent match on contributions up to 6 percent of the employee's salary, though some double that or more.

As you determine how much you will invest for retirement each month, and what your investment vehicles will be, you should focus on funding your 401(k) first. Contribute the annual limit before setting aside any other retirement savings, even in your IRA. That company match is too good to ignore; neglecting your 401(k) is just like leaving money on the table. Try to contribute at least enough to obtain the maximum company match. It may be hard at first, but its well worth it in the end. Bump the percentage up as your earnings improve.

Not-for-profit corporations generally offer 403(b) rather than 401(k) plans. 403(b)'s are essentially tax-sheltered annuity plans. Like 401(k) plans, you may be able to contribute a significant percentage of your salary pre-tax. Be aware that in both plans there is usually a substantial penalty for early withdrawal.

A 5 to 20 percent deduction from each paycheck may seem like a huge bite out of your discretionary income. However, you may notice that after tax the difference in take-home pay with 401(k) participation is not that large. Because 401(k) deductions are pre-tax, your taxable income is less after you contribute to your plan, so you will see fewer dollars diverted from your take-home pay to your taxes.

Always speak to your company's plan administrator after starting a new job. They can help you understand how your firm's plan works, what kind of match is offered, how contributions will affect your pay after tax, and whether borrowing against your own account is allowed. In addition, consult your tax advisor about funding both 401(k) plans and IRAs in the same year – it can get a little complicated.

Pensions and ESOPs

Your employer may also offer other types of retirement programs like pensions or Employee Stock Ownership Plans (ESOPs). Pensions are retirement plans based on the number of years an employee works for a company. Each year, the employer contributes a small matching percentage of the worker's salary into a fund, which isn't taxed until later. Pensions can be a very nice addition to your retirement savings, especially since they are generally paid out in monthly installments like Social Security.

Federal law dictates that you may be entitled to receive pension benefits based on years of service, even if you leave the company before retirement. After five years of service, you can either take a lump sum to be rolled over into an IRA, or wait and receive a minimal monthly pension at retirement.

ESOPs use a percentage of your paycheck that you designate to buy stock in the company at a reduced rate. ESOPs are a little more complicated and may entail a greater degree of risk than a typical 401(k) plan. If your company's stock dips sharply, you can quickly lose money. We recommend that you discuss the specifics of such programs with your company's plan administrator and a financial advisor before participating. Determine how your money will be used and how much risk is actually involved.

Annuities

Annuities are a kind of hybrid life insurance policy and retirement account sold by brokers and insurance companies. You pay with after-tax dollars today for a stream of monthly income after retirement. In between, the funds are invested in assets of your choosing. Should you die early, your beneficiaries will receive the entire payout you would have been entitled to.

Annuities are similar to IRAs, in that your money grows tax-deferred until withdrawal, and cannot be taken out before age 59 without penalty. Unlike IRAs, your contributions are not tax deductible. As a result, financial planners suggest you fully fund all IRA and 401(k) possibilities before investing in an annuity. They are generally considered supplemental rather than primary retirement savings vehicles.

The Right Plan for You

As we've said throughout this tutorial, if you haven't yet begun saving for retirement, now is definitely the time.

In this last section, we'll look at some of the factors you should take into consideration as you begin setting up your retirement savings plan. For a more detailed understanding of how these factors may affect your choices, please visit the Bloomberg University website for a list of current courses. You will find a number of helpful classes focusing on retirement planning.

Some things to keep in mind as you plan for your retirement include:

· Your age. The closer you get to retirement, the lower your investment risk should be. Conversely, most experts recommend a fairly aggressive approach between ages 20 and 30. The reasoning is that when you are young, you have plenty of time to recover from a savings setback. It's not so easy at 55. Trying to make up a big stock or mutual fund loss in one fell swoop is a sure recipe for headaches or worse. Consider a fairly conservative investment program if you are within 10 years of retirement.

• Your asset allocation. A fundamental financial rule is that the higher the possible return, the greater the risk. Investors demand higher potential returns for taking on more risk (if high-risk investments promised low returns, no one would buy them). Be aware of the pitfalls of every retirement investment. This is money you probably cannot afford to lose, as opposed to non-retirement risk capital for "playing" the market. Never invest in any type of retirement plan you don't understand.
• · Your risk tolerance. It's a good idea for all investors to assess how they feel about risk. Can you complacently ignore market fluctuations on the road to retirement, or does a small stock downturn cause you to lose sleep? If the latter, it might be prudent to steer clear of higher-risk asset types, even if they eventually lead to better returns. The constant anxiety you'll undoubtedly feel can't be worth a few extra points of return. Stick to assets and retirement plans you can live with comfortably.

Some Final Tips

Here are a few other guidelines to help prepare for a secure retirement.

Don't Be Afraid to Seek Financial Advice

It never hurts to hear from experts, so think about finding a financial advisor. They can help you make decisions about when to sell a stock, bond, or mutual fund and give you direction on when it's time to reallocate your investment plan as you get closer to retirement age. Find an advisor by asking friends if they have one to recommend, or contact one of the professional organizations listed in this page's sidebar. Regardless of how you locate a prospective advisor, be sure you check their references carefully and don't be afraid to ask questions. Remember, it's your money, not theirs.

Write Down Your Retirement Goals

On a vacation, you generally need a road map to make sure you arrive safely and on time. The same is true with financial planning. Taking a little time now to outline your ideal retirement can help your dream become a reality. Retirement questions to ask yourself include:

• How and with whom will you spend your time?
• Where and in what kind of house do you want to live?
• Do you want to work part time or even full time?
• Where and how often will you go on vacation?
• Do you plan to make monetary gifts to loved ones?

These are important answers to nail down now. You might even want to experiment with several options (like vacationing to several of the places you've always wanted to live in) well before retirement rolls around.

Organize Your Financial Life

Getting organized is probably one of the more important steps you can take. After retirement, it's likely you'll be asked for a lot of financial and other documentation:

• To apply for Social Security you need a copy of your birth certificate.
• You will need past income tax returns if you are audited.
• You will need proof of any early IRA withdrawals for withdrawals during retirement.
• For you or your beneficiaries to collect on insurance you will need to keep all policies and beneficiary designations up to date.

You may also find yourself asked to produce records regarding bank accounts, 401(k) and IRA rollovers, or self-employment income. If you couldn't find the time before retirement, make getting organized one of your first projects afterwards.

Reduce Your Debt

What sense does it make to pay more in credit card interest than you earn on your retirement investments? It's always smart to temporarily reduce your retirement contributions in order to pay off high rate consumer debt (first mortgages or home equity lines are not included in that category). You can always revitalize your savings program again after the debt load is reduced.

A good way to start is by writing down everything you owe and pay interest on. Next, figure out a way to consolidate all those debts onto a lower rate card or home equity loan. Try to completely pay off the higher interest loans first, even if it means foregoing some luxuries or paying only the monthly minimum on the lower rate cards.

Get rid of those outstanding balances before you retire. There's nothing worse than dragging a debt burden into retirement, when you'll be making less with which to pay it.

Pay Down Your Mortgage

Along the same lines, some experts recommend paying off your home mortgage before retirement. It's easy to do by making a few extra payments here and there, as circumstances allow. In the end, it will save you quite a bit in interest. In addition, heading into retirement without any mortgage will free up monthly income for discretionary spending (the best kind), not to mention lower your stress levels.

WARNING
Before you pay off your mortgage, consider your decision carefully and get the advice of a financial advisor. Some experts recommend that money you might use to pay down the mortgage be put into other investments, instead. An advisor can help you choose the path that that best fits your financial situation and retirement needs.

Shore Up Long-Term Health Care Insurance

Once upon a time, most companies provided full health care coverage for retirees. Due to the escalating cost of health insurance, those days are rapidly disappearing. As you get closer to retirement, meet with your employer to understand exactly what will and won't be covered. It may still be possible to purchase additional insurance before retirement through your employer at an advantageous rate. If you wait until later, you'll be very surprised at the cost of medical coverage for senior citizens, especially for those with pre-existing conditions.

Find Out About Estate Planning

It's not only the Rockefellers who need estate planning. Many "regular" Americans build up sizable nest eggs, particularly the ones who started planning for retirement early. Estate taxation is a complicated area. Although the tax laws have recently become more lenient, they remain subject to revision. An estate planner or trusted family lawyer with a little foresight can save your heirs plenty of financial pain.

A good rule of thumb is to consider expert help when your estate exceeds half a million dollars. You may not really need to do a lot of financial maneuvering at that level, but at least you'll understand your options. The cost of estate planning advice is well worth the satisfaction of knowing your heirs will receive the maximum inheritance possible.

Pay Yourself First

If you are the kind of person who likes to spend what you make (aren't we all), you might want to put a portion of your earnings out of immediate reach. Most employers offer some form of auto-deduction savings plan, which operate on the "if you don't have it, you can't spend it" principle. In addition, banks and brokerages are quite happy to set up plans that automatically transfer investment funds from your checking account.

Alternately, just do it on your own. Most people who have gotten into this good habit say they really don't even miss the amount set aside from each paycheck. Discipline is never any fun, of course, but it will certainly help you meet your retirement savings goals.

Goodbye and Good Luck

We hope you've enjoyed this overview of planning for retirement. Ideally, it has whetted your appetite for further study on this important part of your financial life. If so, we recommend the previously mentioned curriculum at Bloomberg's online University, along with any of the supplementary texts that accompany this course. Do your best to stay informed, and above all, don't procrastinate about setting up your retirement savings plan. It's up to you. Good luck!