Chapter 1 - Why Invest?

Save for a Rainy Day

“It’s not your salary that makes you rich, it’s your spending habits.”  – Charles A. Jaffe, American financial columnist

How much money have you set aside for the future in the past month?  If the answer is “nothing”, then you are like most North Americans, who simply live for today, not worrying about tomorrow.  If your answer is “some”, then you are already off to a good start!  If you have set aside nothing, do not despair since all that is needed is a little soul-searching or introspection on your part.  Most people do not save simply because they have not set personal or financial goals for themselves.  I will help you define such goals in a minute.  But first, let’s take a closer look at just how few North Americans save for the future.

Since 2005 both Canadians and Americans of all ages have been spending more than they earn.  North Americans’ personal savings rates have dipped into negative territory hovering at around -0.5%.  Only in the years 1932 and 1933 were personal savings rates in negative territory.  Back then, people were depleting their savings to cope with massive layoffs and business failures during the Great Depression.  Today, people save less for other reasons.  Low interest rates (which encourage borrowing), low levels of inflation, and easy access to credit are some of the main reasons that entice us to spend more.  This is not solely a regional trend but rather a global phenomenon that is occurring amongst many developed nations.  Still, in other countries – especially Asian countries such as China – personal savings rates rank as high as 25%.  The lack of savings in North America is becoming a huge problem.  It is time for us North Americans to start saving more for a rainy day as our Asian counterparts do. 

A significant factor that is contributing to the lack of personal saving lies in the ability of marketers to get you to buy things now while paying later.  We all want that ultra-large flat-panel plasma television set NOW!  Not only is that an impediment to your savings but you will likely have to pay interest in the future – especially if you bought on credit or used a credit card.  In fact, this is the opposite of investing.  Instead of saving your money and watching it grow through investing, you are both losing money now and taking a hit to your wallet in the future.

“My riches consist not in the extent of my possessions, but in the fewness of my wants.”  – Joseph Brotherton (1783-1857), English parliamentary reformer

That is why it is important for us to make a distinction between a want and a need.  A need is, well, something we need.  For example, we need water, food, and toilet paper!  A want is often more superficial, such as “I need a car; I want a Porsche.”  Too often and for most people a want becomes a need.  A good thing to do is to ask yourself: “Do I really need to buy this?”  Next time you go shopping, ask yourself that very question.  You will be surprised to find how often the answer is no.  Of course we all need to treat ourselves once in a while.  But we should really demonstrate more self-discipline and save that moolah!

Set Goals

“When you cease to dream you cease to live.”  – Malcolm Forbes, Publisher of Forbes magazine

As promised, I will help you define your goals.  It is time for you to do a little soul-searching.  What are your dreams for the future?  Where do you see yourself in five, ten, and twenty years?  What makes you happy?  Close your eyes and take a few moments to fantasize about what you want out of life.  Allow your imagination to take over.  At this point there are no rules, limits, or money constraints.  Let your creative juices flow and block out all barriers that may inhibit the process.  Now, it is time for you to take an inventory of your thoughts.  Putting your dreams and goals down on paper is a great way to establish them.  I recommend using a pencil to write them down because your goals may change and you will be able to easily make changes or additions in the future.  I have provided some space below for you to write them down.  Feel free to use a separate sheet of paper should you need more space.

Having goals and dreams are wonderful.  But do you have a plan that will help you realize them?  You gotta have a plan!  Now you must ask yourself: “What do I need to do, starting today, to help myself achieve these goals?”  A good place to start is to assess your current knowledge, skills, abilities, and interests.  What are your strengths and weaknesses?  What can you do better than most people?  In which areas do you need to improve on?  What activities do you enjoy doing?  Once again you should record the answers to all these questions in the following personal self-assessment:

With a clear and concise inventory of your goals and personal skills you will be in a much better position to map out a plan that will help you achieve your dreams.  Taking into account your current strengths, weaknesses, skills, and abilities, jot down specific things you plan to do that will help you reach your dreams and goals.  Be sure to address how you will address your weaknesses and approach your areas needing improvement.

Often our dreams and goals require a lot of hard work and commitment, not to mention some money.  Maybe you want to go to college or take specialized courses to improve your skills and knowledge base.  You may dream of one day owning your own business and being your own boss.  Perhaps you want to buy that home you have been dreaming about for so long.  Or you may want to retire young and help yourself to a sunshine paradise on a beautiful beachfront property.  Who knows?  They are your dreams.  Regardless of what your dreams and goals may entail, many of them often require a serious financial contribution on your part.  Once more you will have to define your financial goals before you put your money anywhere.  This is a very important step for you to take as it will serve as a compass and guide you in the right direction.  It is essential for you to take into account your current financial position and obligations.  How much income are you taking in from your job?  What are your family obligations?  Are you able to pay all your bills and credit cards when they are due?  Are you putting money aside to increase your personal savings?  Many financial advisors believe that one should have enough money aside to pay for three months’ living expenses.  Think about it.  Should you lose your job next week, will you have enough cash to survive for a few months?  The idea here is not to scare you.  Rather, it is to have you weigh your goals against what can realistically be achieved given your current financial situation.  Once more you should take a moment to write down your financial goals.

The last thing we want to look at with regard to goals is probably related to the reason why you bought this book.  Yep.  You guessed it.  Investing.  This chapter’s title asks: “Why Invest?”  Hopefully, at this point in time, you have a better understanding of why you want to invest.  You may have brainstormed some short, medium, and long-term goals you wish to accomplish.  Properly managing and investing your hard-earned money will certainly put you in a better position to bring your dreams to fruition.  Despite all the progress you have made up to now, it may still be too early to clearly define your investment objectives.  Add to this the fact that you still have many more chapters to read in order to learn about the wonderful world of investing.  Regardless, it is time for you to record your initial investment objectives.  Feel free to come back later and add or modify them accordingly.

Take advantage of the Magical Power of Compounding

“Compounding interest is the greatest mathematical discovery of all time.”  – Albert Einstein

Of all the benefits derived from investment, compounding is definitely the grand daddy of them all.  If you are an investor, compounding is your friend.  If you are a young investor, compounding is your best friend.  What is compounding?  Simply put, compounding is the accumulation of growth of your investments over a long period of time.  The idea is simple.  If you place your money in an investment and obtain a given rate of return, say 10% , and you reinvest all your gains along with your initial investment, your money will grow at an even higher rate.  Let’s demonstrate with an example.  Suppose you invest $1,000 in the stock market and obtain a 10% annual return.  At the end of the first year you will have made $100.  If you reinvest your gain with your original investment you will start year two with $1,100.  At the end of the second year and assuming the same rate of return, you will have made an additional $110.  Notice the extra $10 that you made in the second year as opposed to the first year.  This may not seem like much after just two years of investing.  But fast-forward forty years into the future and your original investment of $1,000 will have blossomed to $45,259.  The longer the period in which you let your investment grow, the higher return you will get.  The magical power of compounding produces a snowball effect.  The longer it rolls, the faster you become rich. 

Now, it is time for you to experiment with compounding by using the following online tool generously provided by the folks at MoneyChimp.com:

Figure 1 – MoneyChimp.com’s Compounding Calculator

Looking at Figure 1 above we can see that an initial investment of $1,000 with an annual rate of return of 10% placed untouched for a period of forty years would give you $45,259.  Now just imagine how much more you could make if you were to add an additional $1000 every year.

Another cool way to measure how fast your money can grow is to use a tool called the Rule of 72.  The Rule of 72 helps you determine how fast your money will double given a certain rate of return.  The tool is extremely simple to use.  All you need to do is divide 72 by your expected rate of return.  For example, suppose you believe you can get a 10% return on your investment.  You divide 72 by 10 which gives you 7.2.  This means that approximately every seven years you double your money.  This is yet another reason to start investing earlier.  Using the example above, should you start to invest at age eighteen instead of twenty-five you would double your money one more time before retirement.  So, if you had one million dollars seven years before retirement you would end up with two million upon retirement.  Not bad at all!

There are a few things one must keep in mind with regard to compounding.  Firstly, you may not be able to get a steady or fixed rate of return year-over-year, especially if you invest in the stock market.  This is because all markets go through ups and downs. These are called cycles.  The good news is, however, that over the long, run stock markets – especially in developed countries – have often shown more positive gains than negative losses.  In fact, between 1926 to 2005 the overall stock market in the United States returned an average annual rate of return of just over 10%.  I will talk more about various markets in the next chapter.  Thus, over the long haul the probability is still favorable for a good return.

The next thing to consider is inflation.  In a nutshell, inflation refers to the yearly increase in the prices you pay for goods and services.  In other words, the value of your money or its purchasing power decreases every year as things get more expensive.  In recent history, inflation has remained steady at a little over 3% a year in Canada and the United States.  Do not worry about this; inflation is just part of life.  Of course, if you invest more of your money rather than spending it you will partly shield the effects of inflation because your funds will grow more due to the effects of compounding. 

The last thing to consider, especially if you live north of the U.S. border, is the reality of the dreaded tax burden.  They say there are two certainties in life: death and taxes.  Believe it or not, our governments even like to tax the deceased!  Every year we all have to give up a significant portion of our income to the taxman.  Income also generally includes the returns we obtain from our investments.  So in a way you are not only taxed on your income and the goods and services that you pay for but also on the fruits of your investment efforts.  Don’t despair.  There is a way in which you can either deter or avoid Uncle Sam or the Canada Revenue Agency, if you live in Canada, from grabbing that cash directly from your pockets.  Retirement Accounts to the rescue!  If you really want to reap the benefits of compounding and watch your investments grow for many years to come in a tax-deferred or even tax-free fashion then keep on reading.

But before you learn how to avoid the taxman, you need to take a long, hard look at government-sponsored retirement pensions since they will be your primary source of income in the future.  It is very important for you to begin thinking about and planning for your retirement now.

Make the most of Government-sponsored Retirement Pensions

Both Canadians and Americans have access to a government-sponsored retirement pension. I say sponsored, but in reality you and your employer are the real ones who sponsor or contribute to the plans.  The government simply manages and distributes benefits to eligible participants.  Unfortunately, a large number of North Americans depend on such pensions as their principal source of retirement income. 

1. Canada Pension Plan

In Canada, the pension is referred to as the Canada Pension Plan (CPP).  The plan in the province of Quebec is known as the Quebec Pension Plan (QPP).  The normal age at which you can start receiving a CPP retirement pension is sixty-five.  However, there are provisions by which you can qualify for early retirement benefits if you are between the ages of sixty and sixty-four, albeit at a reduced rate.  During your working life you and your employer will have to contribute to the CPP through payroll taxes at a rate close to 4%.  The contribution rate is double for self-employed individuals.  The average monthly benefit for retirees in 2006 was about $473.  The CPP is calculated as 25% of a worker’s average lifetime earnings.  However, one must be very careful using this method of calculation.  Since there is a maximum monthly benefit, you may not be receiving the full 25%.  For example, in 2007 the maximum monthly benefit was set at $863.  If we multiply $863 by twelve months we get an annual pension of $10,356.  Therefore, that means that an individual with an average annual salary of more than $41,424 (i.e., $10,356 x 4) would not be receiving the full 25%.  Get the idea?  The CPP pension may not seem like much.  But wait: there is more bad news.  Pension income is subject to income taxes.  Therefore, you will see your retirement income shrink some more before you get cash to pay your bills and feed your cat.  The only good news is that each year the benefits are adjusted for increases in the cost of living.  The CPP also includes provisions for disability and survivor benefits. 

2. Old Age Security

The Old Age Security (OAS) pension is another taxable monthly benefit Canadians are entitled to receive when they reach the age of sixty-five.  The amount of a person’s pension is determined by how long s(he) has lived in Canada, among other factors.  The full pension is granted to individuals who live in Canada for at least forty years after turning eighteen.  In April 2006 the average monthly pension was approximately $461 and the maximum monthly benefit stood at about $485.  The OAS pension is adjusted four times a year to account for increases in the cost of living as measured by the Consumer Price Index. 

3. Social Security

Elderly Americans rely on Social Security as their largest source of income.  If you were born in 1960 or later, your retirement age will be sixty-seven.  In other words, only at age sixty-seven will you be entitled to the full benefits of the plan.  In 2006, the maximum benefit was fixed at $2,053 a month.  You can retire and claim benefits as early as age sixty-two.  But you will only be able to get 70% of the monthly benefit.  This figure will increase roughly 0.4% each month until you reach the age of sixty-seven.  The average monthly Social Security check in 2006 was $1,002.  The Social Security Administration sends you a statement about your situation each year about three months before your birthday.  The statement lists, among other things, all your earnings contributed throughout the years.  You can calculate your estimated benefit online, using several calculators.  One that is quite simple to use to estimate your future benefits is provided by the CATO Institute as seen below in Figure 2.

Figure 2 – Cato Institute’s Social Security Benefit Calculator

Social Security is funded through payroll taxes.  Each year both you and your employer pay 6.2% of your total salary in Social Security taxes.  If you are self-employed, you pay the full 12.4%.  In addition, you will also be contributing to help fund the Medicare program at a rate of 1.45%.  Contrary to what many people think, Social Security funds are not put into a trust; rather, they are used to pay existing retirees.  Social Security benefits are based on your lifetime earnings.  They are calculated by averaging the earnings from your thirty-five highest income-generating years.   About one-third of people who receive Social Security have to pay income taxes on their benefits.  If your total income is more than $25,000, you will have to pay taxes on your benefits.  As an example, if you are an individual and your total income is between $25,000 and $34,000, you may have to pay taxes on 50% of your benefits.  If your total income is more than $34,000, up to 85% of your benefits are subject to the tax-grabbing efforts of Uncle Sam.  Once more, just like your Canadian counterparts, you are subject to a “double-taxation” crunch on your retirement income.

What’s more, the Social Security system is facing some serious financial problems.  Today, about thirty-three million American retirees rely on Social Security benefits.  This number is expected to more than double to over seventy million people by 2031 as a very large number of baby boomers head into retirement.  According to the Social Security Administration itself, by 2018 it will begin paying more benefits than it will collect in payroll taxes.  Without changes to the current system, by 2041 the Social Security trust will be exhausted.  One word:  S-C-A-R-Y.  At that point, there will be enough money to pay only about 74 cents for each dollar of scheduled benefits.  The expected shortfall is estimated at about $3.7 trillion.  What’s worse is Medicare’s huge deficit which is twice as large as Social Security’s.  The only way the government will be able to remedy the situation is by increasing taxes, reducing benefits, increasing the retirement age, or any combination thereof.

The moral of the story here is you would be foolish to depend solely on your government for your retirement.  If you do not want to be eating cat food in your old age it would be better to start thinking now about how you can generate other sources of future retirement income. 

Avoiding the Taxman…Building your Retirement Nest Egg

Before looking at how you can deter the taxman from grabbing your hard-earned cash, take a look at Table 1 below where I have included a schedule of federal income tax rates; please note that this table does not include the provincial or territorial income tax rates which you must also consider when remitting taxes to the government.  Feel free to use Fidelity.ca’s Tax Calculator as seen in Figure 3 below to determine your total tax burden.  As you can see, we pay a lot of income taxes in Canada.  This is not to mention all the other taxes such as federal and provincial sales taxes, real estate property taxes, school taxes, gasoline taxes, sin taxes (booze & smokes), etc.  It is important for us to take a moment and realize just how much we are giving back.  Each and every tax dollar you must remit to the government is one that is gone forever and one which you will not be able to invest for your future.  Keep on reading to find out how you can keep as much of your earnings as possible for your own future instead of feeding it into the government’s coffers.

Table 1 – Canada - Federal Income Tax Rates for 2007

Figure 3 – Fidelity.ca’s Tax Calculator

1. Registered Retirement Savings Plans (RRSPs)

A Registered Retirement Savings Plan, more commonly known as an RRSP, is a government-approved program that is designed to encourage Canadians to save for their golden years.  RRSPs provide two powerful ways in which you and your investments can be shielded from the taxman.  The first tax break lies in the fact that whatever money you put into your RRSP becomes deductible from your taxable income.  In other words, your taxable income is reduced by the amount you contribute into your RRSP, placing you in a lower tax bracket and meaning you will pay less income tax in a given year.  This is great news for Canadians because, as we know, we are some of the most highly taxed individuals in the world.  Let’s take a simple example.  Suppose you live in Ontario and your gross earnings in a given year equal $50,000.  With no contribution to an RRSP you would have to pay a total tax bill of $10,188 (federal and provincial taxes).  But if you invested $9,000 of your income into an RRSP the same year you would only pay $7,384 in income taxes (instead of $10,188) giving you an additional $2,804 or a 27.5% reduction in net savings for the year.  Do you see the initial magic of investing in an RRSP?  Now it is time for you to experiment with your own potential tax savings using the RRSP calculator provided by Walter Harder & Associates and accessible via Morningstar.com’s website (see Figure 4 below):

Figure 4 – Morningstar’s RRSP Calculator

Of course, you must keep in mind that when you retire and take money out of your registered retirement account it will become taxable.  But at that point you will likely be in a lower tax bracket.

There is more good news.  The second tax advantage of an RRSP resides in the sheltering of the income generated from your investment within your RRSP.  Outside an RRSP, investment profits such as capital gains or dividend income become part of your taxable income.  Half of the capital gains (profits) generated from the sale of stocks or mutual funds, for example, would be charged a capital gains tax.  But in an RRSP your investment profits are allowed to grow tax free.  Thus, you will be enjoying the true benefits of compounding as discussed earlier.

Let’s explore the difference with an example.  In Scenario 1, assume you would be investing outside an RRSP and, in Scenario 2, inside the RRSP.  For both scenarios, assume that you start with $10,000, that you are able to obtain an annual rate of return of 10%, that your Marginal Tax Rate is 31.15% (i.e., over $36,378 up to $61,206), and that you plan to retire in thirty years.  In Scenario 1 your retirement savings would be worth only about $73,706.  But in Scenario 2, should you invest inside the RRSP, all other things being equal, your retirement savings would be $174,494.  In addition, should you decide to invest all tax refunds back into your RRSP you would have an extra $155,143, giving you a total of $329,637.  Thus, over the long-term, investing within an RRSP makes a huge difference.  Feel free to experiment using the RRSP Sheltered Investment Calculator provided by our friends at InvestorEd.ca (see Figure 5 below):

Figure 5 – InvestorEd.ca’s Sheltered Investment Calculator

The example above doesn’t even include any additional yearly savings you could possibly contribute to your RRSP.  With additional yearly contributions, your total savings would grow even more.  For example, using the same parameters as above and adding additional yearly contributions of $5,000 would render you a hefty $996,964 for your retirement nest egg.  To really see the effects of additional contributions, please consult the RRSP Savings Calculator as seen in the link box below.

Too much of a good thing can be harmful, they say.  So the government sets limits as to how much one can contribute to an RRSP on a yearly basis.  Briefly put, you are allowed to contribute to your RRSP the lowest amount of: 1) 18% of your earned income from the previous year; 2) the maximum contribution limit for the year (see Table 2 below); or 3) the remaining limit after you and your employers’ contribution to your company pension plan made in the previous year.  Maximum annual RRSP contribution limits for the years leading up to 2010 are listed in the following table.

Table 2 – Maximum Projected Annual RRSP Contribution Limits

If you are one of the vast majority of Canadians who cannot contribute the maximum allowable amount, do not feel so bad.  Any contribution is helpful over the long haul.  Whatever amount you can contribute is beneficial.  Plus, it helps you nurture a good habit.  I do recommend, however, that you try to maximize your yearly contribution in order to decrease the amount of taxes you pay and to jazz up your retirement nest egg.  Even borrowing money to do so can be a good idea.

As you can see, borrowing $1,000 and investing in your RRSP will give you over $28,000 in thirty-five years.  Now you can make money from borrowing cash from the bank – not just the bank!  To make sure the calculation is correct you can plug the numbers in InvestorEd.ca’s Sheltered Investment Calculator (as seen above) and it all computes!  I have included a screenshot of the Loan Calculator from this website below in the following figure:

Figure 6 – RRSP.org’s Loan and Interest Calculator

Keep in mind that it is best to pay back the loan as quickly as possible to avoid recurring interest charges on it.

RRSPs seem great but what types of investments are eligible?  Glad you asked.  Here is a list of eligible investments you can buy and own in your RRSP:

• Guaranteed Investment Certificates (GICs)
• Mutual Funds
• Stocks
• Bonds
• Gold and Silver coins, bars, or certificates

Please refer to Chapter 3 – Investment Types for more information on the characteristics of each of these investment vehicles.

As of 2005 there are no contribution limits on foreign investments within RRSPs.  In the past one could not own more than 30% of foreign securities within their RRSP.  But this limit no longer exists.  Thus you are permitted to invest as much as you want abroad.  However, investing all of your savings abroad can be risky.  In Chapter 4 – General Investing Guidelines and Tips I will discuss general tips and guidelines you should follow to diversify your portfolio (i.e., your investments).  It is very important to diversify your investments.

An interesting point I want to make about RRSPs is that you can borrow funds (that you will remit in the future), without penalty, from your RRSP to make a down payment on the purchase of a house (first home).  This is referred to as the RRSP Home Buyer’s Plan (HBP).  Consult your local bank to obtain more information about the rules and conditions of the Home Buyer’s Plan.

Similar in concept to the Home Buyer’s Plan, the Lifelong Learning Plan (LLP) permits you to make withdrawals (up to $10,000 a year, tax free, to a maximum of $20,000) from your RRSP to pay for training or education for you or your spouse or common-law partner.  Certain conditions apply: you must be a full-time student registered in a qualifying educational program at a designated educational institution.  Participants in the plan must start to make repayments two years after their last eligible withdrawal, or five years after the first withdrawal, depending on which due date comes first.  There is no limit on the number of times you can participate in the plan over your lifetime.  Finally, you can even participate in the Lifelong Learning Plan even if you have withdrawn funds under the Home Buyer’s Plan.

Okay, RRSPs sound great.  Now how do I get started?  It is as simple as opening a Self-Directed RRSP account at a brokerage firm.  Most Canadian banks and other financial institutions offer such accounts.  Please consult Chapter 7 – Do it Yourself! Online Investing for more information about online brokers as well as links to their websites.

“I’m proud to be paying taxes in the United States. The only thing is – I could be just as proud for half the money.” – Arthur Godfrey, American radio and television broadcaster and entertainer

As with your neighbors to the north you will have to assume a significant tax burden.  This is not to mention all the other taxes you must pay such as sales taxes, gasoline taxes, sin taxes (booze & smokes), property and school taxes, etc.  As much as possible you want to avoid having to “donate” your hard-earned cash to Uncle Sam.  Each and every tax dollar you must remit to the U.S. tax authority is one that is gone forever and one you will not be able to invest for your future.  Keep on reading to find out how you can retain as much of your earnings as possible for your own future instead of feeding it into the government’s coffers.

Table 3 – United States - Federal Income Tax Rates for 2007 (Single)

Even though few American workers have access to them many employers offer traditional pension plans.  In such plans employees contribute a portion of their pay into a retirement fund.  Sometimes an employer will match employee contributions dollar for dollar.  But this is becoming rarer as firms are cutting costs in order to be more competitive in today’s global business environment.   If you are lucky enough to work for an employer who fully or partly matches your contributions then by all means do try to maximize your contributions as you will be getting access to “free” money.  This additional money will have a very significant impact on your returns over the long term.  If you are among the majority of workers who do not have access to a traditional company-sponsored pension plan, then your most likely option is to adhere to a 401(k) plan or open an IRA (Individual Retirement Account).  I will explain each in great detail.

2. 401(k)

What is a 401(k)?  It sounds like a new brand of breakfast cereal, right?  Not quite.  A 401(k) is an employer-sponsored plan in which an employee elects to save a portion of his or her pay in an account for retirement.  The main advantage of a 401(k) is that the money (or earnings) you contribute comes out of your pay check before income taxes are calculated.  In other words, it decreases your level of taxable income so you will pay less income tax.  Paying taxes on the contributed earnings is deferred until you withdraw funds upon your retirement.  This may be more advantageous for you as you will likely be in a lower tax bracket by then.  And perhaps you will be living your golden years in a state that has no state income tax!  Thus, you will be able to reap the benefits of watching your money grow in a tax-free, compounding environment.  The second main advantage of a 401(k) is more psychological in nature.  Since money is automatically deducted from your pay, you never really get a chance to touch it and blow it on something else.

How the heck did they come up with a name like 401(k)?  Simple.  The plan got its name from its section number (401) under paragraph (k) of the United States Internal Revenue Code.

How does a 401(k) work?  Easy.  You simply decide how much you want to put into your account each pay period or each month.  However, the IRS (Internal Revenue Service) limits total annual contributions.  The contribution limit for a 401(k) plan is limited to $15,500 for 2007.  Be sure to check out the limit for subsequent years via the following link box.

Just like traditional pension plans, some employers will match a portion, sometimes dollar for dollar, of your contribution in your 401(k).  Once more, if your employer does so then maximize your contribution to take advantage of this “free” money.  On occasion, some employers may decide to make contributions to your 401(k) by means of profit-sharing.  Profit-sharing is an incentive by which an employer distributes company profits among its employees.  Companies offer such incentives as a means of retaining employees’ loyalty and commitment. 

How are funds in a 401(k) invested?  There are two main ways in which funds are invested.  The first one is by way of a trust in which the employer appoints trustees who decide how the funds will be invested.  In other words, funds are managed by a third-party administrator who invests them bonds, mutual funds, money market funds, etc.  With this option you have little say on how the funds are to be invested.  The second and most common option is to let employees select amongst different investment vehicles such as bonds, mutual funds, money market funds, etc.

The following investment types are eligible for inclusion in your 401(k):

• CDs
• Bonds
• Stocks
• Mutual Funds
• Money Market Funds

As for other types of investments such as Exchange-Traded Funds (ETFs), gold, etc., it will depend on what the custodian trustee (bank or investment provider) offers and allows in the retirement account.  More choices for investment types (see Chapter 3 – Investment Types) may be available for self-directed accounts.

Some companies also offer their employees a chance to purchase company stock in their 401(k)s.  Should you choose to do so, please keep in mind that you should limit the amount or proportion of stock you purchase in order to have a diversified investment portfolio.  Just ask former Enron employees about this.  Many of them had put their entire earnings into the energy giant’s stock, only to see their entire life savings evaporate following the accounting scandal that led the company to its ultimate demise.  Lessons are learned the hard way, they say.  So don’t be foolish, and spread your savings across different types of investments.

Since employees can decide where they want to invest funds for their 401(k)s they have to be cautious, as there are different risks associated with different types of investments.  Often, employers will provide guidance to employees in order to help them choose investments that are in line with their own personal financial objectives.  In Chapter 3 – Investment Types I explore the advantages, disadvantages, and associated risks in each type of investment.

Figure 7 – Bloomberg.com’s 401(k) Calculator

3. Individual Retirement Account (IRA)

An Individual Retirement Account is exactly what it says it is.  It is an account in which you save for retirement.  Funds that you contribute to an IRA may be tax deductible.  However, there are limits imposed by the IRS regarding the “tax-deductibility” of your contributions.  Such limits are summarized in the following table:

Table 4 – Projected Contribution limits for an IRA

For instance, if you contribute $4,000 to an IRA and you are situated in the 25% marginal tax bracket, then you will benefit from $1,000 in tax savings.

In general, if you have not contributed to a qualified retirement plan such as a 401(k) in the last year, you may be fully eligible for a full tax deduction depending on your level of income.  Conversely, if you did participate in such a plan, you may still be eligible for either a full or partial tax deduction.  In the latter case, it depends on the level of earnings you received.  To be more precise, you need to look at your Adjusted Gross Earnings or AGI.  It is quite simple to verify your AGI; simply refer to the last line on the first page of your 1040 (U.S. Individual Income Tax Return) from the last taxation year.  If your AGI is less than $50,000, you will be able to fully deduct your contribution.  If your AGI was between $50,000 and $60,000, you will be able to partly deduct your contribution (assuming your filing status is either single, head of household, or married and filing separately).  Lastly, if your AGI was $60,000 or more, you are out of luck as you will not be able to deduct your contribution at all.

Figure 8 – Dinkytown.net’s Traditional IRA Calculator

Any tax-deductible contribution you can make to a retirement account is beneficial, especially over the long term.  Most of us simply do not have the means to contribute several thousand dollars per year to our retirement accounts.  The idea is simply to maximize contributions every year without fail.

Another advantage of opening an IRA lies in the fact that you can decide which investments you want to place in the plan.  There are, however, some restrictions as to which types of investments are eligible for an IRA.  Such restrictions are usually listed when you open up the account. But it is still up to you to determine the makeup of your investment portfolio.

An IRA sounds great.  How do I sign up?  The process is very simple.  All you need to do is find a discount broker, then open and fund an IRA account.  Then you are ready to start buying securities.  In Chapter 7 – Do it Yourself! Online Investing I will discuss how to select an online discount broker.  So please refer to this chapter carefully as you really want to shop around for the best broker who will not shaft you with unnecessary fees.

4. Roth IRA & Roth 401(k)

The difference between a Traditional IRA/401(k) and a Roth IRA/401(k) is quite simple.  With a Roth, you do not get an immediate tax deduction on your contributions as they are considered an integral part of your regular earnings.  On the other hand, the good news is that upon retirement you will not be required to pay any income tax when you make withdrawals from your Roth account.  The other main advantage of a Roth IRA/401(k) is that it allows you to make tax-free withdrawals at any time without penalty.

Should I choose the Traditional or the Roth IRA/401(k)?  To Roth or not to Roth?  That is the question.  The answer really depends on your own personal financial situation.  I would advise you to seek the opinion of a professional financial planner to see what is best for you.  In brief, if you can do without a tax break now, then go the Roth route.  If you need the tax reduction now (to lower your level of taxable income), then choose a Traditional IRA/401(k).  My advice is that in most cases it is better to choose a traditional IRA/401(k) for two reasons.  Firstly, if you take the tax deductions on your contributions now it will provide you with more money to invest in the realm of a tax free, compounding environment.  Thus, your nest egg will grow at a much higher rate especially over the long term.  Secondly, you are most likely to be in a higher tax bracket now than you will be upon your retirement.  And perhaps you will retire in a state that has no income tax.  So, it is more advantageous for you to take the tax break now as you will assume an overall smaller tax burden, all the while investing the difference for additional future earnings.  Contribution limits for a Roth IRA/401(k) are identical to the traditional plans.

I have included several links to calculators in the link box below so that you can make an informed decision about which IRA – Traditional or Roth – is better for you.

Well, there you have it.  Although other types of retirement accounts exist and are available, most people will contribute to a 401(k) or IRA.  Please feel free to consult other online resources to find out more about other retirement plans.

© Dan Fournier, 2007, 2008