by Suze Orman
September 11, 2006
Last month, Congress passed and President Bush signed new legislation that affects your 401(k) and IRA savings.
The Pension Protection Act of 2006 also includes some changes on how traditional pensions -- known as defined benefit plans -- are run, but given that fewer and fewer firms offer those types of accounts, I'll focus on what most of you are relying on for retirement: your 401(k)s and IRAs.
There's a lot to commend in the new legislation, but that doesn't mean you should just sit back and settle for the new federal guidelines. Many of the changes simply create minimum "floors" for your retirement savings. To save enough to retire on comfortably, you need to aim for the ceiling, not the floors.
Automatic Isn't Automatically Perfect
Let me explain. A major provision of the legislation encourages employers to automatically enroll their employees in the company 401(k) plan rather than requiring employees to "opt in."
Furthermore, the law suggests setting the base contribution level at no less than 3 percent of an employee's salary, and to increase that contribution rate by 1 percentage point a year until it reaches 6 percent and no more than 10 percent.
I'm all for auto enrollment (amazingly, up to 30 percent of employees eligible for a plan don't participate), but I don't want employees to assume that a 3 percent contribution rate -- or 6 percent for that matter -- is enough.
The first rule of 401(k) investing is to always invest enough so that you'll get the maximum company matching contribution. If that requires you to invest more than 3 percent of your salary, do it. It's simply the best move you can make: Every penny your employer pours into your 401(k) account is akin to a bonus. You don't want to turn down bonus money, do you?
Contribute to the Max
It's no secret that my favorite type of retirement account is a Roth IRA. And I've said repeatedly that if you're eligible for a Roth but don't have enough money to invest in both a Roth and a 401(k), the best strategy is to sock away whatever amount you need to qualify for the maximum 401(k) employer match -- but not a dollar more -- and then concentrate on building up your Roth.
The maximum annual IRA contribution is $4,000 this year, or $5,000 for individuals at least 50 years old. (Quick review: individuals with incomes below $110,000 and married couples filing a joint tax return with income under $160,000 are eligible to fund a Roth.)
The maximum annual employee 401(k) contribution this year and in 2007 is $15,000 ($20,000 if you're at least 50 years old). The good news is that the new legislation makes those high contribution levels permanent; up until now they were scheduled to phase out after 2010 and revert to the lower limits put into place back in 2001.
So let me be clear: If you have the ability to max out your contributions to both your Roth IRA and 401(k), go for it. Don't assume that the 3 percent or so contribution rate your employer automatically signed you up for is all you need. You can and should invest more if you're able.
A New Kind of 401(k)
The new law also gives "permanent" status to the Roth 401(k), which could be a huge win for you. Employers have been somewhat slow to offer these new types of 401(k)s, in large part because they were only temporary; without an act of Congress, Roth 401(k)s were scheduled to disappear in 2010.
The fact that Congress acted and made these 401(k)s permanent should encourage more employers to offer them to employees. If yours doesn't, start making a fuss.
The Roth 401(k) is a fantastic saving opportunity if you're young, and if you happen to think that your tax rate in retirement will be higher than it is today. That's likely for many of us given that rates today are near historical lows, even though our federal budget is under tremendous strain.
With the Roth 401(k) you don't get any tax break on your initial contributions, but just like a Roth IRA you'll never pay a penny of tax on the money you withdraw in retirement, assuming you meet some basic requirements. That can be a huge advantage over a traditional 401(k), where all your withdrawals are taxed at your income tax rate and you don't even get to take advantage of the typically lower capital gains rate.
Taking Stock
A recent survey of 401(k) plans by Vanguard found that among plans that offered company stock, about 70 percent of participants had more than 20 percent of their assets invested in their employer's stock.
That's way too much. No single stock should be more than 5 percent to 10 percent of your invested assets. This doesn't just protect you from Enron-like debacles, it's also basic diversification common sense: Your retirement shouldn't ride on a single investment.
The new legislation addresses the fact that many employers use company stock to make matching contributions to their employees. In a sense, these employers force their employees to own the stock. The new law provides some relief here, pushing employers to make it easier for employees to unload company stock they get as a match or profit sharing.
The change is good, but doesn't really help address the real problem -- the fact that participants aren't quick to take action. Study after study shows that inertia, not action, tends to run our 401(k) behavior. We tend to stick with what we have, rather than make changes that will help us.
So the pressure is still on you to protect yourself. If you have more than 10 percent of your money in one stock -- regardless of how much you love your company and are optimistic about its future -- you're putting your retirement in danger. You owe it to yourself to diversify.
A Boon for Beneficiaries
Congress just gave your heirs a very nice tax break. Under the old rules, any 401(k) beneficiary other than a spouse had limited options in how to take the payout; the reality was that most took it as a lump sum that triggered a big tax hit. (Remember, 100 percent of 401(k) withdrawals are taxed as ordinary income.)
With the new law, beginning in 2007 beneficiaries can instead move the 401(k) into a special IRA specifically designated for beneficiaries, and make annual withdrawals over many years based on their own life expectancy.
That means heirs will be able to leave more of the money invested in the tax-deferred account for longer. And that's a great way for your heirs to build their own sizeable retirement nest egg.
No Charity Tax
Finally, the new law also has a great break for IRA investors older then 70-1/2 who face making required minimum distributions (RMD) even though they don't need the income.
In 2006 and 2007, you'll now be allowed to donate up to $100,000 each year from your IRA to a public charity and not owe any tax on that money. That is, you won't first have to claim the money as a taxable RMD before you make the donation.
This can be a useful way to support a charity and meet your RMD requirements without boosting your adjusted gross income. The donation can't also be claimed as a deduction, so it makes the most sense for those of you who don't itemize.
