Suze Orman Money Matters

The debate over Social Security seems to get louder by the day. But in the midst of all the pronouncements, I want to remind you that Social Security is still intended only to provide a safety net to keep people from sliding into poverty in their later years. It is not, and was never meant to be, the central part of a retirement package.

So while the politicians are busy tossing around this hot potato, I want the rest of you to stay focused on making sure Social Security ends up being merely the side dish to your real retirement. To ensure that you will have enough money to live comfortably in retirement requires that you create your own main course: a combination of 401(k), IRA, and regular savings that will produce the bulk of your retirement funds.

So let's talk about things you can start doing now in order to thrive, not just survive, when you retire.

Save More in 2005

Washington got smart a few years ago and realized that we all need to save more on our own for our retirement. So they increased a bunch of limits on tax-deferred savings accounts such as 401(k)s and IRAs. But I know for a fact that most of you are clueless about the changes, and that means you could be missing out on the savings. Here's a brief run-down on those limit increases:

• You can invest up to $14,000 in your 401(k) this year, compared to $13,000 for last year. If you are over 50 years old, you can pile in an additional $4,000 this year, for a total 401(k) investment of $18,000.
• The IRA annual contribution limit is now $4,000, up from $3,000 last year. Again, there's a nice incentive for those of you over 50 years old; you can invest an additional $500 this year, for a total of $4,500.
• The income cutoffs to claim a full deduction for a traditional IRA have increased. If you are single and have a retirement plan at work, you can get a full deduction on your traditional IRA if your income is below $50,000 in 2005, which is up from $45,000 for last year. Married couples that file a joint tax return, and are both covered by retirement plans at work, can each claim the full deduction if their combined income is below $70,000; that's also a $5,000 increase over last year. And if you are married and just one of you is covered by a retirement plan at work, you can get the full deduction if your combined income is below $150,000.
• The cutoffs to be eligible to invest in a Roth IRA remain the same: you can invest the full $4,000 if you are single and your income is below $95,000, or if you are a married couple filing a joint return and your combined income is below $150,000.

Stop Thumbing Your Nose at Free Money
A recent study by Hewitt Associates, a big global-benefits consulting firm, along with researchers from Harvard and the Wharton School at the University of Pennsylvania, found that 77 percent of employees at a Fortune 500 firm weren't maxing out on their company's 401(k) matching contribution.

Wake up, folks! Not contributing enough to your 401(k) to get the maximum contribution from your employer is literally throwing free money away. Would you turn down a bonus from your boss? I sure doubt it. So why aren't you putting yourself in a position to get the max match? That's just dumb. Sit down first thing tomorrow with your employee benefits rep in the H.R. department to figure out what you need to contribute this year to snag the entire matching contribution offered by your boss.

And those of you who can't even get motivated to join 401(k) plans that offer a match are bordering on the insane. You aren't getting a single penny from your boss's largess. What's up with that? And don't you dare tell me it's too confusing, or that you can't afford it.

In fact, I find that once people sign up and have the money automatically deducted from their paycheck, they just as automatically learn to adjust their spending to offset the reduction in their income stream. Besides, come tax time you get a nice payback: your taxable income is lowered by the amount you contributed to the 401(k). So let's say you manage to set aside $10,000 this year and you are in the 28 percent federal tax bracket. That will essentially reduce your tax bill to Uncle Sam by $2,800.

The Roth IRA: As Close to Perfect as You Can Get

I cannot repeat this enough: If you are eligible to invest in a Roth IRA, I think it is hands down the best retirement investment you can make. (Quick recap: you may make the full $4,000 contribution to a Roth this year if you are single and your income is below $95,000, or if you are married filing a joint tax return and your household income is below $150,000.)The advantages of a Roth, especially when it comes to taxes, may not be immediately apparent. When you invest in a Roth, you see, you get absolutely no tax break. There is no deduction for your contribution; in fact, you invest in a Roth with money that has already been taxed. But before you decide I am nuts to push Roths, stick with me for a few more minutes.

The way our tax system works is that at some point all retirement money gets taxed. There is no free lunch. Your IRAs and 401(k)s are tax-deferred, not tax-free. "'Deferred" is code for: "Uncle Sam will take his bite later." So when you invest in a 401(k) with pre-tax money, you need to be aware there's going to be a bill from the government somewhere down the line. Specifically, you will be required to pay tax on all your withdrawals when you retire.

But since you invest in a Roth with money that has already been taxed, you are free and clear of Uncle Sam. You already gave the federal government its bite. So when you reach retirement and start making withdrawals, there will be no tax. Zero. The only trick is that you need to be at least 59 1/2 when you start the withdrawals, and your Roth account must be at least five years old.

And wait, it gets even better. The money you contribute to a Roth has no strings attached. You can pull it out next week, or next year, and there will be no tax and no early withdrawal penalty, regardless of your age. Why? Because it's your money that you have already paid the tax on. That's a nice bit of flexibility, eh? My strong suggestion is that you never touch your Roth assets before you retire, but I know life is full of unexpected turns. If you ever find yourself in a financial pickle, your contributions to your Roth can be tapped as an emergency cash fund.

The only money you can't touch is the earnings in your Roth account. Yank that money and you will get hit with a 10 percent penalty.

When Regular Can Beat Special
We get so twisted in knots about tax breaks I think we overlook a really simple way to invest for our retirement: straightforward "regular" taxable investment accounts. If you own assets in a regular account for at least one year, when you go to sell, you will owe tax on any gain. But it will qualify for the long-term capital gains rate, which right now happens to be a super-low 15 percent. Remember, withdrawals from your 401(k) and traditional IRA will be taxed at your income tax rate, which can be as high as 35 percent. That's a big, big difference.

Now the one trick to using a regular account is to not generate a tax bill during the period you are invested. Remember, with a regular account any time you move your money around it is considered a "sale" by the IRS and you will owe tax. Bottom line: you want to be a real buy-and-hold investor. Stick the money in an index fund or an ETF (Exchange-Traded Fund) and don't touch it. Those of you who invest in mutual funds know that even if you don't touch your account, you can still get a tax bill from the fund each year, because it is required to pass along its gain to shareholders. That's why I recommend an index fund such as the Vanguard Total Stock Market fund. Index funds tend to generate no, or very small, tax bills. Even better, use an ETF, which operates like a stock; you are guaranteed not to have a tax bill until you sell your shares. The Vanguard VIPER (symbol: VTI) is the ETF version of the Total Market Fund.

Home in on Lowering Your Income Needs in Retirement

Let's do a 180. Instead of thinking about all the money you need to save to be able to afford to retire, what if you instead focus on reducing what you will need income-wise in retirement?

Just think about it for a minute: reducing how much cash you need to pay the bills in retirement is just like putting the amount of the savings away in your retirement account.

And for almost everyone the single biggest ongoing cost you can have is your mortgage. That's why I think one of the smartest retirement planning moves is to get your mortgage paid off before you retire. Of course, this only makes sense if you are within 15 or so years of retirement and you intend to stay in the home you are in now after you stop working.

If that's your situation, I would make paying off the mortgage one of your main retirement savings goals. I ran through this theory in a previous column, but let's do the numbers one more time:

Let's say that right now you are 50 years old and plan to retire in 15 years. You recently bought a new home, or refinanced, and you have a $300,000 30-year fixed-rate mortgage at 6 percent. So your monthly mortgage bill is $1,799. That means you're looking at paying $1,799 a month until you are 80.

By my calculations, you'll need to have at least $600,000 in your retirement kitty to be able to generate enough income just to make the mortgage payment. To keep this example simple, I am assuming you don't have a company pension, and let's also agree to leave Social Security out of the equation for now, since it is unclear what benefits any of us will receive down the line. So basically we're looking at needing $600,000 in your 401(k) and IRAs to generate the income needed simply to pay the mortgage.

Here's how I got that $600,000 figure: In retirement you need to invest more conservatively than when you are young, so let's say your money will grow at an average rate of 5 percent. A $600,000 pot earning 5 percent will generate $2,500 a month in income. Before you remind me that you only need $1,799 for the mortgage, let me remind you that Uncle Sam takes a huge cut out of all the money you withdraw from a 401(k) or a traditional IRA. The withdrawals are taxed as ordinary income; you don't even get to pay any of it at the lower capital gains rates. So let's pick a reasonable tax rate, say 28 percent. That reduces your $2,500 in income to -- drum roll, please -- $1,800 after tax.

Yep, you need a huge $600,000 pot just to be able to make the basic mortgage payment. So that's why your best retirement move today can be to pay off that mortgage. And please don't yelp about losing the tax deduction on the mortgage interest payments. Remember, we're worrying about your retirement. In 15 or 20 years the majority of your mortgage payment is going to be principal, not interest. So just when your income goes down (in retirement) you are not going to be getting much pop from the deduction. Besides, you do realize that in return for the supposedly great deduction the reality is that you are forking over tens of thousands of dollars in interest payments? I'd rather reduce my total interest payments by paying off the loan fast.