The MyRA : A Retirement Account for Millenials

confused1
“What is this “retirement” you speak of?” Image courtesy of FutureTraining.org

If you’ve read my posts on traditional IRAs or Roth IRAs you may have walked away a bit confused. That’s ok. Retirement accounts are a confusing topic for the majority of Americans.  The U.S. Treasury picked up on this intimidating complexity and has very recently released a simple alternative for those wishing to save for retirement. This new type of account is called a MyRA. Let’s explore this new invention a bit further.

Key Points

  • A MyRA is a starter retirement savings account that enables those with low income or those new to investing to begin saving for retirement.
  • The benefits of of the MyRA include near guaranteed appreciation, account is linked to you, no related fees, and simplicity
  • The limitations of the MyRA include max contribution limits, limited returns
  • The MyRa is best for those earning low income, or someone just starting to save for retirement.

What is a MyRA Account?

Eggs
Behold the eggs of your financial future. Image courtesy of USNews.com.

A MyRA account is a specialized Roth IRA account that invests and holds only United States Treasury retirement savings bonds.  These savings bonds are backed by the full faith and credit of the U.S. Treasury meaning unless the U.S. government defaults on its debt, you have a riskless investment.  In addition the MyRA is relatively simple to set up and has no fees or costs associated with its operations.  The MyRA account is best suited for those who do not currently have access to an employee sponsored retirement plan (such as a 401k or IRA) or those who currently have low income employment.

Benefits of a MyRA Account

1. Guaranteed Risk Free Appreciation: Arguably the best part of the myRA is that you have risk-free appreciation. This means that there is no risk you will lose value in your investment.* When you invest these funds into the MyRA account, the U.S. Treasury then invests these funds in United States Treasury bonds.  The average annual return over the past ten years has been 3.19%.  A good assumption when calculating future returns would be to err on the side of pessimism and predict an annual return of 2.5% ( Which is much more than the 0.5% most people earn on savings accounts in banks).  Though this return may barely outpace inflation, a 2.5% return is better than a 0% return or a 0.5% you would earn in a standard bank savings account.

*Assuming the U.S. Treasury does not default on its debt.

2. The MyRA is Tied to You: Most retirement plans are employer sponsored (meaning that your employer manages most of the account and may match your contributions) and thus are attached to that employer.  This is not the case for the MyRA.  A better way to think of the MyRA is that instead of being attached to your employer, it is attached to you. What this means is that should you change jobs and get a new employer, it is very simple to have this new employer direct funds to the MyRA for you.  Another option is to set up a recurring or one-time contribution from a checking or savings account.  This added flexibility makes the MyRA great for younger adults or those who are switch
ing jobs or locations frequently.

Simple_pic
Image courtesy of susanlazarhart.com

3. Simple Setup:  Set up for these accounts are free and can be completed in a few minutes.  The simple setup is  on myRA.gov, clicking the “Sign Up” option, and going through the step by step process. The instructions are pretty straight forward and you will have a functional retirement account setup pretty quickly.

4. No Associated Fees or Minimum Balance Required: From a cost perspective the MyRA is a great choice. There are no maintenance fees (fees for a third party to handle the account) and no penalty for contributing too little funds or having a low balance in the account.  As the investor you have total control over how much or how little you wish to contribute.

 

Limitations of a MyRA Account

1. Contribution limits:  Similar to the Roth or Traditional IRA the MyRA has a annual contribution limitation.  The max contributions to all IRAs combined cannot exceed $5,500 ($6,500 if age 50 or older).  The example below illustrates what this could look like.

Ex. Let’s assume I have three IRAs, a traditional IRA ,a Roth IRA and a MyRA. In 2015 I contribute $2,000 to my Roth IRA and $3,000 to my MyRA. How much could I contribute to my traditional IRA?

$5,500 – $2,000 – $3,000 = $500

Thus I could contribute $500 to the traditional IRA without going over the contribution limit.

2. Max Value Limitations: As the MyRA is designed to be a “starter” retirement account, there is a limitation on the max value the account can reach.  Once an account reaches $15,000 in total value (principal + interest earned), the account must be transferred to a private sector Roth IRA.  Before this point is reached the investor is contacted and informed how to transfer the funds to a private sector Roth IRA where the principal and interest can continue to compound.

3. Interest Withdrawal Limitations:  The MyRA does have a strikingly similar limitation to the Roth IRA in the way of withdrawal.  At any point you may withdraw the money you personally invested into the account with no penalty. However, the withdrawal of the interest earned can be taxed if it is not distributed in a qualified distribution.  A qualified distribution is only allowed after five years of the first contribution and you are 59 ½ years old or meet certain criteria (buying a first home).  The purpose of this is to encourage savers to treat the account as an account for retirement and thus save for the age of  retirement.

Ex. Let’s assume December  2015 I contribute $1,000 to a MyRA account.  The account earned a 3.00% return over the year and thus the account is now worth a combined $1,030.  At December 2016 I can withdraw any to all of the $1,000 I personally contributed. However if I withdraw the $30 earned in interest, the $30 will be subjected to additional taxation.

$1,000 * (1+3%) =   $1,030

4. Limited Returns: The final limitation of the MyRA is related to one of my initial lessons on risk and return. The risk of the MyRA is close to zero. As a result the return on the investment should be relatively stable and low around 3.00%.  Though this may not seem like a great return, it does beat inflation and is a higher return than most bank savings accounts.

 

How To Get a MyRA Started

Nestegg_Pic
This is your nest egg. There are many like it, but this one is yours. Image courtesy of protectmyid.com

If you are a young or low income earning individual who wants to start saving for retirement and currently has no retirement savings plan with your employer, the MyRA is the retirement account for you.

To get started go to MyRA.gov, click the “Sign Up” button, and be on your way to building your
nest egg!

Definitions

  1. MyRA: A specialized type of Roth IRA with features designed for those new to saving for retirement.
  2. Maintenance Fees: Fees charged by an account manager for handling an account.

Further Reading

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Who Wants to Be a Millionaire? (The Power of the Roth IRA)

PFT Retirement Plans Roth IRA Millionaire Pic
This is another method. Hope you brushed up on geography!

Want to get excited?  What if I told you there is a way to near guarantee you will retire a millionaire? If I sound like one of those charlatans who will now tell you the “Five Secrets to Stock Picking” or “How to Predict the Market”, you should recheck the site name. Unlike those methods, my method requires a great deal of time and a great deal of patience (a hint of luck also never hurt).   So what is this “magical method”?  First we need to discuss the primary tool of the method: the Roth IRA

I’ve continued to make hints at this mysterious “Roth” designation. You will soon see why this type of account makes it easy for someone to accumulate wealth.  Deluxe RV and golf courses here we come.

Key Points

  • A Roth IRA is a type of investment account that allows the owner to receive tax-free qualified distributions at the age of retirement.
  • The benefits of using a Roth IRA include one of the most beneficial tax treatment of all retirement accounts and the ability to contribute is limited only by the life of the owner.
  • The limitations of a Roth IRA include distribution limits and contribution limits.
  • The Roth IRA is arguably the easiest and most efficient way to ensure a high net worth at the age of retirement.

What is a Roth IRA?

A Roth IRA is an individual retirement account that does not allow for tax deductions, but instead allows for tax free qualified distributions.  If you recall the traditional IRA or even the traditional 401k you may recall how you were allowed to take the contributions off of your taxable income for a given year. This is NOT the case for the Roth IRA.  The Roth IRA forgoes this benefit in exchange for another. The primary benefit of the Roth IRA is that qualified distributions are totally tax free. Said differently the investments you make are enabled to grow totally tax free. As you can imagine, this seemingly small benefit creates a huge benefit to the investor.

What are the Benefits of a Traditional IRA?

1.Tax treatment: The Roth IRA behaves a bit differently than the traditional 401k and IRA. Those investment accounts allowed a reduction in the current year’s taxable income, but when qualified distributions were eventually made those withdrawals were taxed as regular income. In stark opposition to this the Roth IRA does not allow for a reduction in the current year’s taxable income, but instead forgoes this opportunity for a greater opportunity down the line.

Qualified distributions from a Roth IRA are tax free. This means the investments made are allowed to grow and then be withdrawn at the time of retirement completely tax free.  To illustrate the astounding benefit of this let’s use a very quick example.

PFT Retirement plans Roth IRA Scrooge McDuck
I don’t recommend swimming in your new wealth though…just don’t.

Say you had both a traditional and Roth IRA and by the time you reached age 60 they were each worth $1,000,000. Let’s also assume if you become $1,000,000 wealthier you will be placed in the 25% income tax bracket.  If you withdraw all your funds from the traditional IRA, $250,000 of the $1,000,000 will be eaten away by taxes.  Yikes.  If instead you withdraw the funds from the Roth IRA, the amount of taxes you will owe is $0. The Roth allows the $1,000,000 to stay intact and does not affect your taxable income. That’s a pretty awesome deal!

2. Limited to life of owner: The other benefit of the Roth IRA over its traditional counterpart is that the “life” of the Roth IRA is only limited to the life of the initial owner. This has two implications. One implication is that while you must cease contributing to a traditional IRA at age 701/2, you can contribute to a Roth IRA till you pass away. The other implication is the lack of MRDs with a Roth IRA. A Minimum Required Distribution (MRD) is a required distribution that is a characteristic of a traditional IRA. Basically when an individual reaches age 701/2 that individual is required by law to take some amount of distribution from the traditional IRA each year. This constraint is not present in the Roth IRA.

Limitations of a Traditional IRA Plan?

1. Distribution Limitations: Delayed gratification is once again harsh mistress. Before going into too much depth it should be noted that your contributions to the Roth IRA are always distributable without tax consequence. Said differently you can withdraw the money you invested into the Roth IRA at any time and suffer no penalties.  The Roth IRA has two conditions that must be met in order to receive both your contributions and the earnings that the contributions have accumulated.

  1. The Roth IRA must have existed for five years.
  2. You must be of age 591/2 or a qualified first time home buyer.

If either of the above conditions is not met, the distribution is subject to a 10% penalty tax in addition to the taxation of the earnings.  Said differently if you withdrawal from the Roth IRA early, the entire benefit of the Roth IRA disappears. Be wary about early distributions.

2. Contribution Limitations: There are two limitations to contributions to the Roth IRA.  The first is that your AGI (Adjusted Gross Income) must be below a certain range depending on your marital status of your tax filing.  A link to the table with the 2014 values can be found here. As you can see from the table at certain income levels you may not be able to invest in a Roth IRA. Let’s assume you can. This brings us to our second limitation which is the amount you can contribute in a given year.

Your combined contribution to the Roth IRA and any other IRA account can be a max of $5,500 if younger than age 50 ($6,500 if older than 50) in a given year. To use an example suppose I have set up both a Roth IRA and traditional IRA. If I contribute $3,500 to the traditional IRA, the max amount I can contribute to the Roth IRA is $2,000 ($5,500 – $3,500 = $2,000).

No Later Taxation: An Example

For a comprehensive example let’s look at Mr. Davis who works at Apollo Inc. Mr. Davis has been contributing the $5,500 per year contribution limit in a Roth IRA account he has with a broker.  Assuming that Mr. Davis has been working for 35 years the principal of his Roth IRA alone is worth $192,500 before taxes. That’s not bad, but the neat thing about that number is it’s grossly underestimating the value of the Roth IRA. Why? The money in the IRA has been invested in stocks, bonds, and other assets depending on the risk Mr. Davis took on.  If we assume that he earned a 8% average return over that time period the value of his Roth IRA is not $192,500…it’s around $1,025,000 before taxes.  The best part? Because the investment account was a Roth IRA Mr. Davis can withdraw that amount as a qualified distribution and owe $0 in taxes.

Mr. Davis is now a millionaire.

Conclusion

PFT Retirement Plans Roth IRA Golf Pic
Because this looks enjoyable to say the least.

The Roth IRA is an amazing tool that could easily make anyone a millionaire given enough time and a somewhat favorable return on investment.  The most difficult part is achieving the 8% average annual return over the time period that we assumed in the example.  How to achieve that constant return? That is the billion dollar question that Wall Street brokers and financiers have been trying to solve for decades.  Though I can’t guarantee a return, I can guarantee that for many people the Roth IRA is your best bet for growing a nest egg that results in you walking away a millionaire and enjoying retirement in style.

You may be wondering “How do I decide whether to put my money in a traditional or Roth IRA?”. In my next article I will tackle this subject and give you the facts to decide what type of account best suits your needs.

Definitions

  1. Roth IRA: A type of individual investment account that forgoes immediate contribution tax deduction and instead allows the owner to receive tax-free qualified distributions at the age of retirement.
  2. Minimum Required Distribution (MRD): A characteristic of traditional IRAs that requires that participants must begin distributing the funds within the account once the owner reaches age 701/2.
  3. AGI (Adjusted Gross Income): A metric calculated by the IRS by subtracting allowable deductions from gross income from taxable sources.

 

Further Reading

Retirement: What is a Traditional IRA?

PFT Retirement Plans Traditional IRA RV Pic
Nothing says “I made it” quite like this. Image courtesy of Uptownmagazine.com

We’ve already discussed the role of a 401k and its place in your retirement. The 401k is not the only type of retirement account out there. For example let’s assume you max out the 401k contribution but are still worried about putting away money for retirement (you want the exclusive RV for when you tour the country, not just the standard RV). On another note let’s assume that that your employer doesn’t offer a 401k matching program. What do you use to grow your nest egg even more?

Thus is the need of the IRA (Individual Retirement Account). It will be useful to keep in mind some of the similarities between the 401k and the traditional IRA as they both serve the same basic function: to provide financial security in retirement.

Key Points

  • A traditional IRA is a type of investment account that allows the owner to make tax-deferred investments to provide financial security in retirement.
  • The benefits of using a traditional IRA include favorable tax treatment and ease of rolling over the account.
  • The limitations of a traditional IRA include distribution limits, contribution limits, deduction limitations, and later taxation.

What is a Traditional IRA?

A traditional IRA is a retirement plan that an individual can set up for him or herself through a financial institution and usually allows for tax deductions.  An individual can set up a traditional IRA with many different types of financial institutions including banks, life insurance companies, mutual funds, or a broker.  The institution that serves as the administrator of the IRA is referred to as the trustee. A trustee is simply a person or firm that holds assets for the benefit of a third party (the third party in this case is you).

What are the Benefits of a Traditional IRA?

So why would I want to forgo the use of some of my earnings instead of putting that money in my pocket? There are a few reasons this would be a wise move:  favorable tax treatment and the ease of rolling over the money in the account.

1.Tax treatment: Like the 401k  the traditional IRA provides a way to decrease your income taxes payable in a given tax year. By contributing to the IRA the federal government is rewarding you for investing in your future retirement.

Also similar to the 401k though the contributions are allowed to grow tax free in the fund, when you withdraw the funds (a distribution) they are taxed as ordinary income.  For example, if at age 60 you withdraw $50,000 from the IRA, this $50,000 will be treated as ordinary income for tax purposes.

2. Ease of Rollover: A rollover is when you transfer the assets of one retirement plan into another (such as transferring funds from a traditional IRA to a Roth IRA).  Certain types of investment accounts are restrictive in what they can be rolled over into.  For example the funds in a Roth IRA cannot be rolled over into a traditional IRA or a qualified plan such as a 401k. Unlike the Roth IRA, the traditional IRA can be rolled over into many different investment account without consequence adding to the flexibility of the traditional IRA. For a complete chart of which accounts can be rolled over click here for a table provided by the IRS.

PFT Retirement Plans Traditional IRA Dog Roll Over Pic
On a somewhat related note here is a dog rolling over. Image courtesy of animalfair.com

 

 

Limitations of a Traditional IRA Plan?

1. Distribution Limitations: Delayed gratification is a harsh mistress. It may be tempting to dip into the funds you’ve saved in your IRA to fund a trip or do some other fun thing. Unfortunately the IRS would rather you not do this, especially after allowing you a tax break.  The deterrent for this action takes the form of a 10% additional tax if you receive a distribution (withdrawal) before age  591/2.

Another important note is that you can generally withdraw any contributions if done before the due date of the tax return in the year in which you made the contributions. Additional conditions are that you did not take a deduction and you withdraw any interest or income earned on the contribution.  For example if I made a $1,000 contribution to the IRA in November and did not take a tax deduction on it and earned no interest or other income on the contribution. I could withdraw it in December with no tax consequence.

2. Contribution Limitations: The total contribution you could make to both traditional and Roth IRA plans for 2014 was $5,500 ($6,500 if you are age 50 or older). Said differently this means that assuming you are below the age of 50 the total amount of contributions you could make to any traditional or Roth IRAs in the 2014 year had to be less than s$5,500. For example I could contribute $3,500 to a traditional IRA and $2,000 to a Roth IRA but not $3,500 to both.  This number is  periodically adjusted year to year to account for inflation.

3. Deduction Limitations: I have good news and bad news. The good news is that the amount you can deduct is based on the amount of contribution you make. The bad news is that the allowed deduction may be less than your contribution depending on factors such as whether you are covered by a retirement plan at work, your marital status as of filing, and your adjusted gross income (AGI).

  • The table for the allowed deduction in 2015 if you are covered by a retirement plan at work can be found here.
  • The table for the allowed deduction in 2015 if you are not covered by a retirement plan at work can be found here.

There are a few general observations that can be gleamed from the tables. Notably if you are not covered by a retirement plan at work the amount you can deduct is generally much greater and the greater your AGI, the less of a deduction you are allowed.

4. Later Taxation: As I mentioned earlier, the funds in the traditional IRA enable a tax reduction based on the contribution made in the corresponding year. Unfortunately, when the funds are distributed (withdrawn) they are subject to ordinary income tax.

 

IRS Soldier
“Sorry I’m late, traffic was awful!” Image courtesy of offthegridnews.com

An Example

For a comprehensive example let’s look at Ms. Amy who works at Artemis Inc. Ms. Amy has been contributing the $5,500 per year contribution limit in a traditional IRA account she has set up with a broker.  Assuming that Ms. Amy has been working for 30 years the principal of her traditional IRA alone is worth $165,000 before taxes. That’s not bad, but the neat thing about that number is it’s grossly underestimating the value of the IRA. Why? The money in the IRA has been invested in stocks, bonds, and other assets depending on the risk Ms. Amy took on.  If we assume that she earned a 5% average return over that time period the value of her IRA is not $165,000…it’s around $380,000 before taxes.

Conclusion

PFT Retirement Plans Traditional IRA RV Pic
Because honestly…this is a thing. Image courtesy of Uptownmagazine.com

The traditional IRA is yet another vehicle to build that nest egg and enjoy a worry free retirement.  Together the 401k and traditional IRA provide great vehicles for putting aside retirement income, but there is a small problem.   What if instead of taking the tax deduction now due to the retirement account, you paid taxes in full now and did not have to pay the taxes later down the road when you withdraw from the account? This interesting concept is behind the “Roth” designation that has been referred to throughout this and the 401k post.  In our next lesson we will introduce the Roth IRA and the differences in operation between it and the traditional IRA.

Definitions

  1. Traditional IRA: A type of investment account that allows the owner to make tax-deferred investments to provide financial security in retirement.
  2. Trustee: A person or firm who holds and administers assets for the benefit of a third party.
  3. Rollover: The transfer of assets from one type of retirement account to another type of retirement account.
  4. Adjusted gross income (AGI): A metric calculated by the IRS by subtracting allowable deductions from gross income from taxable sources.

Further Reading

Retirement: What is a Traditional 401k?

Beach Picture
Like this…but with lots of tourists. Image courtesy of funcrisp.com

Imagine you’re on a nice beach in Florida without a care in the world.  Do you feel the soft breeze on your skin and hear the soft crashing waves on the shore and the tropical birds chirp in the distance? This could be what retirement feels like.  On the other hand imagine having to reach out to your children for help in paying your hospital bills as you didn’t realize health care costs could become so expensive. You have to keep working because you don’t think you can afford to lose your income stream. This could also be retirement feels like. I bring up these opposing visions to illustrate a simple point: retirement is a big deal.

In the next few posts I will be discussing the various retirement plans  available and how to make the most of the dollars you earn today.  It is never too early to think about retirement.  As I mentioned in Lesson 1 there is a benefit in investing today and not fifty years down the line.

Let’s begin with one of the most common terms in the world of retirement plans: the 401k. I will note that most people will be able to use a traditional 401k plan. There are some exceptions including employees of the government or nonprofit plans which I will address in later posts.

Key Points

  • A traditional 401k is an elective retirement plan which grants an employee the ability to defer some of his/her earned income in order to obtain current favorable tax treatment.
  • The benefits of using a traditional 401k plan include favorable tax treatment and employee matching.
  • The limitations of a traditional 401k plan include distribution limits, contribution limits, and later taxation.

What is a 401k plan?

Put simply a 401k plan is a retirement plan an employee enrolls in through his or her employer. There is a tax benefit associated with contributing to a 401k plan and in addition the employer generally will match the employee’s contribution according to some predetermined formula.

In general the company offering the 401k plan does not manage the plan.  It usually serves the role of the sponsor of the plan. To think of it differently, the sponsor of the plan (the company you work for) usually outsources the management of the plan to a financial service company who you contact for the actual management of your plan.  The identity of the financial service company that manages your 401k plan should be detailed in the benefit guide of your employer.  The role of the employer as the sponsor is to pay for the setup of the plan and to make matching employer contributions according to some formula.

A very important term to become familiar with is the term elective deferral. An elective deferral is simply the portion of your paycheck that you are choosing to put into the 401k.

What are the benefits of a 401k Plan?

So why would I want to tell my employer to funnel some of my earnings into my 401k plan instead of putting that money in my pocket? There are two main reasons: tax treatment and contribution matches from your employer.

1. Tax treatment: Taxes suck. Luckily the 401k provides a way to decrease your federal income tax payable.   Your elective deferrals do not show up as taxable income. Said differently the income you choose to defer (put off until retirement) does not count as your taxable income in a given year.   The federal government is rewarding you for investing in your retirement.

IRS Soldier
“Did someone say that taxes suck?” Image courtesy of offthegridnews.com

 

If you think this sounds too good to be true, you’re correct. Though these contributions are allowed to grow untaxed in the fund, when you withdraw the funds (also called a distribution) they are subject to taxes as ordinary income.  An example would be if you have invested in a 401k plan and at age 65 withdraw $50,000 from the plan, this $50,000 would be reflected as ordinary income and subject to taxes.

2. Employer matches: Who likes free money?   By contributing to a 401k plan, this is a possibility.  Most corporations as part as their benefit package offer “401k-matching”. What this means is based on a predetermined formula your employer will contribute to your 401k fund. For example a company may match 25% of your contributions up to $2,500 per year.  Meaning for every $1.00 I set aside in the fund my company will contribute $0.25.  Getting paid for investing in your retirement is a pretty neat thing.

PFT Retirement Plans Traditional 401k Vest Pic
Vesting is surprisingly not related to clothing. Image courtesy of honeybuy.com

There are some caveats to be aware of.  While you always have a claim to the money you contribute to the plan, you may not always be able to have total claim to the employer’s contributions.  Many companies enact a vesting condition in their contributions. Vesting refers to an amount of time that must pass before you have claim to some asset.  This is generally done to ensure you will remain employed by that company for a longer period of time. An example of a vesting schedule would be that you vest 100% in the company’s contributions after five years with vesting beginning at 20% in year one and increasing by 20% each subsequent year.

Let’s use a quick example.  Say John Galt works for Eos Inc.  and Eos has a 25% matching contribution and the vesting schedule is 20% each year for the first five years at the company.  Mr. Galt has been working at the company for three years and contribute $5,000 to the 401k plan each of those years. How much principal does Mr. Galt have claim to (assuming the fund did not earn a return)?

 

John Galt’s contribution to the plan:

3 years * $5,000 = $15,000

Eos Inc.’s contribution:

3 years * 20% of our $5,000 yearly contribution * 60% vesting limit

3 * $1000 * 0.60 = $1,800

Total principal in the fund = $15,000 + $1,800 = $16,800

Limitations of a 401k Plan?

1. Distribution Limitations: Waiting is hard.  At some point that $15,000 may look very tempting to withdraw and go spend on a new boat. Unfortunately the IRS would rather you not blow your 401k and has put in place deterrents to discourage that action.  The deterrent takes the form of a 10% additional tax if you receive the distribution before age 59 ½.  The reasoning is sound. The 401k is to provide you with retirement income, not a boat.

That being said the ways the elective deferrals can be distributed without incurring additional charges include: you die, become disabled, or become unemployed; your employer terminates the 401k plan; you reach age 59 1/2  or incur significant financial hardship.

2. Contribution Limitations: There are two annual limits that every 401k owner should be aware of:

1. The limit on the amount you as an employee contribute to the plan 2. The limit on the total amount that can be contributed to the plan.

The annual contribution limit for the employee in 2015 is $18,000.  This ceiling has increased in increments of $500 for some years and is expected to so as the IRS adjusts it for costs of living and inflation.The annual total of elective deferrals and employer matching contributions cannot be greater than $52,000 or 100% of your compensation, whichever is less.

3. Later Taxation: As I mentioned earlier, the funds in the 401k plan can’t avoid the tax man forever.  When the funds are distributed to you (and hopefully not with the added 10% tax) these distributions will show up on your taxable income.

IRS Soldier
“Did someone say Tax Man?” Image courtesy of offthegridnews.com

An Example

For a comprehensive example let’s return to Mr. Galt who works at Eos Inc.  Mr. Galt has been contributing the $5,000 per year and has been matched by his employer 20% of his contribution.  Assuming that Mr. Galt has been working for Eos for 30 years the principal of his 401k alone is worth $180,000 before taxes. That’s not bad, but the neat thing about that number is it’s grossly underestimating the value of the 401k. Why? The money in the 401k has been invested in stocks, bonds, and other assets depending on the risk Mr. Galt took on.  If we assume that he earned a 5% average return over that time period the value of his 401k is not $180,000…it’s around $400,000 before taxes.

Conclusion

Senior couple
Pictured: Golden Years. Image courtesy of gainesvilletoday.com

Retirement is important to everyone.  Why should someone start early? Growth. What may not be clear is that your 401k will allow you to allocate and invest the funds as you choose. Said differently a 401k is just another type of account for saving and investing, but with an emphasis on retirement.  If done correctly, your fund can grow quite dramatically over the years of employment and you won’t have to worry about money when you reach your golden years.

In the next few posts I will be discussing other retirement plans that exist including the Roth 401k, IRA, and Roth IRA.

Definitions

  1. 401(k): A type of retirement fund which allows employees to defer funds in order to obtain favorable tax treatment and to obtain matching employer contributions.
  2. Sponsor: The employer who contributes funds and facilitates the participation in a 401k plan by its employees.
  3. Elective Deferral: A portion of earned income that an employee chooses to defer by transferring into a 401k and which does not contribute to taxable income in the year earned.
  4. Vesting: The process by which an employee accrues certain rights or privileges from his/her employer.

Further Reading

Student Loans and Paying for College (Part 2)

Student Debt with Ball and Chain
A commentary on today’s student loan situation. Image courtesy of Cognoscenti.

Let’s explore a bit more of the technical details relating to the different grants and loans out there. I won’t touch on scholarships because they vary so widely depending on the offering organization.  Just as a quick refresher grants are need-based gift aid, scholarships are merit-based gift aid, and student loans are loans that must be paid back. We will first discuss the types of federal grants then move on to the different types of federal loans.

Key Points

  • The most common federal grants offered are Federal Pell Grants, FSEOG, and TEACH grants.
  • The most common federal loans offered include Perkins loans, direct unsubsidized loans, direct subsidized loans, and direct PLUS loans.
  • Pay close attention to the Master Promissory Note (MPN), which is essentially the terms and agreements when accepting a federal loan.
  • Federal loans possess many qualities that make them superior to federal loans.

Federal Pell Grants

Federal Pell grants are federal grants granted to undergraduate students who have not earned a bachelor’s or a professional degree who exhibit a degree of financial need.  It also should be noted that you cannot receive a Federal Pell Grant if you are incarcerated or subject to an involuntary civil commitment so before you commit that crime realize it could affect your future education prospects.  The yearly distribution amount differs on a number of factors including the level of your financial need, the cost of attendance, and whether you are a full-time or part-time student. The maximum award for the July 2014-June 2015 academic year was $5,730. This number can be adjusted slightly each year, but do not expect it to jump $1,000 in one year.  You can receive the Pell Grant for 12 semester (or approximately six years). You will receive the full amount you qualify for from your attending college.  As I nagged last lesson and will nag this lesson, you must fill out the Free Application for Federal Student Aid (FASFA) in order to receive a Federal Pell Grant.

Federal Supplemental Educational Opportunity Grant (FSEOG)

The FSEOG is a federal grant granted to undergraduate students who exhibit exceptional financial need such that a Federal Pell Grant is insufficient.  A FSEOG is only available to those student who have received a Pell Grant and exhibit the most financial need.  The FSEOG is not offered at all colleges therefore contact your prospective college’s financial aid office to find out if your college offers the FSEOG. The amount of aid offered through the FSEOG ranges from $100-$4,000 depending on your financial need, the other financial aid you receive, and the availability of funds at your college.

TEACH Grant

The TEACH Grant program is a specific federal grant program that grants up to $4,000 per year to students who are completing coursework related to a career in teaching.  There are some stipulations to accepting this aid such as if you accept you must teach: in a high-need field, at an elementary or secondary school that serves low-income families, and teach at least four academic years of the eight years after you cease schooling. What happens if you do not fulfill these requirements?  The grant is transformed into a direct unsubsidized loan for your breach of contract.  In addition to completing the FASFA if you are interested in the TEACH Grant program, be sure to contact your college’s  financial aid office and ask if they participate in the program. The other stipulations are explained in the TEACH Grant Agreement to Serve which acts as the contract for the grant.

Federal Perkins Loan

The Federal Perkins Loan is a low-interest student loan offered to undergraduate and graduate students who exhibit exceptional financial need.  Once again not all colleges participate in this program so you should contact your college’s financial aid office to see if it participates in this program. The amount you are allowed to borrow depends primarily on your financial need, the amount of aid you have received, and the availability of funds at your college. Unlike the Pell Grants, not everyone who qualifies for a Perkins loan will receive a loan.  As an undergraduate you are allowed to borrow up to $5,500 up to a total of $27,500.  As a graduate you are allowed to borrow up to $8,000 per year up to a total of $60,000.  Repayment begins nine months after you graduate, leave college, or drop below half-time status.  Before the nine months has passed interest does not accrue on the loan.  In addition the interest rate on these loans is fixed at 5% (currently).  To apply for this or any of the following loans you must complete and submit your FASFA (a big surprise I know).

 The Difference between Direct Subsidized and Unsubsidized Loans

Before I describe the direct subsidized and unsubsidized loans, it is worth that the biggest difference between the two is that with a direct subsidized loan the U.S. Department of education pays for (subsidizes) the interest payments that accrue when you are in college. If a student has an unsubsidized loan interest does accrue during your time in college.

Direct Subsidized Loans

Direct subsidized loans are student loans available to undergraduate (not graduate) students who exhibit financial need and are enrolled at least half-time. Once again check with your college’s financial aid office to see if the college participates in the Direct Loan Program.  The annual award is $3,500-$5,500 depending on grade level.  One of the most notable characteristics of the direct subsidized loan  is the interest owed (the rate is now at 4.66%) is paid by the federal government as long as you are in school as at least a half-time student and the grace period during the first six months after leaving school.  Also repayment of principal is not required until this grace period of six months has ended.

Direct Unsubsidized Loans

Direct unsubsidized loans are student loans available to both undergraduate and graduate students who are enrolled at least half-time and there is no requirement for financial need to acquire the loans.  The annual award can range from $5,500-$20,500 depending on grade level and dependency status.  The difference between the unsubsidized and subsidized loan is that that while you are in school you are responsible for paying the interest that accrues on the loan and during all grace periods.  You have the option to not pay the interest at that time but if you choose this option the interest will be capitalized (added to the principal amount of money you owe) thus increasing your interest payment later down the road.  The interest rates for direct unsubsidized loans are fixed and are currently 4.66% for an undergraduate student loan and 6.21%. Similar to the subsidized loans there is a six month grace period following the first six months after leaving school during which no principal payments are required.

Direct PLUS Loans

PLUS loans are federal student loans that graduate students and parents of dependent undergraduate students can use to pay college expenses without the need to show financial need.  Not all colleges participate in the federal loan program so be sure to contact your financial aid office. One of the most notable features of the PLUS loans is that the borrower must have a “good” credit history.  The maximum loan amount is the student’s cost of attendance (which is equal to total costs of attending minus financial aid received). Accrued interest must be paid while in school else it is capitalized to the principal of the loan.  If a parent takes out the loan for his (her) student, there is no grace period and repayment of principal must begin immediately, this is not the case for a graduate student who has a grace period following the first six months of leaving school. The current interest rate on direct PLUS loans is 7.21%. I really should stop beating this dead horse, but in order to apply for the direct PLUS loans you have to complete and submit the FASFA.

Federal vs. Private Loans

I’ve outlined a lot of different options and some may not seem very generous. You may be thinking “Is that the best that is out there?” Sadly I would say yes it is.  Many aspects of federal loans make them superior to loans offered by other institutions (private loans).  These include fixed interest rates instead of variable interest rates (interest rates that could change), the student is not required to repay any principal while in school, and the need for an established credit history or cosigner in order to secure the loan.

Before you agree to any federal loan be sure to read the Master Promissory Note (MPN) that serves as the loan contract and outlines the terms of the loan.

Definitions

  1. Grant: A need based form of gift aid which usually does not require repayment
  2. Student loan: A loan made to a student in college which may either by administered by the federal government or a private financial institution.
  3. Grace period: A period of time during which principal payment of a loan may be suspended.
  4. Interest capitalization: A type of loan stipulation in which unpaid interest is added to the principal balance of a loan.
  5. Private loans: Student loans offered by a private institution.
  6. Master Promissory Note (MPN): The contract outlining the terms and conditions for most federal student loans.

 

Further Reading

Student Loans and Paying for College (Part 1)

I can’t tell if the money is coming out or going into the hat. Image courtesy of saleshq.com

So you got accepted to the school of your dreams?

Congratulations! I’m happy for you! My next question merits a bit of scary thought. How are you going to pay for attending that school? Maybe you have wealthy relatives. If so, count your blessings and the rest of this post is irrelevant for you so you can move on to something else.  For the rest of us…paying for college is no laughing matter. Cost is one of the top determinants of where an individual chooses to attend college (I was one of these individuals). As tuition continues to rise and the job market continues to flounder financial aid for students is becoming a very ubiquitous issue that merits a bit of explanation and study.

Key Points

  • There are some key differences between scholarships, grants, and student loans.
  • The FASFA is arguably the most important financial aid form to complete.
  • Scholarships, grants, and student loans are the most popular methods to pay college costs.
  • Your financial aid office at your school is your friend not your foe.

Grant, Scholarship, or Loan?

Let’s start with the good news. There are entities out there who will give you free money to attend school. These entities can be the school you choose to attend, the company your parent(s) work for, or even the federal government. This “free money” or “gift aid” is usually referred to as grants and scholarships.  Grants are financial aid packages usually given on a financial need basis. Scholarships are financial aid packages usually given on a merit basis.  It is important to note that while scholarships and grants do not usually require repayment they may still have performance conditions attached to them (ex. You cannot fall below a certain G.P.A. while attending school). The largest provider of grants is the U.S. federal government.

Here’s the bad news: this form of aid may not cover all the costs of attending college. When gift aid isn’t enough we must turn to student loans which are loans specifically provided to individuals attending universities that do require repayment. The largest provider of student loans is again the U.S. federal government though there are private student loans offered by banks, credit unions, and universities.

How a Piece of Paper Can Save You $100,000

The Free Application for Federal Student Aid (FASFA) is arguably the most important form to fill out when it comes to financial aid for paying for college.  By filing out the FASFA you are essentially revealing to the government how much of the cost of attendance your family will have to pay (the exact term for this is expected family contribution) and how much of the bill the government will cover.  Needless to say the FASFA is a pretty thorough form that will ask family net worth, family income, number of family dependents, etc.  I do not recommend lying on this form. Why? Because the information you enter is cross referenced with the friendly, neighborhood IRS (Internal Revenue Service) and the last thing someone wants is a call from the IRS regarding the apparent fraud you filled out on the FASFA.

Different states and schools have different deadlines than the federal government (the deadline page can be found here). It is very important to not miss these deadlines as you would be missing out on free money…ouch.  Usually the deadline for the upcoming school year is before the fall of that academic year (Ex. If I were attending LSU from Fall 2015 – Spring 2016 I would have to submit the FASFA before June 30, 2015.)  Another important aspect of the FASFA is that you must reapply each year you want to receive some form of financial aid.  Why? Let’s say that your second year of college your family wins the lottery (or your father loses his job).  This new source (loss) of income will show up on your FASFA and as a result the federal government will expect a larger (smaller) expected family contribution. To capture situations like this the federal government and universities require the FASFA be completed each academic year. Thus write down your log-in information and keep it in a secret, reliable place.

Scholarships

Scholarships are a merit based form of gift aid and are arguably the most sought out form of financial aid. They are offered by universities and many private and non-profit organizations.  The best ways to find these financial gold mines are contacting the university you plan to attend or performing your own private research.

A quick caveat about private research on financial aid: Beware companies that want you to pay for scholarship or grant searches.  Most of these companies want you to pay for results you could get by googling ‘’popular scholarships”.

Once you find a scholarship that you fit the criteria for, apply.  Though sometimes a pain you are sacrificing your time for a chance to lessen that financial burden (I personally applied to a scholarship offered through the finance department at my school and received $3,000 from it. Not bad for spending an hour on the application.)  Scholarships have their own deadlines and criteria so pay close attention so you don’t miss out.

Grants

Grants are a financial need based form of gift aid and take up the greatest percentage of total financial aid offered to students.  They are commonly offered by both colleges and the federal government.  The federal government has quite a few notable grant options which will be discussed in part two.

Apart from being based on financial aid vs. merit, grants function in the same way as scholarships. Based on the results of the completed FASFA different grant options may be available.  Once again grants may have terms attached to them so be sure you understand the terms of agreement when you accept the financial aid.  What do you do if the scholarships and loans are not enough? Other than working three part time jobs, you may want to consider taking on a student loan.

Student Loans

So you have crunched some numbers and discovered that the grants and scholarships just won’t cover all of the expenses. Now what?  You could put the remaining costs on a high interest credit card and bite the bullet, but I would not recommend that.  Seeing the need for a reliable source of student loans the U.S. Department of Education created a loan program to help fill the gap in paying for all of college costs. Some banks and other financial institutions began to offer student loans. The major distinction in the world of student loans is that there are federal student loans (government) and private student loans (non-government).  In many of the cases federal student loans have some key characteristics (fixed low interest rate, possible tax reductions, and post-graduation payment plans) that make them superior to most private student loans.  To apply for a federal student loan you must complete your FASFA (told you it was kind of important) and the results of the FASFA will dictate which types of federal loans you are eligible for.

 

Student with ball and chain attached
You shouldn’t feel like this. Image courtesy of McCarthy’s Weekly.

 

If there is one take away from this lesson let it be this: Your school’s financial aid office is your friend when it comes to paying for college; go to them if you have financial concerns.  For now let’s look a bit more in depth at the different types of federal grants and loans available to students.

Definitions

  1. Grant: A need based form of gift aid which usually does not require repayment.
  2. Scholarship: A merit based form of gift aid which usually does not require repayment.
  3. Student loan: A loan made to a student in college which may either be administered by the federal government or a private financial institution.
  4. Cost of attendance: The total cost of attending a particular university for a certain period of time (usually a year) and includes expected costs such as tuition, room and board, books and supplies, etc. This metric is used in calculating the amount of financial aid offered.
  5. Expected family contribution: The expected dollar amount the family of a student is expected to contribute to college expenses. This metric is used in calculating the amount of financial aid offered.

Further Reading

All About Credit Cards (Part 2)

We have discussed some of the basic functions of the credit card. “But Colby what do these rates and acronyms mean? And this contract needs a magnifying glass to read the fine print.” Obviously we still have some material to cover concerning credit cards. The material discussed may seem eclectic but that is because when it comes to credit cards there are a bunch of seemingly unrelated pieces that add together in that tiny piece of plastic.

Key Points

  • There are different types of credit cards available.

    -Image courtesy of urban tastebuds
    Image courtesy of urban tastebuds
  • One of the most important features of a credit card is the card’s annual percentage return (APR) or the interest rate charged on the card.
  • The annual charge and the grace period are two other features to pay attention to.
  • If you have more than one credit cards in use, pay the balance on the card with the higher APR first.

Continue reading All About Credit Cards (Part 2)

All About Credit Cards (Part 1)

Ah the credit card.  When you think about it ideas of platinum and gold cards and the high life may come to mind. This is part of the story. The other part of the story is that using a credit card irresponsibly can burden a person with an enormous amount of debt and keep him up late at night. So what is a credit card and how does it function?

Continue reading All About Credit Cards (Part 1)

Credit Scores, Credit Reports, And Why They Matter

You have probably seen commercials about “improving your credit score” or companies that will “give you your credit score” now you may be thinking “What the hell is a credit score?” Put simply a credit score is a three digit number that indicates how reliable you are as a borrower. Why does that matter? When you apply for a loan at a bank the bank has to evaluate whether to loan you the money and what interest rate to charge you.  If only there were a way for a bank to see how you have paid other loans and whether you default (don’t pay) on a lot of loans. Surprise! There is a way and it is called credit-scoring systems.  So before we delve deeper remember that the better your credit history and thus your credit score, the easier it is to obtain a loan and the lower the interest rate you will be charged.  Also remember that debit card payments and cash payments are not relevant here. Only credit financing (credit cards, loans, etc.) affects your credit score and credit report.

Continue reading Credit Scores, Credit Reports, And Why They Matter

All About Interest Rates

So we have discussed a bit about returns and rates, but there is some terminology that needs to be addressed and will make you a bit better off for knowing it. At the end of the day interest rates are pretty powerful things that shape the entire financial system, so let’s learn a little more about them. (Warning: simple math ahead so non-math types bear with me).

Continue reading All About Interest Rates