A number of people have asked me how I’m saving for retirement now that I’m self-employed, and several more asked yesterday when I mentioned that I was signing up for a SEP-IRA. In order to clarify everything, here’s exactly how I’m saving for retirement as a self-employed writer.

For comparison’s sake, my previous retirement savings were exclusively in 403(b) and 401(k) plans. Even though I planned to open a Roth IRA in 2007 (and even went so far as to fill out the paperwork), I eventually elected not to do it, primarily because of the costs associated with purchasing a house in 2007 and the fact that I was already rolling about 20% into my retirement plan. In fact, my savings in there is quite a bit above what’s considered “normal” for a 29 year old - I have substantially more than a year’s worth of my old salary in there, and it’ll just do nothing but grow over the next 30 years.

My current self-employement retirement planning is handled exclusively through Vanguard. I’ve invested with them in the past, I feel wholly comfortable with the way they do business, I agree strongly with their company’s investing philosophy, and I want to put all of my retirement into index funds, which is what Vanguard specializes in.

So what did I do? Almost as soon as I moved to self-employment, I opened up a Vanguard Roth IRA. A Roth IRA is a retirement account that almost anyone can set up (well, anyone with a Modified Adjusted Gross Income below $114,000 for an individual or $166,000 in a married couple). Each year, you can contribute up to $5,000 to the Roth IRA out of your after-tax money - it isn’t pulled straight out of your paycheck like a 401(k) is. However, once it’s in the account, it’s sweet - as long as you follow the very simple withdrawal rules (basically, no withdrawing until the account is more than 5 years old or you’re over 59 1/2 years of age), you can withdraw the earnings tax free - you don’t have to pay income tax on any earnings in the account (you can also withdraw your contributions at any time without penalty). For a lot more detail, read up on Roth IRAs at Wikipedia.

So, basically, each month I put a few hundred dollars into my Roth IRA at Vanguard - just enough so that after the year’s up, I’ll have contributed my total $5,000 (my wife is considering opening one as well, so that will make our combined contribution $10,000 for the year if she does that). Ideally, then, I’ll contribute $5,000 each year over the next thirty years into this account, taking me right up to retirement age. If I do that, and it earns even just 6% per year, that’s $395,290 I have access to at age 59 1/2, all of it tax free. If I get an 8% return on it, that’s $566,416 - tax free. That’ll certainly help with retirement.

What about the SEP-IRA? So, as I mentioned yesterday, I’m setting up a SEP-IRA through Vanguard as well, mostly because I wanted to contribute more towards retirement than the $5,000 a Roth IRA allows for me. A SEP-IRA allows a self-employed individual to contribute up to 20% of their profits to the SEP-IRA. I’m allowed to invest up to (approximately) 20% of my self-employment income into this plan (though I’m not going to be putting in quite that much). This plan is tax-deferred, meaning that I put in money before paying taxes on it and then pay income tax on everything I take out later on. For the purposes of most people, it’s like a 401(k) for the self-employed, except that you don’t get employer matches.

Right now, I’m contributing roughly 5% of my income each month to this plan - that’s in addition to the Roth IRA, but way under my contribution limits for the year.

How did I invest? In both cases, I set up a regular investing schedule and bought into the Vanguard STAR fund because I didn’t want to put in the $3,000 minimum for other funds. I’ll sell the STAR shares when it reaches $3,000 and move it to another fund. Eventually, I plan on having all of it split among a few funds just to ensure diversity - I want some international stocks, some domestic stocks, etc.

For most self-employed people, particularly those under the cap for a Roth IRA, this is a solid path to follow.

Lately, I’ve had a lot of fun playing with Wachovia’s 401(k) contribution calculator. Ever wondered what sort of impact changing your 401(k) contribution would have? This calculator tells you based on your own information. What’s interesting is that for most people, the benefits far outweigh the drawbacks.

To play with the tool, I created a person I call “Jimmy” with the following attributes:

Jimmy wants to contribute 1% to his 401(k), and his employer will match that 1%.
Jimmy is 29 years old, and intends to work for 31 more years.
Jimmy makes $55,000 a year, and is in the 28% tax bracket.
He also pays 3% in state income tax.

This is a pretty typical situation for a person entering their thirties, so let’s see how things go for ol’ Jimmy in terms of his 401(k) contributions.

Short term costs Putting away 1% of his paycheck will cost Jimmy $32 a month in take-home pay reduction. Over a whole year, that’s $384.

Short term benefits However, Jimmy’s income tax bill is reduced by $171 by the contributions. Remember, a 401(k) contribution is before taxes, so Jimmy doesn’t have to pay income tax when he puts in the money, just when he withdraws it.

The short term balance This means that Jimmy’s total real cost for his contributions is $213 ($384 paid in, minus the $171 tax benefit). However, his 401(k) balance goes up $768 ($384 in his own contribution, and $384 from his employer). Immediately, Jimmy’s $213 becomes $768 in his retirement account. This is why employer matching is such a big deal - you simply cannot get that kind of return on your dollar anywhere else.

Long term benefits If Jimmy keeps putting in that 1% until he retires at age 60, and the investment returns 9% over the long haul, Jimmy will have $164,533 in his retirement account.

So, let’s extrapolate that a bit. If Jimmy were to contribute up to 5%, which is his employer’s maximum match…

Jimmy will lose $158 a month in take home pay. That’s the only real drawback here.

However, Jimmy will have his income tax bill reduced by $853.

Plus, Jimmy and his employer combined will contribute $3,792 to Jimmy’s 401(k). Jimmy’s total cost for that benefit is $1,043. That $1,043 instantly becomes $3,792 in the retirement account.

Here’s the kicker. For just that $1,043 a year, Jimmy will have $822,664 in his retirement account in 31 years. Is it worth reducing Jimmy’s weekly spending by $20 to make him almost a millionaire at age 60? I certainly believe so.

What’s the real story here? If you’re passing up on 401(k) contributions now, especially if your employer offers any matching, you’re doing yourself a massive disservice. Even if Jimmy could only contribute $5 a week, that adds up to about $205,000 at retirement for him - and very similar numbers apply to you.

Make it a high priority to contribute to your 401(k) at least up to what your employer will match - there is almost no better investment on earth that you can make.

One common question I get from people fresh into the workforce and setting up their new 401(k)s is this: how much retirement income should I count on from Social Security? It’s not an easy question to answer because we don’t know what the political future of the United States holds.

We do know one thing: at some point in the future, the exact date depending on how you calculate things, Social Security as it is currently set up and funded will run out of money. That’s simply a fact of basic arithmetic, and most estimates of that “out of money” date put it well before people in their twenties will collect a dime of benefits.

So, in order for people in their twenties to get Social Security benefits, something will have to change. What will the change be? At this point, it’s impossible to really tell. Possibilities include individuals opting out of Social Security, a bailout from other taxes collected by the federal government, or some sort of ending of the program.

Regardless of what might happen to Social Security, I don’t view it as a safe bet that Social Security benefits, as they are today, will be around for us in forty years. In other words, when you’re calculating your retirement savings, don’t include Social Security Instead, view them as a bonus if you happen to receive benefits in your dotage.

So what should you do instead? When you decide to calculate how much you need for retirement (here’s how I calculate it), don’t include any Social Security at all - essentially pretend it doesn’t exist. This way, no matter what happens to the program, you’re covered, and if the program is still ongoing in Generation Y’s dotage, then it can be considered frosting on the cake.

This might be uncomfortable advice to some, who might have been putting away a bit less and assuming that Social Security will make up the difference. In my view, you’re making a wager that the government will bail out Social Security. If that’s a risk you feel comfortable with, then you’re making the right choice. Personally, I don’t feel comfortable with it and thus I’m planning for a retirement without Social Security.

Hopefully, a retirement with a lot of grandchildren around.

Many people have no idea how much they should be saving for retirement and thus quite often they do whatever their retirement counselor suggests without actually knowing if what they’re doing is right. I wanted to understand the full process better, so I spent some time figuring out what I would need for retirement and doing the math on it - no investment knowledge required.

How old will I be when I actually start drawing retirement benefits? That’s a question you need to ask yourself. It’s not exactly the same as “when will I retire?” because, for example, I never plan to actually “retire” in the traditional sense. I will always have some sort of business or activity going until I’m literally incapable of doing anything at all. For me, though, I’m targeting age 62 to start getting out benefits.

How many years will I actually live after retiring? I used a life expectancy calculator to get a very thumbnail approximation of my age to start with. However, this number is flawed in a lot of ways - the younger you are, the more likely it is that medical techniques will extend your life. Plus, it’s only a rough number.

To account for medical advances, I take the number that calculator spits out (for me, it was 70), subtract my age from it, then round that number to the nearest 5. The number I got was 40. Then, divide that number by five, leaving 8, then add that to the age estimation, giving 78. Why divide this by five? The average life expectancy of an American over the last hundred years has gone up roughly a year for every five years that pass. The younger you are, the more likely medical advances will benefit you.

Since this is just an “average” estimation, I also add on half a standard deviation of the normal lifespan, which means add nine years to your earlier number to cover yourself if you exceed the statistical average of how long you should expect to live. This would bump me up to 87.

Then, take this final age calculation and subtract your retirement age from it. I want to “retire” at age 62 and start drawing my benefits, so that means I’ll have 25 years of retirement that need to be covered.

How far are you from retirement? Take the age you want to “retire” and subtract your current age, rounded to the nearest year. This leaves me with 34 years to retirement.

How much will you need your first year in retirement? I don’t believe that Social Security will be a factor at all in my post-retirement income, so I figure what I’ll need without it. My belief is that I’ll want 75% of my current salary each year in retirement, so how much will that be the first year I retire? If I make $50,000 now, 75% of that would be $37,500. Over the last two decades, inflation has been somewhere around 3%, so we also need to figure in 34 years of inflation (that’s how many years I need to retire). Using a basic compound interest calculator, with a current principal of $37,500, no annual addition, 34 years to grow, and an interest rate of 3%, I get a value of $102,446.45. That’s how much I’ll need the year I retire to have 75% of the value of my salary today. Wow.

How much will you need during your whole retirement? Since my investment will still be growing at retirement, I figure that I just need the first year’s dollar amount for the number of years I’m in retirement. That would be $102,446.45 times 25 years, or $2,561,161. I have 34 years to get there.

How much can I afford to put away? If at all possible, you should always put away the maximum amount that you can into your retirement plan; that way, you don’t absolutely need spectacular returns in order to retire. For me, I can put away up to 15% of my salary ($50,000) into a retirement plan, so I put away $7,500 each year.

What retirement plan do I pick? This is the trickiest math part. Fire up that basic compound interest calculator again and plug in how much you currently have in retirement as your current principal, the amount you’re socking away each year as your annual addition, your years until retirement as your years to grow, and 4 as the interest rate. After you hit calculate, the calculator will spit out a “future value.” What you need to do is keep raising and lowering that interest rate until you find a rate that, when you hit calculate, the future value is close to what you need to have for retirement. For me, that was 9%.

Once you have that percentage, get ahold of the person who manages your retirement and ask for help in choosing a package. Tell them that you did the math on your own and you need to have a specific return in order to retire. Ask them which investment plan is most likely to average that level of return over the long haul.

Some people will note that if you put 15% of your salary away every year, your annual addition will increase each year. That’s absolutely correct - I view that extra money as breathing room so that if the return isn’t quite as strong as you hope, it won’t dash your plans.

That’s it. Just start pumping money into the plan just like that and just forget about it until you need it. This is exactly what I’m doing - I’m putting away my 15% into my retirement plan after picking a Target Retirement one that worked for me and I’m just sitting on it and forgetting it.

My wife’s grandfather likes to regularly comment on how fast the price of everything seems to be increasing lately. He’s loudly adamant that the rate of inflation is actually speeding up and that prices are doubling faster and faster and faster. He strongly encourages me to estimate high for inflation when I do my financial figuring.

Whenever someone declares something that adamantly, especially someone that I respect as much as her grandfather (anyone who is old friends with a Nobel Prize winner and can have eloquent discussions on almost any topic will earn my respect quickly), I’ll usually check out what they’re saying, even if my initial reaction is to write it off as ramblings. I took a deep look at the detailed inflation data over the history of the United States, using the consumer price index as a baseline. I calculated the average annual rate of inflation over ten different time bands to see what the change was like. Feel free to play around with that tool using different starting and ending years - the numbers are quite interesting.

What I found was that the really bad period of inflation in the United States was in the 1970s, a simple fact that many economists could tell you. If you look at the ten years from 1973 to 1982, the average annual rate of inflation was an astounding 8.99%. This means that prices from January 1, 1973 to January 1, 1983 went up 136%; in other words, a car that cost $5,000 on January 1, 1973 would have cost $11,826 just a decade later. That’s an incredible amount, an inflation rate that seems alien to people my age.

On the other hand, over the most recent ten years in the calculator (1996-2005), the average annual rate of inflation is only 2.46%. To use that same car analogy, if you bought a car on January 1, 1996 for $5,000, that same car on January 1, 2006 would cost only $6,375.

My wife’s grandfather’s thesis is pretty clearly incorrect - inflation is a lot better today than it was a few decades ago. However, even asking this question brings up an interesting one: how much inflation should one plan for?

If you plan for low inflation rates, then every year with a high inflation rate hurts you. For example, let’s say you planned to have an annual income equivalent to $50,000 a year now when you retire in 30 years and you assume a 2% inflation rate. This means you’re expecting to have an income then of $90,568 a year. A thumbnail calculation says that you can reach that level of steady income by having 25 times that in your portfolio when you retire, so you plan for a $2.2 million portfolio when you retire. What happens, though, if inflation averages 4%? Your planned $90,568 a year retirement will still happen, but that money will only have the buying power of a $27,900 salary today! Moving from an income of $50,000 a year to an income of $27,900 a year is a major letdown.

If you plan for high inflation rates, your annual amount for retirement is much higher now, but every year of low inflation helps you. Let’s say, again, that you plan to have an annual income equivalent to $50,000 a year when you retire in 30 years, but this time you assume a 6% annual inflation rate. This means that you’re planning for an annual income of $287,174.60 when you retire. A thumbnail calculation says that you’ll need a $7.2 million portfolio to retire with an annual income like that - ouch! However, let’s say that inflation averages 4% here? Your planned $287,174.60 will still happen, but that money will have the buying power of an $88,000 annual salary today! Moving from an income of $50,000 a year to an income of $88,000 a year is wonderful!

Because of this, I strongly encourage you to estimate high when figuring for inflation because you’re always better off having more money when you retire rather than less money. This way, if my wife’s grandfather turns out to be right, you’re not caught with a poor retirement plan, but if he’s wrong, you’ll be going on European vacations when you retire.

A few days ago, on my post about SmartMoney’s “7 Money Mistakes”, LTruslow left the following comment:

I have always had a problem with those who believe that you should not invest before paying off all debts and establishing an emergency fund. For many, they would never begin saving for retirement. While an emergency fund and eliminating debts are important, saving for retirement is an absolute must.

My personal feeling is that this is a strongly debatable point and it largely comes down to personal restraint and willpower.

First of all, let’s compare paying off a credit card debt with 16% interest to a 16% annual return on an investment. I worked through an example of this using Bankrate’s loan amortization calculator and some simple spreadsheet math. Let’s say Joe has $10,000 in credit card debt at 16% and another $10,000 in a killer mutual fund that earns 16%. His minimum payment on that credit card debt is $167.51, which will put him in place to pay it off in ten years. Each month, Joe is going to put $1,000 towards investment or debt repayment.

Let’s say Joe only makes the minimum payment on the debt ($167.51) and puts the rest ($832.49) towards investment each month for the next ten years. At the end of those ten years, Joe will have $292,571.48 in his investment and no credit card debt.

Now, let’s say Joe puts the whole $1,000 towards debt repayment each month until it’s gone, then the whole $1,000 towards investment each month. Eleven months into the debt, the entire debt is gone and on that eleventh month, Joe can put $195.04 towards the investment; every month after that, the whole $1,000 goes into the investment. At the end of the ten years, Joe will actually have slightly more in the investment - $296,818.21.

So, we can safely conclude that repaying a debt is just slightly better than getting that same return on an investment. Given that there’s no investment that can guarantee a double-digit return, paying off any debt with double-digit interest is the best investment you can possibly make.

The problem is that this analysis goes strictly by the numbers. It does not take into account human emotion and psychological tendencies. The truth is that if a person is in debt, there’s a good likelihood (far from a guarantee, of course) that the person would go back to being in debt once that debt is paid off.

It takes some willpower and personal strength to be debt-free in our modern world. I’m guilty of being in debt, as are a lot of my readers. It is because of this willpower factor - and the fallibility of our willpower - that it makes sense to put money away for retirement in such a fashion that it is extremely difficult to get at it.

Thus, the kind of saving for retirement that the commenter describes is indeed vital, but only as a hedge against our own weaknesses. The true best path to financial freedom is not through a retirement investment plan, but through the willpower not to spend money lightly - something that’s a challenge for me and for most Americans.

I try very hard to avoid political discussions on The Simple Dollar because it often winds up in partisan bickering, but I feel that a discussion about the future of taxes and their impact on your personal finance decisions today is vital.

First of all, why is it important to think about future tax rates? Yesterday’s discussion about Roth 401(k)s was a very clear illustration of this. In an effort to keep the post from turning into a political discourse, I tried to avoid any discussion about tax rates and their future by making up arbitrary ones for the present and for the post-retirement era. The result? Comments like this from Eugene:

The difference happens when you have enough money to max out the 15.5K 401K limit. If you can’t hit this limit, that means taking a tax hit on the contributions means you can put less in a Roth 401K. If your tax is 25%, the choice is between 10% in a 401K or 7.5% in a Roth IRA. Not 10% versus 10%. And yes, because multiplication is commutative, applying the 25% reduction before contribution/before growth or at widthdrawal/after growth gives you the same result.

Now you also have to consider the impact of tax bands and how money is used during retirement. While working, 401K contribution money sits ontop of your income minus deductions. During retirement, the 401K withdrawals sits ontop of social security minus deductions. I suspect for 99% of people, social security will be a much smaller amount so you end up paying less overall effective taxes during retirement.

And this valid criticism from MossySF:

Trent, you are letting the tax tail wag the dog’s body. The specific tax amount now or later is irrelvant — it’s how much you have after taxes. Paying $2800 now versus $14K later? I have no idea what is better without knowing all the details. If I have to pay more tax because I earned more, hell yes I’d pay more tax. Do not report the tax bill as the final result — report the after-tax gains.

After reading a lot of this, Luke cries out for help:

Is here not ONE example that can be used to make this scenario bullet proof? My head is spinning, but not nearly as much as the arguments that say taxes will change in the future. It’s like hitting a moving target. If someone brings to the table a discussion about Roth IRA’s and 401k’s and someone starts to tear it down because what will happen in 2043 with taxes, how can everyone get on the right page if everything is a variable?

So, is there just a simple example that spells out which one is better without getting into taxology 40-years from now and a ton of what-if scenarios?

Thankfully, Erika came to the rescue with this stellar comment:

Two things:

1. Legally, choosing between a Roth and normal 401k is not an all or nothing decision. If your employer lets you, you can contribute a bit to both (combined contributions still cannot exceed the maximum for any given year).

2. Tax rates are not terribly stable (see the graph at the bottom of the Top US Marginal Income Tax Rates, 1913–2003 page). Your tax rate, regardless of your bracket, may be much higher than it is now or it may be lower.

Combining these two points, deciding which 401k plan to contribute too depends on how you want to manage risk. If you contribute to a normal 401k, you are banking on the belief that you will pay less in taxes when you retire. If you contribute to a Roth 401k, you are banking on the belief that you will pay higher taxes when you retire.

Trying to minimize your total payed taxes is a risky business that involves predicting the future. My opinion is that you should diversify. If you contribute to both types of 401k, you will not end up paying the minimal amount of taxes, but, by paying some now and some later, you will amortize your tax burden across both your working years and your retirement years, and you will reduce the risk of your prediction of the future being wrong.

What can we learn from these comments? Future tax rates are incredibly important in determining which investment is right for you.

The problem is - we can’t predict the future. Or can we? Take a look at the data on historical income tax rates and then look at national debt as a percentage of GDP. Compare the two. Notice that income taxes are high when the national debt as a percentage of GDP is going down, and income taxes are low when the national debt as a percentage of GDP is going up. Notice also that current levels are trending upward and are also at their highest point since income taxes began (excepting World War II). This is expected given that taxes are so low, but at some point, that direction must change - it’s no different than getting your credit card in the bill each month and noticing that the debt is slowly getting closer to your salary.

Eventually, we will have the money to change the trend there, whether through smaller government or more taxes. Since both parties continue to propose plans that revolve around big government to solve our problems right now, it’s inevitable that taxes are going to head back up at some point in the next two decades. That’s the conclusion I draw, anyway.

What does that mean for my wallet? If you believe that taxes are going to eventually have to go up from where we’re at right now, then Roth IRAs and Roth 401(k)s are a very good deal, because you’ll effectively pay the low tax rate now and avoid paying the higher taxes that your future self would have to pay in a normal 401(k) plan.

What if I don’t agree with your conclusion? Many people believe that taxes will remain at the same level in perpetuity, and there’s some reasonable validity to that argument, though I don’t believe it. If that’s the case, then your taxes will probably be lower in retirement than they are right now and Roth IRAs and 401(k)s aren’t that good of a deal.

In general, when describing scenarios on The Simple Dollar, I’ll lean towards believing that I’ll be paying more taxes in the future than now, all other things being equal.

As always, I welcome comments, but please keep partisan political posturing out of it. You can state your view on the direction of America in the future, but kindly refrain from name-calling and other such hallmarks of online political discourse (I’ve read far too much of it over the last few years).

Recently, a number of readers have asked me about the new Roth 401(k). Is it really a good deal, they ask? In a nutshell, it’s a very good deal for almost anyone eligible for it, but let’s walk through the scenario carefully.

What Is A Roth 401(k)?

A Roth 401(k) is not all that different than a regular 401(k). In most regards, it works exactly the same - your employer manages the plan, the money is taken directly out of your paycheck and put into the investment, and once in the investment, you can control the investments to whatever degree you wish (or your employer allows).

The first difference (and this is the one that’s a bit of a negative) is that your contributions to a Roth 401(k) come after taxes. Let’s say that you’re currently contributing 10% of your salary to a normal 401(k) and are thinking of switching to the new Roth 401(k). When you make that switch, you will lose that 10% as a tax deduction, which will increase your tax bill right now.

The second difference (and this one makes up for that downer and more) is that when you make withdrawals from this 401(k), you pay no taxes at all on any withdrawal. Of course, you have to wait until you’re eligible to withdraw money normally from a 401(k), which requires that you have started the plan five years ago or more or are 59 1/2 years old.

If your employer does matching, this will remain in pre-tax dollars and will go into a normal 401(k).

How Does That Work Out?

Let’s use another common straw man example. Let’s say that our hero Joe is in the 28% tax bracket and he puts $10,000 a year into his 401(k) right now - that means that Joe doesn’t have to pay taxes on that $10,000. If he moved to putting that money into a Roth 401(k), he would be able to put in the same $10,000 a year, but he would have to pay taxes on that before it went in, bringing his total bill for that $10,000 contribution up to $12,800. If Joe does this for thirty years, he’ll have paid $84,000 in extra taxes to have the money in a Roth 401(k) versus a regular 401(k).

But trust me, Joe’s going to be happy in retirement. Let’s say Joe retires and he has enough in his 401(k) that he can take out $50,000 a year for the next thirty years, until he’s 90 and passes away. He’s again in the 28% tax bracket. So, when he withdraws the $50,000 from the Roth 401(k), it’s all his! He has $50,000 to spend! But if he were to withdraw the $50,000 from the regular 401(k), he would have to pay $14,000 every year in taxes and only be able to keep $36,000 of the money - over the 30 years, he’ll pay a total of $420,000 (!) in taxes. Let’s even say his tax bracket was lower than that in retirement - let’s put him in the 15% bracket at retirement. He would still have to pay $7,500 each year in taxes and only keep $42,500. He’d still pay $225,000 in taxes over those years.

Basically, by paying $2,800 a year now in extra taxes, Joe saves himself $14,000 a year in retirement.

You can make complex models with inflation and other elements to the point of confusion, but the Roth 401(k) still comes out ahead in almost every scenario - and far ahead in most scenarios. If you still have questions and doubts, contact the retirement counselor in your workplace, who can work you through your specific scenario in detail.

What About A Roth IRA?

If you have access to a Roth 401(k) and your only purpose is to contribute money for retirement, a 401(k) will suit your needs. The one advantage that a Roth IRA has over a Roth 401(k) is the ability to withdraw your contributions without a tax penalty, but the additional benefits of the Roth 401(k) (especially employer matching if your employer offers that) are so great that you should contribute the maximum to the Roth 401(k) first if it’s available to you.