The big question for me was what the contribution limits are for an SEP IRA. And specifically, do contributions to a 401(k) affect how much can be contributed to an SEP IRS? So here's what I learned from my accountant.

For a self employed individual, the 2009 SEP IRA contribution limit is 20% of adjusted earned income, with a maximum contribution of $49,000. If you contributed to other defined contribution plans (e.g., 401(k), IRA), those contributions reduce your $49,000 limit. Also, if an employer matches some or all of your 401(k) contributions, the employer match also reduces your $49,000 maximum. Put another way, all of your investments in defined contribution plans cannot exceed $49,000. For 2010, the maximum SEP IRA contribution remains at $49,000.

If you run an incorporated business and are paid based on W-2 income, the contribution limit is 25% of that income. The $49,000 cap remains the same. Now, if you plan to set up an SEP IRA, consult with an accountant or other tax specialist before making any decisions. While I believe the above contribution limits to be accurate, I am not a tax specialist.

I'll be setting up an SEP IRA soon and will be describing which discount broker I've chosen to use. My plan is to be more aggressive with my SEP IRA than I am with my other retirement accounts. This will likely involve investing in individual stocks or bonds as well as some derivatives (most likely just call options).

I was surpirsed at the "Borrow from your 401k" suggestion. While it's true that it's better than cashing out, so many people are being laid off unexpectedly. When this happens, it must all be paid back or considered a cash-out, which comes at a time when people are least able to repay because they just lost their job. It should at least have been mentioned as a consideration.

--Deborah in San Diego

Deborah makes a very interesting point. She's referring to an article entitled "Need Cash" that discusses 10 ways to raise cash quickly if you're in a jam.

How widespread is the problem? It's hard to find many statistics on 401k loans. But a Harvard report (pdf) cites two statistics that point to trouble. The vast majority of plans allow for borrowing (over 85% in 2005, Investment Company Institute, 2006). And they also report that 18% of 401(k) participants had a 401(k) loan in 2006.

We can't know for sure, but it's probably not an unreasonable guess that about one in five or six people who are laid off will have a 401k loan outstanding when they get the pink slip.

And, that's when Deborah's problem comes in. As a general rule, if you leave your employer you need to repay the 401k loan in full. You may be given a month or so, but that's it.

Any amounts that you fail to repay are treated like a withdrawal. That means that you add the amount of the loan to your income and you'll pay normal income taxes on it. Plus, you'll be liable for a penalty that equals 10% of the unpaid loan.

What can you do about it? First, if you have a 401k loan and think that you could lose your job, you need to take it seriously. Begin by estimating how much the taxes and penalties would cost you if you didn't repay part or all of the loan. It'll be bad. But since your income will be lower than previous years (because of the layoff), your tax rate should drop (that assumes no tax rate hikes).

In any event, you need to have some idea of how much the penalties and taxes are. You'll want to compare that to the cost of other alternatives.

There are a couple of withdrawal exceptions that might help in a layoff situation:

• You were age 55 or over and you retired or left your job
• You paid for medical expenses exceeding 7.5% of your adjusted gross income

What if you don't fit into one of those categories? Your options are limited, but you still have some choices to make.

Now might be the time to consider selling a car. Your ride needs to be worth more than any loans on it. Any cash you raise could help pay off the 401k loan. If you're not working, transportation won't be such a big issue. You can always buy another car when you're employed again.

Do you have a homeowner's line of credit or enough equity to refinance your home? That could provide some money to repay the 401k loan. Refinancing will be easier before you lose your job. So you might want to consider this if you expect to be laid off.

Using your credit card to pay off the 401k loan is a high-risk strategy. You'll probably pay a higher interest rate. And, you'll also need to keep making payments even if your income has dried up. Plus, you'll be consuming part of your credit line that you may need later.

The only advantage to shifting the debt to a credit card is that you avoid the tax problems of a 401k withdrawal. But it's wise to compare the numbers before you make a decision.

The unfortunate fact is that most 401k loans were promoted as an painless way to 'borrow from yourself'. Turns out that's not so true if times get tough.

Gary Foreman is the editor of The Dollar Stretcher.com and newsletters. Not only does the site host thousands of articles on various ways to save money, but you'll also find a vibrant forum where people share their dollar stretching ideas. You can comment on this entry here or follow Gary on Twitter.

There are some exceptions to this rule. For example, a Roth 401k may be the right choice if you make more than $1 million a year or if you make so little that you pay no income tax or very little income tax. But for the majority of us, the Roth 401k is better left alone. Here's why.

Roth 401k Basics

A Roth 401k is a retirement plan set up by employers that allow employees to contribute to their retirement. Unlike a traditional 401k that is tax deferred, however, money invested in a 401k Roth account is included in an employee's taxable income. For example, if an employee is in the 25% federal tax bracket and pays 5% in state income tax, he or she would have to make $14,285 in gross income to invest $10,000 in a Roth 401k.

Here's the math: $14,285 x 30% = $4,285 in taxes. $14,285 - $4,285 = $10,000.

The benefit of a Roth 401k is that your investments grow tax free. If by retirement that $10,000 has grown into $50,000, you pay no tax on the $40,000 gain. With a traditional 401k, the initial investment is excluded from your taxable income, but you do pay taxes on your entire 401k balance as you make withdraws from the account.

Why contributing to a Roth 401k is probably a mistake

Determining whether a Roth 401k or traditional 401k is best requires a bit of guess work. Traditional analysis asks whether your tax rate will be different when you contribute to the Roth 401k than it will when you make withdrawals from the retirement account. If your tax rate will be the same, the argument goes, than it makes no difference whether you invest in a traditional or Roth 401k. A tax rate that is higher when you make contributions than when you take withdrawals favors a traditional 401k, while a tax rate that is lower favors a Roth.

The problem with this analysis, however, is that it glosses over the difference between the marginal tax rate and the effective tax rate. The federal tax rate is progressive, meaning that the tax rate increases as your income increases. For example, here are the 2008 federal tax brackets as released by the IRS:

2008 Tax Brackets

As you can see, the tax rate increases as an individual or couple's income increases.

Now the marginal tax rate is the highest rate that an individual or couple pays based on their income level. For those with taxable income over $357,700, their marginal rate is 35%. In contrast, the effective rate is the average income tax rate paid. Somebody with taxable income of $357,701, for example, only pays 35% income tax on the $1. An individual would pay 33% for taxable income over $164,550, 28% for the portion of their taxable income over $78,859, and so on. In the end, their effective tax rate would be the total tax paid divided by gross income, which would come out to a lot less than their marginal rate of 35%.

The key point for our purposes is that contributions to a traditional 401k reduce an individual's tax liability at their marginal rate, not their effective rate. In contrast, withdrawals from a traditional 401k will be taxed, along with other retirement income, at your effective rate. So unless you expect your current marginal tax rate to equal or exceed your effective tax rate at retirement, the Roth 401k is not the best choice.

If you'd like to read a detailed analysis of the Roth 401k, check out Thinking About a Roth 401(k)? Think Again

Is a Roth 401k the right choice for anybody?

Sure. For those making in excess of $1 million, their effective tax rate and marginal tax rates begin to converge. Furthermore, they are likely to amass sufficient wealth such that their retirement income could exceed their current income, which could favor a Roth 401k. Also, if you live in a state that doesn't have an income tax, but expect to move to a state that does during retirement, the Roth 401k may be the better choice. And a teenager who doesn't earn enough to pay taxes but wants to save for retirement would be better off choosing a Roth account.

So choosing the right investment vehicle is not a one-size-fits-all proposition. And it should be noted that you can invest in both a Roth and traditional 401k. But for most, sound retirement planning suggests that we pass on the Roth 401k.

Here are some other Roth 401k articles worth reading:

Ask the Expert with Larry Swedroe

Should You Choose a Roth 401k or a Regular 401k?

The Case Against Roth 401(k)

Regular 401K vs Roth 401K - The Basics

IRA Calculator

Morningstar's IRA Calculator is a nifty 3-in-1 calculator if you have or are considering opening an IRA. First, the calculator will tell you whether you qualify for a Roth IRA, a deductible IRA, or a nondeductible IRA. Second, based on how much you plan to save in an IRA, the IRA calculator will tell you how much you'll have at retirement in each type of IRA. This is a helpful way to assess which IRA is best for you. And third, the calculator will help you determine whether to roll over an IRA into a Roth IRA. So if you have or are considering an IRA, this is definitely a tool to bookmark.

Online Retirement Plans

Boulevard R offers a unique approach to retirement planning. Unlike most retirement calculators, Boulevard R asks how you want to spend your time in retirement, and uses your answers as part of its analysis. It also offers a very easy user interface and very nice charts and graphics to show you where you stand. At the end it calculates what it calls a Retirement Security Index score.

CNNMoney's Retirement Planner is like creating an online financial plan. The great thing about this tool is that it's very easy to follow and takes just a couple of minutes to input your data and see the results. The retirement planner accommodates data for both couples and singles, allows you to estimate retirement needs in dollars or as a percentage of current income, and factors in social security benefits (which it estimates based on your income). The results include an estimate of the likelihood your nest egg will grow to meet your needs. In our case, the calculator concluded that we need to earn 9.3% on average to meet our retirement goals, which it assessed at an 82% chance of success.

Fidelity's MyPlan Retirement Quick Check is a more detailed retirement planner that uses Monte Carlo simulation to estimate how much money you will have during retirement. Monte Carlo is a mathematical model that recognizes that the stock market doesn't produce the same rate of return each year. One year it could be up 25%, the next it could be down 15%. And this is an extremely important consideration for new retirees. If the market drops 20% in your first year of retirement, the loss can increase the odds you'll outlive your money. Monte Carlo simulation looks at thousands of possible market returns over a period of time, and produces a range of results with the likelihood you'll achieve your goals. Fidelity's Retirement Quick Check is available to Fidelity clients or those that register with Fidelity.

And if you want to understand Monte Carlo retirement calculators better, check out The Retirement Calculator from Hell by William Bernstein.

Retirement Income Calculators

T. Rowe Price's Retirement Income Calculator also uses a Monte Carlo simulation to estimate the likelihood your retirement savings will be enough. The interesting feature of this calculator is that you choose the confidence level that your money will be enough in retirement. In other words, you can select 99% for example, which means the calculator will assess whether your savings at retirement has a 99% chance of providing sufficient income for you during retirement. One limitation of the calculator is that you must input how much you'll have at retirement, but the other calculators discussed here can handle that with no problem.

Fidelity's MyPlan Snapshot is a nifty online tool to help determine how much you need to save to meet your retirement goals. The tool asks your age, income, investment style, monthly contributions to retirement accounts, and retirement savings. Based on this data, it then calculates how much you need at retirement (it assumes 85% of current income) and how much you'll have if the market performs poorly or as it has in the past. You can then adjust the age at which you'll retire, your monthly contribution amount, or investment style to see how these decisions may impact your nest egg at retirement.

Other Online Retirement Calculators

There are literally thousands of retirement calculators available online. The calculators described above should cover most DIY retirement planning needs. But here are few more to check out if you're looking for other options:

• Dinkytown's Retirement Shortfall calculator
• Bloomberg's Retirement Plan
• Yahoo's How Much to Save for Retirement calculator
• AARP's Retirement Calculator
• Nationwide's RetirAbility Check

Dave Ramsey's Step #4 is simply this--save 15% of your gross income for retirement, preferably in Roth 401(k) and Roth IRA retirement accounts. This step raises two important questions: (1) what's so special about 15% as opposed to 10%, 20% or some other savings rate; and (2) why invest in after-tax Roth retirement accounts rather than pre-tax 401(k) and IRAs? To answer these questions, I've created some charts to show the impact of these decisions on your retirement nest egg. Following the charts, I'll list some of the factors worth considering as you make your own retirement savings decisions.

Save 15% of Gross Income toward Retirement

Albert Einstein is said to have quipped, "compound interest is the most powerful force in the universe." Whether he actually said this is undetermined, but to this I would add, "compound interest is the most powerful force in a retirement account." But to unleash this force you need two things: savings and time. The more savings and time you have, the more powerful the effect of compound interest. So what does the effect of compound interest have on saving 15% of your gross income? Check out this chart showing the growth of 15% savings on a $100,000 per year salary assuming a 10% return, 3.1% inflation and savings beginning at age 30:

There are several important observations to make here. First, the ending balance of just over $2 million is in today's dollars assuming a 3.1% inflation rate. The actual retirement savings balance after 35 years is over $6 million. Second, notice that the chart is broken into three colors: yellow, blue and purple. The yellow represents the actual amount of money invested, the blue the amount earned directly from the money invested (called simple interest), and purple the amount earned from the simple interest (called compound interest). All of these numbers are adjusted for inflation. But the point is that given enough time, the compound interest earned will far exceed the amount invested or even the simple interest. That's the most powerful force in the known universe that Einstein was talking about! Finally, note that the $2 million balance in today's dollars is enough to withdraw about $80,000 a year for retirement, exactly what you'd need if you were seeking to replace 80% of your income in today's dollars (I've written before about the 4% withdraw rate rule for retirement accounts).

No what happens if instead of saving 15%, you save 10%? Here's the chart:

Notice that you still get the benefit of compounding. That's because the benefits of compounding depend on how long you invest and what return you earn. But of course, the more you invest, the more you end up with. In this case, at a 10% savings rate, you end up with about $1.3 million in today's dollars. This is not enough to withdrawal 80% of your current pay during retirement, assuming a 4% withdrawal rate. You may get social security benefits to make up some of this shortfall, but Dave Ramsey's view is we shouldn't count on social security. While I'm not as pessimistic on this point as he is, ignoring social security in your retirement assumptions is certainly a conservative approach.

From this we can conclude that a 15% savings rate for retirement is a reasonable approach, given all of the assumptions we've made. In making your own decision on retirement savings, you may want to consider these additional factors:

• When you start saving for retirement: If you start saving for retirement at age 18, you may not need to save 15% (although it's a good habit anyway). At age 18, you have 47 years to invest before you're 65. At a 10% savings rate using the numbers above, your inflation adjusted balance at age 65 is more than $3 million (more than $13 million in actual dollars!). If you wait until your 40 to begin, you may need to save considerably more than 15%. At that age, a savings rate of 15% yields less than $1 million in inflation adjusted dollars, and even a 20% savings rate results in just under $1.3 million. So when it comes to retirement savings, one of the most critical success factors is to start saving as soon as you can. I should add that if you are in your 40s or older and have little retirement savings, there's no point in beating yourself up over it. Just start saving now.
• Assuming a 10% return is generous: The above calculations assume a 10% return on investments. Change it to just 9.5% and the numbers drop considerably. Many believe that annual returns of 10% will be unrealistic in years to come. If you're looking for predictions, you've come to the wrong place. But I can say that sticking your money in a money market or "safe" bond account won't get you the returns most of us need for retirement. I've written extensively about asset allocation, and here are to great books that have helped me a lot in formulating my investment plan: The Bogleheads' Guide to Investing (don't let the goofy title of the book fool you, it's a very good guide to investing) and All About Asset Allocation.
• Making your own calculations: You may want to make your own calculations for retirement using assumptions that are different than what I've used. If so, here is the investment calculator I used in this article.

Invest Retirement Savings in Roth Accounts

I believe that for most people most of the time, Roth retirement accounts are best. Why? Well, let's first look at the numbers. As with the above calculations, let's assume you start saving at age 30, retire at 65, invest $15,000 annually for retirement, are in the 25% tax bracket and (this is important) will be in the 25% tax bracket during retirement. Under these circumstances, which is best, a $15,000 investment in a Roth 401(k) or a traditional 401(k)?

The Roth 401(k) beats the traditional 401(k). But this test is unfair. Investing in the Roth 401(k) costs us more because we don't get an immediate tax break like we do with a traditional 401(k). So let's assume that we invest the tax savings we enjoy with a traditional 401(k) into a taxable investment account. Now which is best?

The traditional 401(k) balance improves, but it still doesn't catch the Roth 401(k) balance. Why? It doesn't catch the Roth 401(k) balance because the after-tax money invested in taxable accounts doesn't grow tax-free like the Roth 401(k) does. The difference in these two account balances represents the taxes you pay on the earnings from your taxable account. If you could invest the tax savings from the traditional 401(k) into a Roth IRA, the two accounts balances would be identical.

Now, what if your tax rate goes down during retirement? Here is a chart assuming a 25% tax rate during your working years and a 15% tax rate during retirement:

The balances get closer, but the Roth still edges out the traditional 401(k). Why? Again, it goes back to the fact that the tax savings from the traditional 401(k) are invested in a taxable account where taxes must be paid on all earnings. And if your tax rate goes up during retirement, the choice in favor of a Roth 401(k) becomes even more clear. If you'd like to play with these numbers and assumptions yourself, here is the Roth 401(k) versus Traditional 401(k) calculator that I use.

Now, let's put aside the numbers for a moment and consider some additional factors that are important to this decision:

• Future tax rates are unknown: The fact is we don't know what the tax rates will be a year from now, let alone 30 years from now. Many argue that they have only one way to go--up. Maybe, although the government can increase taxes without increasing the income tax rate. For my retirement investing decisions, I make no assumptions about future tax rates. How then, you may ask, do I make a decision between Roth and traditional retirement accounts?
• You can pick both: I invest in both Roth and traditional retirement accounts. Like so much in life, this is not an all or nothing choice. Since I don't know where tax rates will go, I invest in both. My employer matches 401(k) contributions, and these matches must go into a traditional 401(k). Thus, I've started increasing the portion of my contribution that goes to a Roth 401(k). My goal is to direct 100% of my contributions to my designated Roth 401(k), while the matching contributions go to a traditional 401(k).
• Roth accounts bring certainty to retirement planning: One of the things I like about Roth accounts is that you know exactly what you have saved for retirement. With traditional retirement accounts, you have to make a guesstimate about taxes to know how much money you have to fund your retirement.
• Conversion to Roth IRAs: Roth 401(k) retirement accounts can be converted to Roth IRA accounts without any tax liability. I like this feature because Roth IRAs offer a distinct advantage over deductible IRAs and 401(k)s--no required minimum distribution during retirement. You can hold onto your Roth IRA for as long as want, and it is a great way to pass on wealth to your children or grandchildren if that's one of your goals. If you'd like to read more about this feature of retirement accounts, here are two books I own that are very good on the subject of taking your money out of retirement accounts: The Retirement Savings Time Bomb . . . and How to Defuse It: A Five-Step Action Plan for Protecting Your IRAs, 401(k)s, and Other RetirementPlans from Near Annihilation by the Taxman and IRAs, 401(k)s & Other Retirement Plans: Taking Your Money Out.

The M-Network Dave Ramsey Baby-Step Series

Here are all of the articles thus far from the M-Network series:

• Overview at Cash Money Life
• Step 0 - No More Debt at Debt Free Revolution and Single Guy Money
• Step 1 - $1000.00 Emergency Fund (@Gather Little By Little)
• Step 2 - Pay off all debt using the Debt Snowball (@Paid Twice)
• Step 3 - 3 to 6 months of expenses in savings right here! (@ Being Frugal)
• Step 4 - Invest 15% of household income into Roth IRAs and pre-tax retirement (@ The Dough Roller)
• Step 5 - College funding for children (@ My Two Dollars)
• Step 6 - Pay off your mortgage (@Moolanomy)
• Step 7 - Build wealth and give! (@ Plonkee) Money
• Series Wrap Up (@ Being Frugal) and (@ Paid Twice)

Photo Credit: sco

Are your retirement savings enough to live comfortably during your golden years? The March edition of Money Magazine has some guidelines to help you answer that $64,000 question. Before we get to the guidelines, it is important to understand that they are built on a number of assumptions. First, they assume you will need to replace 80% of your current, pre-tax income during retirement. If you make $100,000 now, for example, you'll need $80,000 of pre-tax income per year during retirement. Second, the guidelines assume you will receive about $20,000 a year in social security benefits. If you would like an estimate of your social security benefits, check out this social security benefits calculator. Third, the assumption is that you won't receive any pension benefits (a good assumption for most of us). And finally, the guideline assumes that your retirement savings will grow by 8% a year during retirement and that you will withdraw 4% per year to live on.

In the above example, you'll need to replace $60,000 of income ($80,000 - social security benefits of $20,000) with your retirement savings. At a 4% withdrawal rate, you'll need to amass $1.5 million by the time you retire ($60,000 / 4% or if you hate division, $60,000 * 25). The 4% withdrawal rate has become a fairly accepted conservative estimate of how much you can take from your retirement savings if you want your money to last 30 years. Using a 4% withdrawal rate, simply multiply how much money your savings will need to pay you each year by 25, and you have the amount you'll need in savings at the time of retirement.

The big question, though, is whether you are on track to hit this number. Money Magazine provided this nifty chart to answer that question:

Now at this point you may be asking why the chart started at 45. What about the Gen X kids? Having recently learned that I'm a member of Gen X, not a Boomer (barely), I feel obligated to cover the younger crowd. It turns out that this chart comes from Charles Farrell of Northstar Investment Advisors. Mr. Farrell wrote a paper back in 2006 that went into much more detail about how much savings (and debt) you should (and should not) have at various stages of your life. The complete chart from his original paper is to the right.

You'll note that the chart starts at age 30. You may also note that the Savings to Income ratio beginning at age 45 is different than what Money Magazine listed. So what's going on? This is an important point. In Farrell's original paper, he assumed a 5% withdrawal rate; Money Magazine assumed a 4% withdrawal rate. And if you think just 1% is no big deal, think again. At 4%, you need 15 times your pre-retirement income ($100,000 in our example) at retirement to produce 60% of this amount (remember social security covers 20%). But at a 5% withdrawal rate, you "only" need 12 times current income. In our $100,000 hypothetical, the difference in retirement savings is $1.5 million versus $1.2 million.

So which assumption is best? I don't think there is a best here. Four percent is more conservative than five percent. The logic behind the 4% rule is that you will earn 8% a year with a relatively conservative mix of stock and bond investments. Four percent stays in savings to keep up with inflation, and 4% comes out to pay for your living expenses.

By the way, Farrell's original article, Personal Financial Ratios: An Elegant Road Map to Financial Health and Retirement is definitely worth reading.

So are you saving enough for retirement?

Photo Credit: pasotraspaso

Traditional retirement looks like this--work until you're 65 or so, and then stop working until you die. More recently, views of retirement have begun to change, as more and more "retirees" are forced to work long after 65. There is a major problem with this approach to retirement, which I'll come to in a moment. But first, how would you answer the following question: How much of your life today is spent doing what you want to do when you want to do it?

If I were to answer that honestly, the answer would be somewhere around 20%. Yuck! And I don't hate my job. I wouldn't work where I do if I were independently wealthy, but I have a good job, work with good people, and earn a good wage. But I still work. I still get up five days a week, spend one hour getting ready for work, spend 50 minutes commuting to work, spend about nine hours at work, and then another 50 minutes returning home. Under the traditional views of retirement, I will keep doing this same routine for the next 24 years, then I'll stop cold turkey and do who knows what until my end of days.

I started this website in part because I don't like the traditional way of looking at retirement. And what's worse (here's the major problem I mention a moment ago), I believe that looking at retirement as something that happens decades from now for many of us is one of the major reasons why so many people don't save for retirement. It's just too far away to worry about, many believe. I want to change that way of thinking, so consider the following questions:

1. Would you move to a different, less expensive city if it meant you could begin immediately to work less than you do now?
2. Would you move to a smaller, less expensive house if it meant you could begin immediately to work less than you do now?
3. Would you own fewer cars (or less expensive cars) if it mean you could begin immediately to work less than you do now?
4. Are you passionate about something that you would love to spend more time doing AND could make some income doing it?
5. Are there changes you could make in your current job that would give you back some of your time (e.g, telecommuting one or two days a week)?

Slow Motion Retirement

The questions above bring me to the key point. What are you willing to do to get back some of the time you now spend doing stuff you'd rather not do? I call this concept slow motion retirement. The idea is to start retiring now, little by little, not waiting to take the plunge when you're too old to enjoy it. So what sacrifices are you willing to make today in exchange for getting more of your life back? Six years ago I took a $100,000 pay cut (yes, $100,000) to get back more of my time for my family and me. I haven't regretted it for one second. And it's not enough. I want even more of my time back that I now give to my employer. So how am I going to accomplish this? I have a 3-step plan that looks like this:

Step 1--Telecommuting: My first step to get back more of my time is to telecommute to work one or two days a week. For each day I work from home, I'll save at least 1.5 hours commuting and about $15 in transportation costs. If I telecommute twice a week, in a year I'll get back the equivalent of 12 days of my time and save nearly $1,500. Over the next 20 years, I'd get back 240 days and save $30,000. I've begun discussions with my supervisor about telecommuting, and will be writing more about how that goes over the coming weeks.

Step 2--Work part time: My second step will be to scale back to part time work. Even if I work four days a week instead of five, the time I'd get back would be substantial. Over the course of a year, I'd get back more than a month of time. Combine this with telecommuting one or two days a week when I do work, and I'd quickly take charge of a significant portion of my life that I now give away to my job.

Working part-time would of course involve a financial sacrifice, although probably not as much as you might think. For somebody making $100,000, a 20% cut in pay would not actually cost them $20,000. You first have to look at the after-tax cost, and then consider the money you'd be saving by not working that fifth day of the week (e.g., transportation costs, clothing costs, lunch, daycare). For me, a 20% cut in pay would actually cost me about 12% of my take-home pay.

Step 3--Redesigning your life: This is where we don't just get back some of our time; we get it all back. To me, this is not retirement in the traditional sense. This is where I spend most of my time doing what I want to do, when I want to do it. The key question to answer is this: If you could design your life from the ground up, what would it look like? Notice I'm not asking: If you won the lottery, what would you do with your life? That's a common question, but beyond some entertainment value, it's not helpful (unless of course you win the lottery). Most of us have responsibilities, whether to a spouse, our children, our parents and so on. And we all have to eat. But within those responsibilities, what would your life look like if you could redesign it?

Here's what my life would look like. First, I'd teach at the college level. I love teaching, and I'd love to be a life-long student, as well. Teaching is one profession that offers an incredible work--life balance. Second, I'd write books. I've wanted to be a writer for a long time, but have never had the discipline to complete a book. Third, I'd spend more time taking care of my family and me. I'm taking some steps toward this reality that I'll write about another time.

But enough about me. What would your life look like if you could redesign it (within reason) and what are you waiting for?

The report is worth reading if you'd like a primer on social security. Social Security: An Essential Asset and Insurance Protection for All (48 page pdf document) includes a section describing social security benefits and how they are calculated. For example, the percentage of income replaced is higher for lower income families (as you'd expect). Here's a chart from the report depicting this aspect of social security:

The report also notes that while most associate retirement with social security, the program covers a lot more. A full 31% of social security benefits are paid out as disability payments or life insurance.

The future financial health of social security is sobering. The report notes that by 2041, "dedicated Social Security taxes coming into the program will cover only 75 percent of the benefits promised under current law." Social Security benefits now represent 4.3 percent of the nation's gross domestic product, but this percentage is expected to rise to 6.2 percent by 2030. This rise is the result of the aging of the baby boomers combined with the simple fact that people are living longer.

Source: National Academy of Social Insurance

I definitely do want to open a Roth IRA as soon as possible because I hear it's typically better than the Traditional IRA. However, I'm not certain whether one should be putting money way in one's 401K or Roth. As you can tell, I'm not that financially knowledgeable. I do have some credit card debt that shouldn't take too long to pay off and of course I have some student loans. I'm guessing you're recommending me to pay off my credit card debt first before opening a Roth IRA. My student loans on the other hand will take a while to pay off.

I receive questions like this a lot, and so today we'll walk through an approach you can use to answer these questions for yourself.

Save versus pay off debt--it doesn't really matter

If you are living below your means and either saving/investing the difference or using the excess cash to pay off credit cards, you're moving in the right direction. Certainly you can base your decision by comparing the interest rate on the credit cards and the returns you believe you'll earn on your investments. If the interest rate on the credit card is higher than the returns you're likely to earn on the investments, the math would tell you to pay of the debt first. Fine. But the reality is that if you consistently live below your means, in the long run it probably won't matter in which order you invest or pay of debt. If your debt is at a very high interest rate, though, paying it off first is probably best.

Also, the decision is not all or nothing. You can split your excess cash between savings and paying off debt. That's what I do. And if you have a lot of debt that will take years to pay off, I believe waiting that long to save for emergencies and retirement generally is a mistake. Even if you save just a little, developing the habit of saving and investing is too important in my opinion to be put on hold for too long.

Does your employer match 401(k) contributions?

Whether your employer matches contributions is important both to the question of investing versus debt reduction and investing in a 401(k) versus Roth IRA. If there is a match, failing to take advantage of it is leaving good money on the table. Of course, there could be situations where your finances are in such dire shape, that contributing to a 401(k) is impossible. But apart from extreme situations, an employer match is a significant incentive to contribute enough to a 401(k) plan to take advantage of the match.

Investing in a 401(k) versus Roth IRA

There are a number of factors to consider here:

• Does your income qualify you to invest in a Roth IRA? You can see the limits in my article about what's new in 2008 for traditional and Roth IRA accounts. We'll assume that you can invest in a Roth IRA.
• Does your employer match 401(k) contributions? As mentioned above, if your employer does match contributions, the 401(k) is probably the best bet. We'll assume going forward that your employer does not match your contributions
• How old are you? This may seem like an odd question, but here's why it's important. If you are in your 20s or 30s, you likely are in a relatively low tax bracket. Therefore, paying taxes on your Roth contributions today is likely to be more profitable than waiting to pay the taxes in retirement. In fact, if you use one of the many calculators to determine which is better (here's one), you'll find that they almost always favor the Roth, particularly if you are in a low tax bracket.
• What will you do with the tax savings if you invest in a traditional retirement account? Because traditional 401(k) contributions are excluded from income tax, you'll have more take-home pay than if you invest in either a Roth 401(k) or a Roth IRA. If you invest that savings, than the choice between a Roth and traditional savings vehicle is generally a close call (although I still am partial to Roth accounts). But if you don't invest that savings, the Roth is a clear winner.
• What are your investment options in your 401(k)? Unfortunately, many 401(k)s don't offer great investment choices. That the situation I have at my job. We have a couple hundred options, and with the exception of a couple of funds, they are all bad. Most of them have expense ratios of more than 1%. With a Roth IRA, you can choose where to open the account and invest in just about anything.
• When will you need the money? When and under what circumstances you can take money out differs between a 401(k) and an IRA. What your loved ones can do with the dough if you pass away is also different. These might not be major considerations for you, but if they are, I can recommend two books:
  
  

  I have both of these books, and they are very informative.

• How much do you have to invest? The contribution limits are higher for a 401(k) than a Roth IRA. Of course, you could always max out the Roth IRA and invest in a 401(k).
• One final thought--consider tax diversification. The fact is we don't know what tax rates will be a year from now, let alone when we retire. So keep in mind that you can invest in both a traditional 401(k) and a Roth IRA retirement account (assuming your income doesn't disqualify you). And if your employer offers a Roth 401(k), there is no disqualification based on your income. This is the approach I plan to take now that my employer offers a Roth 401(k).

Are there other factors you consider in making these decisions?

The IRS each year issues a very helpful and thorough publication about Individual Retirement Accounts or IRAs. Called Publication 590, the document covers traditional IRAs, Roth IRAs, SIMPLE IRAs and other related issues. The IRS just released its 2007 edition (it comes at the end of the year). It's available as a pdf, but be warned, it weighs in this year at a hefty 108 pages. You can download it here. It's also available in an html version here, but I much prefer the pdf version. If you're not interested in trudging through a 108 page tome, however, here is what's new for 2008.

Traditional IRA contribution and deduction limit

The contribution limit to your traditional IRA for 2008 will be increased to the smaller of the following amounts:

• $5,000, or
• Your taxable compensation for the year.

If you were age 50 or older before 2009, the most that can be contributed to your traditional IRA for 2008 will be the smaller of the following amounts:

• $6,000, or
• Your taxable compensation for the year.

Roth IRA contribution limit

If contributions on your behalf are made only to Roth IRAs, your contribution limit for 2008 will generally be the lesser of:

• $5,000, or
• Your taxable compensation for the year.

If you were age 50 or older before 2009 and contributions on your behalf were made only to Roth IRAs, your contribution limit for 2008 will generally be the lesser of:

• $6,000, or
• Your taxable compensation for the year.

However, if your modified adjusted gross income (AGI) is above a certain amount, your contribution limit may be reduced. For example, if you are married and filing a joint return, you generally cannot contribute to a Roth IRA if your AGI is $169,000 or more in 2008.

Modified AGI limit for traditional IRA contributions increased

For 2008, if you are covered by a retirement plan at work, your deduction for contributions to a traditional IRA is reduced (phased out) if your modified adjusted gross income (AGI) is:

• More than $85,000 but less than $105,000 for a married couple filing a joint return or a qualifying widow(er),
• More than $53,000 but less than $63,000 for a single individual or head of household, or
• Less than $10,000 for a married individual filing a separate return.

If you either live with your spouse or file a joint return, and your spouse is covered by a retirement plan at work, but you are not, your deduction is phased out if your AGI is more than $159,000 but less than $169,000. If your AGI is $169,000 or more, you cannot take a deduction for contributions to a traditional IRA. Note, these limits determine whether you can deduct your IRA contributions, not whether you can make an after-tax IRA contribution.

Modified AGI limit for Roth IRA contributions increased

For 2008, your Roth IRA contribution limit is reduced (phased out) in the following situations.

• Your filing status is married filing jointly or qualifying widow(er) and your modified AGI is at least $159,000. You cannot make a Roth IRA contribution if your modified AGI is $169,000 or more.
• Your filing status is single, head of household, or married filing separately and you did not live with your spouse at any time in 2008 and your modified AGI is at least $101,000. You cannot make a Roth IRA contribution if your modified AGI is $116,000 or more.
• Your filing status is married filing separately, you lived with your spouse at any time during the year, and your modified AGI is more than -0-. You cannot make a Roth IRA contribution if your modified AGI is $10,000 or more.

Modified AGI limit for retirement savings contributions credit increased

For 2008, you may be able to claim the retirement savings contributions credit if your modified adjusted gross income (AGI) is not more than:

• $53,000 if your filing status is married filing jointly,
• $39,750 if your filing status is head of household, or
• $26,500 if your filing status is single, married filing separately, or qualifying widow(er).

Rollovers from other retirement plans

For 2008, you can roll over amounts from an eligible retirement plan into a Roth IRA. Before, you had to roll over amounts to a traditinFor more information, see Rollovers from other retirement plans in chapter 2.

Statement of required minimum distribution

If a minimum distribution is required from your IRA, the trustee, custodian, or issuer that held the IRA at the end of the preceding year must either report the amount of the required minimum distribution to you, or offer to calculate it for you. The report or offer must include the date by which the amount must be distributed. The report is due January 31 of the year in which the minimum distribution is required. It can be provided with the year-end fair market value statement that you normally get each year. No report is required for section 403(b) contracts (generally tax-sheltered annuities) or for IRAs of owners who have died.