Hopefully I have given you enough tease to get you curious about the tax advantages of a retirement savings account. I recommend you peruse these introductory posts to gain a basic understanding of retirement saving before reading this number-heavy post.
Chances are you have heard about the tax advantages of a 401(k) or IRA somewhere before. Let me sum up and illustrate in an easy-to-understand way, and as always, I’m available to answer questions.
Let’s clarify this first: retirement savings accounts have tax advantages over what?
Like a 401(k), an IRA is a retirement savings account. You put money in it, and use that money to invest. But unlike a 401(k), an IRA does not have an employment requirement. IRA stands for Individual Retirement Account; anyone, even if he is not employed, can contribute to an IRA unless his income is too high. This works perfectly for freelancers such as my friends that are dancers and do not work for any particular company.
This post has 3 parts. Part 1, I explain what a 401(k) is. Part 2, I explain how you contribute to a 401(k). Part 3, I explain why you should contribute to a 401(k).
Part 1. What the heck is a 401(k)
A 401(k) is a retirement savings account sponsored by employers. In order to contribute to a 401(k), you need to be employed.
I’m sure you have heard of these terms before. They probably appear on the media more frequently than the Kardashians. Traditional 401(k), Roth 401(k), Traditional IRA, and Roth IRA are 4 types of retirement savings accounts.
“Saving” is a funny word in this context. It may not mean what you think it does.
In my previous post, I hinted at why putting your money away in a checking account may not be a good way to save for retirement. Let’s compare this strategy with investing the money saved away. Consider this graph which I used for another post (“The power of compound interest”) a while ago:
After 40 years, by investing your money, you will end up with 4 times the amount you contributed. 4 times. In other words, investing your retirement saving basically cuts the amount you need to save by 75%. Instead of saving 40k per year, now you only need to put away 10k per year.
OK, let’s face this. I am in my 20’s. If you are reading my blog, you are probably in your mid-20’s as well. What’s up, retirement? Geez, why care about anything 40 years out?
Well, I’m an actuary, so I speak in terms of probability. What if I’m one of the (un)lucky few bastards that make it past 65 years old? Well, first off, I will most likely be out of jobs. And secondly, my health will not be cheap. Think more doctor visits, more ways to exercise, healthier food, higher health insurance premiums. And I may want to give something to my grandchildren if they choose to attend Harvard….
Where does the money come from?
As you know, this summer I wrote two blog posts on the AMR Corporation and US Airways Group merger to explain how it affects AAMRQ stock price. Using the information available at that time I derived a formula to estimate AAMRQ stock price based on LCC stock price:
I know I mentioned that I would write more about the AAMRQ stock case if there was a huge surprise. And there was a huge surprise when the Department of Justice filed an antitrust lawsuit against AMR Corporation and US Airways Group, but this happened when I was entangled with a few life issues, so I had to skip.
Not to say that I am much less busy now, but I thought this case deserves another mention. Caution: math abound ;)
I don’t have much time to comment much on this merger right now, so I will just go ahead and post what I consider to be the final AAMRQ conversion formula:
AAMRQ stakeholders officially receive 544.4 million AAL shares. Each AAL share is worth an LCC share. Using the approximate number of AAMRQ shares outstanding 335.5 million, and the approximate debt of $8 billion, the share conversion formula is:
I wrote in “Personal Finance 201: Credit scores” about how FICO scores are almost the only credit scores that matter. Most large financial institutions such as Bank of America, American Express, Discover Financial Services, and Citigroup, rely on FICO scores for creditworthiness measurement. Knowing your FICO scores is helpful in timing your credit application; a few points difference in credit scores can translate to thousands of dollars of payment on your mortgage.
Based on the table above, the difference between the first category and second category of credit scores translates to a difference between a 4.236% and a 4.014% on 30-year mortgage loan. For a $300k mortgage loan, the difference in payments is approximately $39 per month, which comes out to be around $460 per annum, or $14,000 over the duration of 30 years.
In a previous post: Credit Card vs Debit Card, I explained the basic differences between credit cards and debit cards. Unless you have trouble controlling spending, credit cards are a much better choice for your regular method of payment. If my previous post didn’t twist your arms, I’m offering you more reasons to favor credit cards over debit cards (and cash, of course!)
- Credit cards help build credit
- Credit cards give you better fraud protection
- Credit cards give you the ability to dispute charges previously paid for
- Credit cards cover warranty extension
- Credit cards offer 60-day return on most merchandise
- Credit cards cover rental car insurance
- Credit cards cover travel insurance
- Credit cards cover luggage delay reimbursement
- (Some) Credit cards provide free concierge service
- (Some) Credit cards offer rewards on purchases
What do you think? Are you convinced that you should buy everything with a credit card now? Let me know if you’re still looking for justification… ;)
Usual warning: none of these reasons applies if you can’t control your spending. :|
Richard (Hiep Tran)