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The very best way to sock money away

Here's the least you should know:

Annuity: An insurance contract that assures regular payments for life or for a fixed period.

Certificate of deposit (CD): A short-term security that "matures" within a matter of weeks to several years.

Compound interest: Interest credited on both the initial investment and the interest that the money has already earned.

Deferred annuity: Actually, taxes on its growth are deferred, not the annuity payments.

Fixed annuity: Annuity whose guaranteed interest rate protects it from market risk.

401(k) plan: Retirement plan offered by your employer. 401(k) refers to the IRS section code that allows pre-tax dollars to accumulate tax-free until withdrawal.

403(b) plan: Nearly the same as a 401(k) but for employees in the education or research fields.

Individual Retirement Account.

(IRA): Your own tax-deferred retirement account that is not associated with your employer.

Load: Flat fee charged on annuities. Front-end load policies charge the fee up front; back-end loads are charged at policy surrender. A no-load annuity doesn't charge this particular fee.

Non-qualified plan: Retirement or pension plan that the IRS does not recognize for preferential tax treatment, such as the deferral of taxes.

Qualified plan: Retirement or pension plan that does qualify for preferential tax treatment.

Rollover: To transfer one qualified account to another qualified account, usually without penalties.

Tax deferral: Putting off your tax liability on investment earnings, usually until retirement.

Variable annuity: An annuity invested in underlying securities whose values fluctuate based on the performance of those securities (see also Annuity).

If you are currently between ages 20 and 29, do you think Social Security will exist in 2040? Are you enrolled in a 401(k) or other qualified retirement plan? Do you know what the heck a qualified retirement plan is?

Between your rent, car payment, student loans, and credit cards, you're probably lucky to have enough money to go out this weekend. However, no matter how empty your wallet is, you should be saving money every week for the rest of your life. If not now, when?

According to the U.S. Census Bureau, the majority of men and women age 22 to 29 earn between $25,000 and $35,000 a year. Not a whole lot to get by on, let alone to save. Sixty percent of that same group carry credit card balances month to month, compared with an industry overall average of 46 percent, according to PSI Global, a market-research firm in Tampa, Fla. Your typical unpaid balance is $3,128, which is 29 percent higher than the average of $2,438.

So if a good chunk of your paycheck is used to pay debts, you're already in credit overload and probably not saving much. Maybe you got into the credit habit in college or maybe it was when you landed your first "real" job.

Bad financial planning will dog you for years. The sooner you take control of your money, the better.

Are you 401(k) okay?

The very best financial decision you can make in your early 20s is to participate in a tax-deferred retirement plan, such as a 401(k) or an IRA. It should be the foundation of your financial planning. Stashing savings into one now will make a huge difference when you retire.

Maybe your employer offers a 401(k). If so, they might have a "matching fund" plan. This is free money to you — take advantage of it! A 401(k) retirement plan allows you to sock away pre-tax dollars while deferring taxes on the earnings.

Translation? The federal income tax on your gross pay is applied after your 401(k) deduction is taken. You don't pay taxes as your investment grows, but you'll pay income tax when you take the money out, presumably at retirement. (For example, a 25-year-old who grosses $500 per week and contributes $25 each week into her 401(k) would pay federal withholding taxes on $475 per week.)

If you're not quite disciplined enough to consistently contribute to your retirement plan on your own, have it deducted from your paycheck and you won't feel a thing. There are no minimum-contribution rules, and the most you can usually sock away is between 10 percent and 15 percent of your gross pay. The amount of money matched by your employer varies, so check it out when you are eligible to enroll in the plan.

Your 401(k) money is pooled in a variety of investments called subaccounts, which are often mutual funds or bond funds. You have control over the subaccounts and can change the allocations without tax penalties on the gains as long as you do not withdraw any money.

For younger entrants into the 401(k) market, it's a good idea to max out your contribution. If one thing is certain, it's that you'll never have as much money as you want by the time you're ready to retire. The more you save now, the less you'll have to save later.

Information on subaccounts can be confusing. Most employers provide a range of subaccounts, from low risk to high risk. Spread the risk around so you'll at least have some money no matter what happens to the economic market. After all, the stock market doesn't always stay high, as we've seen at the beginning of the 21st Century.

Individual Retirement Accounts

If you don't have access to a 401(k), then open an IRA. This is sort of like your own private 401(k) and could require a minimum contribution to start. Fidelity Investments, for example, requires $500, while Prudential Securities has no minimum requirement. Additional contribution amounts are flexible, and you can put up to $2,000 a year into an IRA account; $4,000 if your spouse works; and $2,250 if one works and one doesn't.

If you don't have access to a 401(k), open an IRA.

The newer Roth IRA has some neat features you should consider. While a regular IRA taxes withdrawals as ordinary income, the Roth IRA is free from federal and most state taxes when the initial contribution stays in the account for five years and when you reach age 59 1/2 or die or become disabled or (here's the goody) withdraw $10,000 to purchase a first home. So it's a great way to save for a house, too.

Banks are big sellers of IRAs, offering various interest rate calculations and minimum amounts required to start an account. For instance, in Florida, NationsBank offers a fixed or variable rate IRA with $500 and $100 minimum contributions, respectively.

Are annuities good for 20-somethings?

An annuity does basically the same thing a 401(k) and an IRA do: allows you to save for retirement while deferring taxes due on the investment gains. A variable annuity (VA) is invested by an insurance company in a variety of underlying securities, including mutual funds, whose return may vary. You can choose the subaccounts into which your money is invested. A VA often also carries life insurance that will upon your death pay out at least what you've paid in to your beneficiary. Upon withdrawal at retirement, you can annuitize, i.e., elect to receive lifetime payments. If you die at a ripe old age, the insurance company loses money. If you die a year after you annuitize, the insurance company will keep the rest of your money. If you die before you annuitize, your beneficiary inherits what you've put in plus what the annuity has earned (and the tax liability that comes with it), minus various administration, mortality, and expense fees.

There's an argument that says VAs should not be sold for retirement planning because of their high expense fees and penalties for early withdrawal, although more than half of VAs are, in fact, sold to fund tax-deferred retirement plans such as 401(k)s and IRAs, according to the Life Insurance Marketing Research Association. Annuities also defer taxes, but critics argue the "double deferral" is useless and expensive. The average VA carries 2.08 percent in fees, not including load and surrender charges.

With that said, however, annuities do serve a purpose for certain groups of people: those who have contributed the maximum to either their 401(k) or IRA and those nearing retirement who are looking for less risk and more guarantee on their money. Therefore, many financial-planning experts outside the insurance business rarely recommend annuities for 20-somethings. If you've maxed out all your other means of tax-deferred savings and still have money available to save, then a variable annuity might be a good place to consider.

Many financial-planning experts outside the insurance business rarely recommend annuities for 20-somethings.

If you're in your 20s, annuities are typically not at the top of the list of best places to save. Look around for options that give you higher guaranteed rates of return with limited administrative fees, and limited tax accountability on the earnings.

Tax-deferred variable annuities contracts carry surrender charges up to seven percent that decline each year until they disappear. Also, the government charges a 10 percent penalty for taking your money out if you're under 59 1/2. And you must report that money on your income taxes. So, for instance, if you decided you had to raid your annuity and the balance is $1,000, you'd get around $640 (assuming a 20 percent tax bracket and a 6 percent surrender fee). That's a 36 percent loss — not a smart thing to do.

Mutual fund mania

For many years, mutual funds had high returns. The stock market pushed the performance ratios of these accounts way up, but may also have dragged them down in recent years. While it's true that mutual funds performed very well, and may perform well again, novice investors should steer toward a qualified retirement plan first. Mutual funds are pure "earners" — they don't shelter your money but rather seek to accumulate it. Theoretically, you liquidate your mutual fund at retirement and invest it in the type of annuity that begins payout immediately.

Mutual funds carry an average fee of a modest 1.3 percent. Profits on mutual funds are subject to capital gains tax (20 percent), which applies each time you move your money from fund to fund.

Stop spending! Start saving

Most experts agree that it doesn't make sense to start a savings program if you're up to your ears in debt, particularly credit card debt. Pay down your balances before you do anything else. Then cut up your cards and take a hard look at your spending habits. Otherwise, you'll probably be your parents' age by the time you pay off the round of drinks you bought last weekend.

By paying the minimum payment on a $4,500 balance on a revolving credit card, it will take you more than 44 years to pay it off, assuming you never charge anything else again. You should always pay more than the minimum, which is calculated at a mere 1.5 percent to 2.5 percent of the balance.

The power of compounding

Save your money now and retire in comfort.

There are two ways of charging interest: simple and compound. The interest charged on your credit card balance (and, similarly, interest earned on most investments) is compounded, which means that the credit card company charges you interest on your previous interest, as well as on new purchases and late fees.

 
12% per yr. growth in stocks

18% per yr. growth

in credit card debt

To start

$3,000

$3,000

Year 1

$3,360

$3,540

Year 5

$5,287

$6,863

Year 10

$9,317

$15,701

The original debt could have been paid off with the $3,000 windfall. Instead, 10 years later, the credit card debt has far outpaced her 12 percent investment growth.

But compounding works in your favor, too. For example, say you invest $100 in an investment account that earns 5 percent per year. At the end of the first year, you'll have $105. The interest earned in the second year is figured on $105. This goes on and on, year after year.

If you can manage to save consistently (emphasis on consistently) even $1 a week, this is what should happen*:

Initial investment at age 25
Additional contribution
Value at age 65
$1,000
$1/wk.
$45,259.26
$1,000
$10/wk.
$298,422.20
0
$1/wk.
$25,316.29
0
$10/wk.
$253,162.94

*Assumes a 25-year-old who will retire at age 65.
Thus, the "accumulation period" is 40 years.

Social in-security

It used to be that retirement income hinged on three things: Social Security, company-sponsored retirement, and personal savings. These days, you're lucky to have one and smart if you have two. It's estimated that Social Security will begin to run short of funds in 2029. Although politicans might find a solution to Social Security's potential insolvency, many of the younger Baby Boomers and Generation Xers are not counting on it. This means that saving for retirement could be entirely up to you.

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