Retirement Accounts
Retirement accounts are a great way to save for the future. The benefits are numerous. Some include tax-free earnings for Roth IRA's and pre-tax money going into a 401(k) account with the taxes on earnings deferred until the money is withdrawn from your account. But these benefits apply only when you are willing to follow the rules and not pull out your money early. If you do and do not meet special conditions, you are penalized for your early withdrawal.
There are two investment vehicles that are seen as great tax shelters, the Roth IRA and the 401(k). Typically the advice that most investors will give is that you should max out your employer 401(k) contribution, max out your Roth IRA contribution, and then invest the rest of your retirement money into a 401(k). However, this advice only applies under the assumption that there is no radical change in the economy and that you will not need this money in the next 20-40 years.
The conventional wisdom in virtually every investing and money advice is that you should put your money into these retirement accounts. Under most circumstances, I would agree and would put my money into the accounts. However, peak oil changes everything and clouds the future.
If you believe that peak oil will have a significant impact on everyday life and that it will require funds to overcome, you should think twice about starting (or continuing) investing into your retirement funds. In the remainder of the blog I will discuss the availability of tapping those retirement funds in case of the "Long Emergency" and what readers should consider doing in light of peak oil.
Peak Oil: The X Factor
My knowledge of peak oil makes me extremely wary of putting my money into any investment vehicle that cannot be withdrawn (without penalties) until I turn 59 1/2. For me, that would be 35 years in the future and I personally believe that I will be able to use my money much better if I kept liquid assets. Peak oil will have a tremendous impact on the economy and way of life.
In a world of declining oil supplies and increasing demand, keeping your assets liquid will be vital to adapting to the new economy that emerges. It would be a terrible waste to have all of your hard earned money trapped in a retirement account that you cannot access without heavy penalties, even though you desperately need the money because of peak oil.
I do not necessarily share the same alarmist views like James Howard Kunstler (author of The Long Emergency), but do believe that there will be significant changes. Willingness to adapt, and for better or worse, money, will be the key factors that will determine the quality of life after peak oil. Thus, it is important to ensure that you have access to as much of your money as possible.
Roth IRA
Roth IRA's in 2008 have a $5000 annual contribution limit with post-tax dollars. The reason why the Roth IRA is a great investment vehicle is that all of the earnings and contributions can be withdrawn (under the proper rules) tax free. This is the reason why most people choose to max out their Roth IRA accounts if possible.
Contributions made to the Roth IRA can be withdrawn at ANY TIME penalty free. The only penalties will be assessed is if earnings are withdrawn. If the earnings are withdrawn before 59 1/2 and not within the hardship withdrawal rules, then they will be subject to a 10% penalty and will be treated as taxable income. This will hurt those who are in high federal income tax brackets and investors in states with state income taxes.
Roth IRA Example: Tom invests $5000 for two years for a total of $10,000 in his Roth IRA account. At a later date, the value of his Roth IRA account is $20,000. Let's say that Tom wants to close the account and withdraw the entire balance. Because the $10,000 is a contribution that has already been taxed, he gets all of that money tax free.Because the contributions can be withdrawn at any time penalty free, the only disadvantages to investing in the Roth IRA the penalty on the earnings and the earnings being treated as taxable income if it is not a qualified withdrawal. However, the penalty is a non-trivial amount and if you are not looking to invest in a Roth IRA
However, the $10,000 in earnings is subject to the 10% penalty ($1000) and any Federal or State Income taxes. Let's assume he pays no state income tax and his marginal federal income tax rate is 25%. That means that he will have to pay $2500 of taxes in addition to the $1000 penalty, resulting in a net of $6500 from the $10,000 earned.
401(k)
Although there is the Roth 401(k) option also available, I am going to focus on the 401(k) because most people choose this option in combination with a Roth IRA. This is to diversify your investments and hedge against changes in tax policy. The Roth IRA offers investments that are post-tax dollars, whereas the 401(k) account allows you to use pre-tax dollars. The only difference between the Roth 401(k) and 401(k) is that the Roth 401(k) is funded with post tax money.
The 401(k) is funded with pre-tax money and will be taxed upon withdrawal. The maximum contribution for 2008 is $15,500 unless you qualify for "catch up" payments. Most investors recommend contributing to a 401(k) because the investment starts with a higher principal because it is pre-tax, the earnings can compound tax-free until withdrawal, and the tax bracket at retirement will be lower than when the 401(k) money was contributed. The 401(k) has the same penalty 10% penalty as the Roth IRA and anything withdrawn from a 401(k) will always be considered taxable income.
The main benefit with a 401(k) is that many, if not most employers offer some sort of match. For some it is 33%, 50% or even 100% of the employee contribution up to a certain percentage. Although an early withdrawal will incur a 10% penalty (income taxes must be paid on 401(k) whether it is withdrawn early or in a qualified distribution), it is still wise to invest in order to get your employer 401(k) contribution
401(k) Match Example:Sally contributes $5,000 to her 401(k) and her employer has a 100% match. Let's say that she is fully vested in the employer match and thus she has $10,000 in her 401(k) account.My Thoughts
If Sally decides to take out the money from her 401(k) and does have a qualified distribution (see above), then she will have to pay a 10% penalty on top of income tax. Let's assume that she is in the 25% tax bracket and pays no state income tax. Her penalty will be $1000 and the taxes will be $2500, which leaves her with $6500.
If Sally would have taken her $5000 and put it into a non-401(k) fund, she would have only had $3750 after taxes, which is a little over half of what she would have made with an employer 401(k) match after penalties and taxes.
What do I plan to do? I have thought long and hard about this topic because it could end up being a matter of survival.
Currently I am not contributing to my 401(k) stock plan because I don't get a company match. However, starting in January next year, I will get a 50% match on up to 6% of my income. I will contribute to my 401(k) fund to get my full company match because it would be foolish to give up free money from your employer. Simply put, contribute to get your company match, because you will still make more money even after the penalties.
I am still undecided if I want to contribute to my Roth IRA. I still have until April 15th to contribute $4000 to my 2007 account. "Conventional" wisdom says that you should max out your Roth IRA because it will provide you with the most income when you retire due to the tax free earnings. I agree completely with this statement under "conventional" circumstances. But unfortunately peak oil is far from conventional and will affect us more than most expect. All is not lost if you invest in a Roth IRA and take an early withdrawal, because you can get back your contributions tax free and earnings after penalties and taxes.
Is it better to just take it and invest in a mutual fund or is the Roth IRA and early withdrawal the best method? Unfortunately there is no clear answer for this because it depends on a variety of circumstances. Any earnings from a long term investment (over one year) is currently taxed at 15% for tax brackets 25% and higher.
Naturally, this is better than being taxed at the marginal tax bracket. However, in a non tax-advantaged account, taxes may have to be paid on dividends which will affect the investment compounding. Additionally, the earnings in the Roth IRA account will be penalized by an extra 10%.
What you choose to do related with your retirement accounts should be dependent on how significant you think that peak oil will affect our economy, our country, and our world. I tend to have a non-optimistic view of peak oil and think that we will face a serious crisis. It may not be catastrophe that Kunstler describes, but I believe that it will be significant enough seriously rethink contributing to retirement accounts.
In the end it is up to each person to decide how they should invest their money. If you believe that it is more serious, consider keeping more OUT of retirement accounts and as liquid as possible. This will help you have the flexibility to adapt to the new environment.
If you think that peak oil will be overcome by technology, innovation, and "the market", then it would be wise to keep as much money in the retirement accounts as possible, because they offer the best tax shelter for your money.
Either way, I hope that you are saving money in one form or another and continue to look out and plan for your financial future.
- The Party's Over - Richard Heinberg: Book Review
- Peak Oil: Are we on our way down?
- Shell CEO Virtually Admits to Peak Oil
- Energyville Part I: How Will you Power it?
- Energyville Part II: The Discussion
- The Long Emergency: Surviving the End of Oil, Climate Change, and Other Converging Catastrophes of the Twenty-First Century
- James Howard Kunstler
- The Party's Over: Oil, War And The Fate Of Industrial Societies
- Richard Heinberg
Review - PowerDown - Richard Heinberg
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