You are in a business partnership with a friend. Your friend gives you the following choices for splitting the profits:

		Pay her 40 percent of the profits at the end of every year. of the market is that you are not maximizing the power of time in your investment program.
		Pay her just 20 percent of the profits, and you can pay her one year from now, five years from now, 20 years from now, 50 years from now, whenever. You choose when you want to pay.

Which offer would you take? Only a fool would choose the first option, right?

You'd be surprised how many fools there are in this world.

Whether you like it or not, Uncle Sam is your investment partner. The more your investments make, the more he makes.

But like the partner in our example, Uncle Sam gives you some attractive options for paying his share. You can pay Uncle Sam up to 40 percent of your investment gains at the end of every year. Or you can pay a maximum of 20 percent of your investment profits, and defer payment indefinitely.

Actually, Uncle Sam's offer is even better than your friend's deal. If you want, Uncle Sam allows you to leave your investment profits to your heirs, and they don't have to pay a dime to Uncle Sam. Better still, Uncle Sam gives you a way to avoid paying him altogether.

Trim Taxes by Holding Stocks for a Long Time

Uncle Sam gives you a huge tax break if you hold investments for 12 months or more. Indeed, if you are in the top tax bracket (39.6 percent), the tax savings of holding investments for a year or more are 100 percent (20 percent long-term capital gains tax versus 39.6 percent tax on short-term gains).

Money that you keep from Uncle Sam is money that continues to grow for you. That's the true power of tax deferment. Not only do you pay Uncle Sam a lower percentage of the profits if you hold investments for at least 12 months, but you earn money the longer you defer paying Uncle Sam his cut.

Let's look at the tax impact from another angle. If you sell an investment before you've held it for 12 months, you need to put my money into an investment that will at least compensate for the money I lost paying the higher capital-gains taxes. If you have a decent gain on the stock you sold, that means your new investment may have to rise 10 percent or more just to cover the taxes.

That 10 percent may not sound like much until you remember that the average annual return for stocks since 1926 is 11 percent. In short, by not holding a stock for 12 months or more, you've effectively lost to taxes one year of expected appreciation. When you're trying to build a seven-figure portfolio, you cannot afford to give back one year of growth in a stock due to taxes.

Smart investors play the percentages. What you know for certain when you sell investments prior to holding them for 12 months is that you'll get a big capital-gains tax bill. That's a given. What you don't know is if the new investment will do any better than the one you sold. Don't you think you ought to at least tilt the odds that your new investment will do better than the old one by reducing the new investment's hurdle rate?

Moral of the story: Uncle Sam is making you an offer you shouldn't refuse. Even if you aren't in the top tax bracket, you still save valuable dollars holding investments at least 12 months. In short, you can't afford not to hold investments for at least 12 months. The tax break is just too great. Further, you can't afford not to defer selling as long as possible. Every day you defer paying taxes to Uncle Sam is one more day Uncle Sam's interest-free loan earns you money.

401(k) Plans

You won't find a better deal in the investment world than a 401(k) plan.

Every dollar you invest lowers your tax bill.

Every dollar you invest grows tax deferred.

In most cases, your company matches a portion of your contribution.

And all this from Uncle Sam?

As hard as it is to believe, the answer is "yes." But understand that Uncle Sam isn't giving you 401(k) plans out of the goodness of his heart. Uncle Sam is abdicating responsibility for your retirement. Uncle Sam is saying that Social Security is a giant Ponzi scheme. Uncle Sam is saying you better take advantage of a 401(k) plan. It just might be all there is when you're old and gray.

401(k) Nuts and Bolts

401(k) plans are so named because they were given birth by Section 401(k) of the Internal Revenue Code. Section 401(k) allows employers to offer a way for their employees to delay payment of taxes while saving for retirement. The counterpart to a 401(k) plan for workers in tax-exempt organizations (schools, hospitals) is the 403(b) plan.

Under a typical 401(k) or 403(b) plan, a portion of your pay (the portion is determined by you) is deposited in an account in your name. Your employer establishes the plan and contracts with a 401(k) provider to administer the plan. Your employer provides a menu of investment choices for 401(k) participants. These choices usually include the employer's stock (if the company is publicly traded) as well as stock, bond, and money-market mutual funds. Participants in the 401(k) choose where their contribution is invested. Participants direct their funds into any or all of the funds based on percentages. For example, a portion of your 401(k) contribution may be deposited in a growth mutual fund, a portion in a bond fund, and a portion in a money-market fund. Most 401(k) plans provide the ability for participants to change their allocations, usually at least quarterly and even daily in some plans.

One huge benefit of 401(k) plans is that your contributions are made with pretax dollars. Neither federal nor state income taxes are withheld from this money. Because the amount you contribute to your 401(k) plan is not included on your W-2 form as taxable wages or income, your 401(k) contribution reduces your yearly tax bite.

Another plus is that funds in your 401(k) grow tax deferred. You pay taxes only when you withdraw your money.

And if the tax benefits weren't enough, a 401(k) plan offers one more big advantage — free money. Most employer 401(k) plans offer "matching" contributions.

To summarize, 401(k) plans offer a bounty of benefits for investors:

		No muss, no fuss investing. Since you invest via payroll deduction, you don't have to write any checks. The only decisions you need to make are how much to contribute and where to invest the contributions. Your employer does the rest. Your investment program is truly on autopilot. Investment programs on autopilot are programs that are the most likely to endure.
		Low minimums, high maximums. If you make $100 per week, you can invest one dollar in many 401(k) plans. Anyone can afford to invest $1 per week. And if your paycheck is bigger, you can invest as much as $10,500 (the 2000 maximum). That amount is much greater than the $2000 upper limit in Individual Retirement Accounts.
		Tax benefits. Contributions to a 401(k) plan will not incur federal and state taxes and will lower your taxable income.
		Employer match. If your employer matches contributions, your money compounds quickly, especially when you include the tax benefits.
		Flexibility. Most 401(k) plans allow you to increase or decrease your contribution, usually every three months or so. You can change your allocation among investment options. Some plans permit you to borrow from your 401(k) plan. A number of plans permit after-tax contributions to 401(k) plans. To find out the details of your employer's plan, talk to your benefits department.

401(k) Dos and Don'ts

The 401(k), if managed properly, is the best investment deal available for individual investors. Don't blow this opportunity by doing goofy stuff:

		Don't trade your 401(k) plan. Many 401(k) plans, including my employer's plan, permit participants to buy and sell daily. Having a flexible plan is one thing; abusing that flexibility is quite another. Don't trade your 401(k) investments simply because you can. Trading investments is a bad idea, whether the investments are in a 401(k) plan or not. Granted, you don't incur the tax penalty by frequently trading within a tax-preferenced account such as a 401(k) plan. Still, reinvestment risk — the risk that what you buy doesn't do as well as what you sell — is still great. You'll probably trade 401(k) investments based on fear — these are, after all, retirement funds — and trading on fear is particularly deadly for an investment program. Pick an investment allocation depending on your age (you should have virtually all of your funds in equity investments at least until you are in your 50s) and stay with it through the market's ups and downs.
		Don't "over invest" in "safe" investments. You need to grow your money in a 401(k) plan if these funds are going to take care of you come retirement and beyond. You won't grow your money investing in bond funds or guaranteed investment contracts (GICs). You grow your money investing in equity mutual funds.
		Contribute as close to the maximum as you possibly can. The 401(k) plan is simply the best deal you'll likely ever get. You need to maximize this opportunity. In fact, you have no business investing in any other vehicle — including individual stocks — until you max out contributions to your 401(k) plan.
		Don't fall in love with your company stock. Some companies make it extremely attractive to buy company stock in their 401(k) plans. I have nothing against an employee owning his or her employer's stock. As an employee, you should own your company's stock. There's nothing like having an equity stake in your company to give you a push. And you probably know your company pretty well. Many employees at certain companies (can you say M-I-C-R-O-S-O-F-T?) have become fabulously rich accumulating company stock. Still, you shouldn't abandon prudent portfolio diversification rules simply because you can buy your company's stock 50 cents on the dollar. Try to limit your employer's stock in your 401(k) plan to no more than 35 percent to 40 percent if you're in your 20s or 30s and 25 percent as you approach retirement.
		Your 401(k) plan is not a savings account, nor is it a home equity line. Don't think of your 401(k) plan as a liquid bank account. It is a retirement account. The money is for retirement, not to buy a boat or a house or a car. If you draw on your 401(k) plan before age 59 1/2, you'll likely pay penalties along with taxes. Furthermore, raiding your 401(k) plan impacts the power of time and compounding on these funds. Don't dip into your 401(k). And don't borrow against your 401(k). In 1997, more than 30 percent of participants in plans that permitted loans had loans outstanding. The average loan amount was more than $6000. That's $6000 that is not enjoying the benefits of time and compounding.
		Make sure you roll over 401(k) funds directly. If you change jobs or retire, you don't want to take possession of 401(k) funds, even if you plan to invest them somewhere. Taking possession of the funds may leave you on the hook for taxes and penalties. The best approach is to direct your old employer to send the funds directly to a new qualified plan (such as an IRA) or your new employer's 401(k) plan.

IRAs -- Traditional and Roth

The 401(k) is not the only investment "gimmie" from Uncle Sam. Individual Retirement Accounts provide additional alternatives for retirement investment.

There are two types of IRAs:
Traditional IRA — A traditional IRA lets individuals set aside up to $2000 per year in an investment or investments of their choice. Money contributed to an IRA grows tax deferred. You pay taxes when money is withdrawn. You must begin to withdraw money from an IRA at age 70 _. Whether your traditional IRA contribution is tax deductible depends on the following:

		If you are not covered by a qualified retirement plan at your place of employment, your contribution to a traditional IRA is deductible, regardless of your income. Thus, if you make $500,000 per year at your job, yet you are not covered by a qualified retirement plan, you can make a deductible contribution to a traditional IRA of up to $2000 per year.
		If you are covered by a qualified plan, you may still be able to deduct contributions to a traditional IRA. For the year 2000, a full deduction is available to individuals with adjusted gross incomes of $32,000 or less (single filer) or $52,000 or less (married, filing jointly). For incomes between $32,000 and $42,000 (single filer) and $52,000 and $62,000 (married, filing jointly), partial deduction of contributions is permitted. For incomes above $42,000 (single filer) and $62,000 (married, filing jointly), no deductible contributions are permitted. However, you still can make nondeductible contributions to an IRA of up to $2000. For married couples, the maximum contribution is $2000 per spouse.

The traditional IRA lost luster several years ago when contributions became nondeductible for millions of Americans. The expansion of 401(k) plans and the emergence of the Roth IRA (see below) have also reduced appeal of the traditional IRA. However, any investment vehicle that allows investors to grow their money tax deferred is a vehicle worth considering.

Roth Nuts and Bolts

Remember I said earlier in this chapter that Uncle Sam gives you a way to avoid paying him altogether. That's, essentially, what the Roth IRA gives you — a way to grow your money tax deferred and withdrawal tax free. You pay Uncle Sam not one penny in taxes. Zero.

The Roth IRA is a result of the 1997 Taxpayer Relief Act. Named after Senator William Roth, Jr., the Roth IRA is the best investment deal since the 401(k) plan:

		Money contributed to a Roth IRA grows tax deferred and is withdrawn tax free. In other words, if you invest $2,000 per year in a Roth IRA ($2000 is the maximum per year), and your Roth IRA grows to $1 million, you will never pay a dime in taxes when you start withdrawing that money. This is a big improvement over the traditional IRA in which withdrawals are taxed. In order to withdraw your money tax free, your account has to have been open at least five years and your withdrawal occurs either after you reach age 59 _ or due to disability, death, or if the money is used for expenses under the "first-time homebuyer" rule.
		Anyone is eligible to contribute to a Roth IRA as long as you meet certain income requirements. Single individuals with an adjusted gross income of up to $95,000 ($150,000 for couples filing jointly) can make a full $2000 annual deduction. Partial contributions are allowed for individuals whose adjusted gross income is between $95,000 and $110,000 ($150,000 and $160,000 for couples filing jointly).
		Unlike the traditional IRA, you can make contributions to a Roth IRA if you have earned income even after the age of 70 _ as long as you have earned income.
		Unlike the traditional IRA, you are not required to make withdrawals beginning at age 70 _. In fact, you are never required to withdraw money. If you leave your Roth IRA to your heirs, your beneficiaries do not have to pay taxes on the money either. The ability to leave tax-free income to your heirs makes the Roth an interesting estate-planning tool.
		You can contribute to a Roth IRA as well as a traditional IRA if you have earned income, but the total cumulative contributions cannot exceed $2000 per person per year.
		You can contribute to a Roth IRA even if you contribute to a 401(k) plan.
		Virtually any stock or mutual fund is eligible to be held in a Roth IRA.

The only major downside to a Roth IRA is that money contributed to the plan is never tax deductible. Also, if you withdraw your money before your account is five years old, your earnings may be subject to federal income taxes plus a 10 percent penalty.

Tough Choices

Money is finite. In a perfect world, you would have enough money to fund fully your 401(k) plan and an IRA and still have plenty left over to invest outside of retirement plans. The reality is, however, that you may not have enough money to do all the investing you want. So you have to choose. Do I fund a 401(k) plan or an IRA? And which IRA, a traditional or the Roth? And if I already have a traditional IRA, should I convert to a Roth IRA?

Actually, these choices may be rather simple, depending on your income levels. If your income exceeds the limits for a Roth IRA, the decision is pretty easy — contribute the maximum to your 401(k) plan and consider a traditional IRA with the remainder. If you are eligible for the Roth IRA, I still would max out my 401(k) plan first before investing in a Roth. One reason is the "free money" in your 401(k) plan due to employer matching.

And if you have the choice between a Roth IRA and a traditional IRA, take the Roth IRA.

Does that mean you should convert all traditional IRAs into Roth IRAs?

Not necessarily. In fact, you cannot convert a traditional IRA to a Roth IRA unless your adjusted gross income in the year you convert is $100,000 or less. Also keep in mind that when you convert a traditional IRA, you incur a tax liability. The size of the tax liability depends on whether you are converting deductible or nondeductible IRA funds. If you convert IRA funds that were tax-deductible upon contributions, the entire amount is considered ordinary income for tax purposes. In other words, if you convert a deductible IRA of $40,000 to a Roth IRA, you'll have to pay taxes on the full $40,000.

If you convert a traditional IRA in which contributions were not tax deductible, only the earnings are subject to tax, not the contributions which were made with after-tax dollars.

It makes sense to convert if:

• You have a lot of time until retirement to make up for the tax hit you'll take upon conversion.
• You expect to be in a higher tax bracket when you retire.
• The amount in your traditional IRA is rather small.
• You can pay the taxes without robbing the account.
  

Conclusion

With Uncle Sam's help, it has never been easier to retire a millionaire. 401(k) plans and IRAs, especially the new Roth IRA, are investment vehicles our millionaire investors exploit. Millionaires also exploit the tax benefits Uncle Sam bestows on those who hold investments for at least 12 months.

And Uncle Sam may not be through with his largesse. At the time of this writing, "universal savings" accounts, sweetened tax breaks for IRAs and 401(k) plans, additional cuts in the long-term capital-gains tax rate, even giving individuals control over a portion of their Social Security contributions are all being considered by Congress.

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