Don't Miss Out on Retirement Plan Pretax Dollars
In today's era of immediate gratification, it's hard to convince some people of the need to save for tomorrow. Many who are counting on an inheritance from their parents to pay for their retirement may find their parents living longer and needing it for themselves. When clients ask us how much is enough to save for retirement, we say, "As much as you can." You don't know how long you'll live or how much it'll cost you to live. Let's review some of the benefits of participating in your employer's retirement plan.
The amount you contribute is excluded from current taxationYou can have as much as 100% of your salary up to certain maximum annual amounts automatically deducted from your paycheck and put into your retirement account. Whatever amount you've deducted is excluded from current federal and state taxation, so this means Uncle Sam actually is helping you make the contribution. For instance, if you contribute $100 a month for a total of $1,200 annually and are in the 25% federal tax bracket, your out-of-pocket cost would really be $75 a month or $900 annually—$1,200 minus $300 in federal income taxes you'd have had to pay. In addition, if you live in a state that taxes your income, you'd save that amount of taxes as well.
Whatever you accumulate in your retirement account isn't currently taxedThis means your money grows faster than if it were taxed. For instance, if you contribute $40 every two weeks for 10 years and it gains 8% annually, at the end of 10 years you'll have accumulated $15,945. In 20 years, investing $40 every two weeks will be worth $51,389, and in 30 years it'll become $130,173.
If instead you'd saved that same amount in your own name instead of in a retirement account and it earned 8% annually, and if you had to pay taxes on your earnings at a rate of 25%, the results would have been dramatically different.
The maximum you can contribute to the plan has increased
The Economic Growth and Tax Relief Reconciliation Act of 2001 increased the maximum you can contribute to these plans. This law acknowledged that people who were closer to retirement might not have accumulated sufficient money to retire, so it allowed them to contribute more. The maximum amounts are:
Some employers match your investments in the plan up to a certain amountFor instance, an employer might match every $1 you put in a retirement plan with 20 cents of the employer's money on the first 5% of compensation you invest each year. Your employer puts the matching money in a separate account and can choose from one of two vesting schedules. The first is gradual vesting, in which a certain percentage each year for up to six years becomes yours to take if you leave the employer. The other provides no vesting until the third year, whereupon you're fully vested. When you become fully vested, you can take all matching contributions plus their earnings with you. Note that you're always 100% vested in your own contributions plus their earnings.
You can increase the amount you contribute to your retirement planWhen you first start working, you might not think you can contribute the maximum you're allowed to contribute. As time progresses and you get raises, you can increase the amount you contribute with a goal of contributing the maximum as soon as you can. Most plans allow you to change the amount you contribute at least twice a year.
You can choose how your money is invested within the retirement planThe employer selects the various investment choices, but you can choose from among them to determine how you want your particular plan invested. You can periodically change the amount you're having withdrawn from your paycheck and how that money is invested. Usually, you can make changes to the investments you've already made within the retirement plan at any time.
Whatever you accumulate in your retirement plan is yoursIf you move from one job to another, you can take whatever you've accumulated in the retirement plan with you. You can roll it over either into a self-directed IRA plan in your own name, where it would continue to grow tax-deferred, or in some cases into your new employer's retirement plan. You can even cash it in, which we wouldn't recommend, since whatever you take out will be taxed in your tax bracket. Under certain circumstances you may also be charged a 10% surtax.
You'll receive investment educationYou might be overwhelmed by the various investment choices available in your retirement plan. Typically, the financial adviser who helped your employer select investments for the retirement plan comes in periodically to talk to employees about the various options. Attend those meetings, read the information provided, and ask questions. Usually that person is available to consult with you individually. If you need help, don't hesitate to take advantage of this opportunity.
Sometimes your parents can help you outDespite the many obvious advantages of contributing to an employer-sponsored retirement plan, we find many employees—particularly younger ones—don't participate in their retirement plans or don't contribute the maximum they can. They use excuses such as they're too young or need the money to cover current expenses. It might be true that they do need the money for current expenses. But if they're fortunate enough to have parents who can help them out, the parents could give them enough to make sure they could contribute to their retirement plan. For example, a parent can give a child as much as $13,000 a year without the child paying taxes on receiving that amount. Let's say that the adult child cannot afford to contribute to her retirement plan. She could sign up to contribute $500 a month, which would lower her taxable income, and a parent could give her $500 a month, which would help her build her retirement account. Not everyone is fortunate enough to have wealthy parents who are willing to be that generous.
Procrastination has a priceTo illustrate why it's important to start saving early, let's look at the numbers. If you start at age 22 and contribute $100 at the beginning of each month to your retirement plan, and it earns 8% a year, by the time you're 65 years old the account will be worth $450,478. If instead you wait until age 32 to contribute $100 per month and it earns 8%, at age 65 you'll have $194,654 — quite a difference.
Particularly now that Congress is talking about curtailing Social Security benefits for those under the age of 55, we think that saving for your retirement isn't a choice — it's a necessity. And you should make it a priority. If you want your retirement years to be your "golden years," not your "nickel-dime years," start saving early the maximum amount you can.
Alexandra Armstrong is a Certified Financial Planner practitioner and chairman of Armstrong, Fleming & Moore Inc., a registered investment advisory firm located at 1850 M St. N.W. in Washington, D.C.
This material has been provided for general informational purposes only and doesn't constitute either tax or legal advice. Investors should consult a tax or legal professional regarding their individual situation.
This article was originally published by BetterInvesting. Since 1951, BetterInvesting has helped more than five million people become better, more informed investors. BetterInvesting helps its members build wealth through educational webinars, Web-based mutual fund and stock tools, in-person learning events, publications, an active online community, and software. For more information, visit the website or call 877-275-6242.
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