Planning for Retirement
In one way, planning for a retirement that won’t begin for 30 or 40 years can seem like the least important of your financial goals. But putting some of the money you earn into retirement savings plans now, while you are young, has the potential to pay off in a major way in the future. That’s the case for at least two important reasons:
- Retirement savings plans have tax advantages that allow you to either postpone income taxes on your earnings until you withdraw them after you retire or avoid income taxes on the earnings entirely if you follow the withdrawal rules.
- The effect of compounding means that the longer money is invested, the more it has the potential to grow because any earnings are added to your principal, increasing the base on which new earnings are paid. If you start putting money into tax-advantaged retirement plans from the time you’re 25, you’re on track to have a much larger retirement account balance than someone who invests twice as much but doesn’t start until reaching 45.
Salary Reduction Plans
One of the easiest ways to save for retirement is by participating in an employer-sponsored retirement savings plan called a salary reduction plan. These plans let you contribute a percentage of your gross income each pay period to an account that’s set up in your name. That amount is deducted each time you are paid.
There are several different types of employer-sponsored plans, usually based on the type of employer you work for. Probably the best-known plan is called a 401(k), and it’s offered mostly by businesses. Nonprofit employers, including healthcare providers and schools offer a similar plan called a 403(b) and many state governments offer a 457 plan. If you work for a small company, your plan may have a different name, but it will provide many of the same benefits.
These plans are tax-deferred, and the amount of your contribution reduces the amount of income that’s used to figure the current income tax you owe. For example if you earned $1,000 and contributed 6%, or $60, to a 401(k), the income reported to the IRS would be $940.
Some employers enroll you automatically in their plans, giving you the right to opt out if you wish. With other employers, you have to take the initiative to participate. In most of these plans, you can choose how your retirement savings are invested by selecting among the alternatives the plan offers. When you enroll, you’ll receive information from the employer about what they are.
If you change jobs, you can move everything you have contributed to the plan and any earnings you have accumulated on your contributions into a rollover individual retirement account (IRA) or a new employer’s plan if that plan accepts rollovers. This allows you to continue to build your retirement savings.
Individual Retirement Accounts
You can also save for retirement in a tax-advantaged individual retirement account, better known as an IRA. The only requirement for participating is having earned income, or money you are paid for work you do, during the year. In fact, you can put money into an IRA even if you are also contributing to an employer-sponsored plan. Or, if your employer doesn’t offer a plan or you’re not eligible to participate, you can use an IRA as your primary retirement savings account.
With an IRA, you choose the financial services company, such as a bank, credit union, brokerage firm, or mutual fund company, that will be the custodian of your account. Then you choose the way you want the money invested from the alternatives available through your custodian and make deposits to your account.
Once you have opened an IRA, you can contribute to it every year you earn income. Of course, you could also open a separate IRA each year, but it is often smarter to keep adding to the IRA you have. The larger your balance grows, the more effective compounding can be.
In exchange for the tax advantages of employer-sponsored plans and IRAs, there are withdrawal restrictions. If you take money out of your plan when you change jobs, you will owe all the tax that is due plus, in most cases, a 10% tax penalty if you are younger than 59 ½. There are some exceptions, if you are using the money to pay tuition, buy a first home, cover medical bills, and some other reasons. But the withdrawal restriction is there for a good reason: It helps you accumulate the money you will need down the road to live the kind of retirement you would like to live.