We all have a number of goals in life that we want to accomplish and saving for retirement is a priority for everyone. During our working years, we are trying to produce income and accumulate wealth. We grow our businesses and advance our careers. Asset purchases like homes and cars are made. We save for our children’s college expenses.
And many of us defer a percentage of our paychecks into 401k’s and other retirement plans every couple of weeks. But should you contribute to a Roth or a Traditional IRA? How much should you be saving for retirement?
Retirement seems like the one financial goal that we are always saving for until….well retirement. Most experts will tell you that you should start saving for retirement once you start receiving your first paycheck. The main reason is that the earlier in life that you save, the bigger your nest egg will be at retirement.
There are a number of financial concepts that make this true. A better grasp of these concepts can help you make smarter decisions about the best ways to save for retirement.
The Benefits of Saving
Everyone grows older and eventually stops working, but we still need income to live off of. We all rely on some fixed income sources in retirement. For most Americans, this fixed income is in the form of Social Security.
Other income sources are pensions, rental income, and even part-time employment. But for most of us, these fixed-income sources aren’t enough to cover our spending in retirement.
So it is important to start growing your nest egg earlier in life when your income is higher and you have more to save. This nest egg will provide you with another way to supplement your retirement income.
Compounding
Save early and often. You may have heard this phrase used when reading about saving for retirement. Compounding is when you earn a return on the money you have invested and then reinvest that return. It’s simply your interest earning interest.
As an example, you invest $1,000 at an interest rate of 5%. At the end of one year, you now have $1,050. If you reinvest the entire balance for another year, you now have $1,103.
Fast forward 10 years and your original $1,000 investment is now worth $1,641. Had you withdrawn the interest every year, you would only have $1,500 at the end of 10 years.
Compounding over 20 years would provide you with $2,686 and over 30 years with $4,388. As you can see, the power of compounding has a profound impact on your ability to grow wealth.
Higher Long-term Returns
Investing your money for retirement is another crucial concept to understand. When you begin to save for retirement, you typically have a long time horizon to save for. Let’s say you start at age 30 and plan to retire at 60. Well, that’s 30 years.
Since you won’t need the funds you are investing in for so long, you want to get a high return to enhance the compounding. In my previous compounding example, I used a 5% rate of return. Let’s use the same dollar amount of $1,000 but increase the rate of return to 8%.
In 10 years you have $2,173, in 20 years $4,707 and in 30 years $10,176. The increased return from 5% to 8% over 30 years provides you with an extra $5,788.
What you invest in will determine your rate of return. This is why most investors invest in mutual funds or stocks in their retirement accounts. The value of these types of investments fluctuates in the short-term. But they have historically provided returns needed to outpace inflation.
Tax-benefits
Tax-deferral is exactly what it sounds like – delaying the payment of taxes instead of paying them now. Deferring taxes until retirement is like pouring jet fuel in your compounding tank. Much like your investment returns, money saved from income taxes compounds in retirement accounts.
Roth accounts grow tax-deferred but qualified distributions from these accounts can be tax-free. This can be ideal for someone who is in a lower tax bracket today but anticipates being in a higher tax bracket in retirement. All qualified retirement accounts have special tax benefits to enhance wealth accumulation.
Ways to Save for Retirement
Tax-deferred Accounts
Tax-deferred accounts offer short-term and long-term benefits. Contributing to a tax-deferred account can provide you with a tax deduction in the current year.
They also allow the taxpayer to defer tax on all the growth within the account. Income tax is then due on all distributions made from the account in retirement.
Many employers also offer qualified retirement plans to their employees. There are many different types of employer-sponsored qualified retirement plans, but two main types are Defined Contribution and Defined Benefit Plans. They are one of the most valuable parts of your employee benefits package.
Some general rules about these types of accounts are:
- There are annual contribution limits
- Distributions are subject to the taxpayer’s income tax rate
- Rollovers to other tax-deferred accounts are permitted
- Distributions made before the age of 59 1/2 are subject to a 10% early withdrawal penalty
- There are some early withdrawal exceptions such as death or disability
- At age 72 distributions must begin with a few exceptions
- Taxpayers over the age of 50 are eligible for catch-up contributions
Traditional IRA
A Traditional IRA is an account that any taxpayer can contribute to if they have earned income. Earned income is income from a job or self-employment income. Your IRA contribution may be tax-deductible as long as it passes certain tests.
The annual contribution limit for a Traditional IRA is $6,000 in 2020 and 2021. You can contribute another $1,000 if you are over the age of 50. If you multiply your marginal tax bracket times your contribution amount you will gain a rough idea of your tax savings.
Let’s say your combined (Federal & State) marginal income tax rate is 33% and you make a $6,000 contribution to a Traditional IRA. If the amount contributed is deductible, you have saved yourself roughly $2,000 in taxes.
So your entire contribution of $6,000 including the taxes saved grow tax-deferred. You will then pay income tax only when you begin taking distributions.
Click here to read more about Traditional IRA rules and limitations.
Employer-sponsored Retirement Accounts
Contributing to an employer-sponsored retirement plan is a great way to save for retirement. In fact, this is the most popular method for individuals saving for retirement. The most widely-known being 401k plans.
The tax treatment is the same as for Traditional IRAs – you receive a tax benefit in the year you make a contribution. All growth on contributions is tax-deferred until you take a distribution.
But there are other reasons why 401k’s and other employer-sponsored plans are so popular. One, there aren’t any income limits on contributions like there are with IRA’s. You only need to earn an amount of income equal to the amount you want to contribute.
The contribution limits are also much higher in these plans than in IRA’s. In 2020 and 2021 the annual contribution limit is $19,500. The catch-up contribution amount is $6,500.
Finally, many of these plans offer an employer matching contribution. So you receive free money if you contribute to the plan. That means you are already getting a huge return on your contribution! Couple that with the current year tax benefit and tax-deferral and you have yourself a great savings vehicle.
Other common employer-sponsored plans are:
- 403b
- 457b
- SEP IRAs
- SIMPLE IRAs
- Defined Benefit Plans
Tax-free Retirement Accounts
As we discussed earlier, tax-deferred accounts provide a current-year tax benefit. But these contributions along with any growth in the account are taxable upon distribution.
In a tax-free account, there is no tax benefit in the current year so the contributions are after-tax. In exchange for giving up current-year tax benefits, all the distributions in a Roth account are tax-free.
These accounts can make sense if you are in a lower tax bracket today, but expect to be in a higher bracket in the future. They also make sense for younger individuals saving for retirement. They have more time for growth to accumulate tax-free.
Tax-free accounts have special rules and limitations that different from tax-deferred accounts:
- There are annual contribution limits
- Qualified distributions are completely tax-free
- Contributions that remain in the account for 5 years can be taken out without penalty
- Distributions before the age of 59 1/2 are subject to a 10% early withdrawal penalty if the 5-rule is not met
- Rollovers to other tax-deferred accounts are permitted
- There are some early withdrawal exceptions such as death or disability
- There are no required minimum distributions (RMD’s) in tax-free accounts
- Taxpayers over the age of 50 are eligible for catch-up contributions
Click here to learn more about Roth IRA rules and limitations
Roth IRA
A Roth IRA is an account that any taxpayer can contribute to if they have earned income. This means income from employment earnings.
Roth IRA’s have the same contribution limits as Traditional IRA’s. You can contribute $6,000 in the years 2020 and 2021. If you are over the age of 50, you can contribute an extra $1,000.
Your contributions have to remain in the account for 5 years for distributions to be tax-free.
Employer-sponsored Roth Accounts
There isn’t a better place to save for tax-free growth than through your employer plans. If your employer offers a 401k or 403b plan, you may want to see if there is a Roth option. They have become more common in employer-sponsored plans recently.
If a Roth IRA is a Boeing 747, a Roth 401k is a rocket ship. For the simple reason that you can contribute over 3 times as much as you can in a Roth IRA.
Let’s look at an example of the tax-free compounding in a Roth 401k. Let us assume that you are age 25 and plan to retire at age 65. You begin to contribute $19,500 a year for 10 years and then stop your contributions.
We also assume your account is invested in the markets earning a long-term return of 8%. So you have contributed $25,000 of your own money. By the time you reach retirement, your balance has grown to $392,588. You have now accumulated over $350,000 in tax-free growth towards retirement!
Now let’s say you are able to contribute the maximum annual amount of $19,500 for 40 years, you will end up with $5,475,230. This is the reason why most Americans save into their employer-sponsored retirement accounts.
The Ultimate Goal
Not only is saving for retirement important, but it’s also necessary. Most Americans can’t live on Social Security income alone. Nor is it intended to provide all the income you need in retirement.
Unless you are one of many Americans working in the public sector that still receive pensions, you will need to create your own pension in retirement. The first step to doing so is to save in the most tax-efficient manner. In most cases, that entails saving to employer-sponsored plans and other qualified plans.
The second step is to determine the best withdrawal strategy from these accounts when retirement approaches. In other words, you need to create your own pension. That’s why knowing how distributions from these plans are taxed is so important.
If you have saved into taxable, tax-deferred, and tax-free accounts, you will be well equipped to create a tax-efficient retirement income stream. As you can see, choosing which retirement accounts to save to has a tremendous impact on reaching your goal of retirement.
