1) Start saving for your retirement early. Start now. I know, you have a lot of bills to pay and it will be decades until you retire. You feel like you can start saving when you are more financially secure, and will just make up for starting later by saving more in the future. This could work, but it comes at a cost.
For example, take Bill and his friend Bob. Both are young men with a lot of bills, but Bill's family taught him to start saving for his retirement as soon as he could. Both got hired to full-time jobs when they were 24 years old. Bill looked at his expenses, and realized he could contribute $2,000 a year to his retirement at the end of every year. He invested conservatively, and earned a steady 5% return without taxes every year. At the age of 65, he had just under $270,000 saved.
Bob, on the other hand, did not set aside any money in his 20s or 30s. It took Bob 20 years to feel financially secure enough to start contributing to his retirement account. Bob, now 44 years old, wanted to catch up with Bill and decided to put $7,000 a year into his retirement account at the end of every year. Bob invested the same as Bill, and earned the same steady 5% return without taxes every year. At the age of 65, he had just over $260,000 saved.
As you can see, in order to have between $260,000 and $270,000 in their retirement accounts, Bill only had to contribute $82,000 while Bob had to contribute $147,000 ($65,000 more). This is all because Bill started saving at an early age.
That is the power of compounding investment returns.
2) Invest through a qualified retirement plan. The IRS gives special tax treatment to certain types of retirement accounts including, but not limited to:
- 401(k)
- 403(b)
- Traditional IRA
- Roth IRA
It is very rare for the government to allow you to invest your money without taxing it for decades, if ever.
These types of retirement accounts have another significant tax incentive.
Contributions to 401(k)s and 403(b)s reduce the amount of taxable wages you report on your tax return. For example, if you earned $100,000 in a year, and you contributed $5,000 to your 401(k), your W-2 would only show $95,000 of gross wages.
Contributions to a Traditional IRA are deductible for the year of the contribution. Thus, if you earned $100,000 during the year and contributed $5,000 to your Traditional IRA, you would take a deduction on your tax return for $5,000, leaving you with gross income of $95,000.
Assuming you are in a 25% federal tax bracket, you would save $1,250 in federal taxes for making a $5,000 contribution to your own retirement.
Distributions from a Roth IRA are tax-free. This is delayed gratification, but if you expect to be in a higher income tax bracket when you retire or you think that tax rates will go up, you can choose to put your money into a Roth IRA and let it grow tax-free and then eventually take it out of your retirement account tax-free.
Please note that this is only a very brief overview of retirement plans. I plan to discuss different aspects of retirement plans and the benefits to employers to sponsoring a 401(k) or 403(b) plan in future blog posts.
I strongly encourage you to talk to your financial advisor about setting up a retirement plan if you do not have one already. If you need a referral to a financial advisor, I know a great financial advisor who would be happy to answer any of your questions.
I would love to get your feedback through comments below. If you have a question that you would like to discuss with me privately, please do not hesitate to send me an e-mail.
