Are you under 35? If you are like most young adults, planning for your retirement is one of furthest things from your mind. But it shouldn’t be, because you have a very valuable asset. That asset is something that those of us who are older, do not have. Your valuable asset, is time.
Saving a little bit now when you are young, can pay huge dividends later, especially if the savings are in a tax deferred account. Does your employer offer a salary deferral plan, such as a 401(k), 403(b), 457(b) or SIMPLE plan? If so, it can be one of the best deals going for you.
With a salary deferral plan, you take part of your paycheck and deposit it into a plan account. And with some of these plans, your employer may even a match of all or a part of your salary deferral. Take advantage of these employer matches. It is free money.
Any wages or employer matches you deposit into one of these plan accounts is not taxed to you when it is earned or deposited. It is taxed to you when you take it out of the plan account, usually when you retire. These salary deferrals are called pre-tax dollars since they have not yet been taxed.
Since the amounts in these accounts are never taxed until withdrawn, in the meantime, they build income tax-free and earn income on the income tax-free. You can start making distributions out of these accounts after age 59½ without an early withdrawal penalty. However, you do not have to start taking anything out of these accounts until age 70½, when you must make minimum distributions.
When you wait until retirement to take distributions, your income is usually lower. You would then pay less taxes on the income than when you were working, because you would be in a lower tax bracket.
If you just put $1.00 per month into one of these plans starting at age 22, and you earned 8% on your investment, that $1.00 per month would have grown to over $5,300 by age 67. Some financial advisors and commentators may say that you cannot expect an 8% return.
However, if you look at the last 45 years, including the decade of 2000-2010, the average annual rate of return for long-term income producing securities was 8%. During the same time period, the average rate of return on stocks, was 9.2%. If you increase your savings to, say $200 per month, your retirement account would be over $1 million at age 67.
Some financial advisors recommend saving 15% of your income. I recommend saving at least 20%. And you should start saving as soon as possible. When you start saving when you start working, you won’t miss it. You then start living on the reduced income. You will thank yourself later.
If you earned $30,000 per year and deferred 20% of your income, you would be saving $500 per month into your retirement account. If you started at age 22, at an 8% return, that $500 per month would have grown to $2.65 million at age 67. This is an example of the power of time.
Married couples have other opportunities. If you are married and you both work, try living on one income. I have known a number of couples who have based their lifestyle on only one income, even though both worked. By using one income for living and the other for saving, you can have substantial savings upon retirement.
For example, let’s say that between the two of you, you started to save the maximum amount in 2013 of $17,500 per year into your retirement account at age 22. At an average rate of return of 8%, you would have $7.7 million in your retirement account at age 67. If you cannot live on one salary, with two incomes, at least you have the opportunity to do more saving than if you only had one household income.
Many small employers do not offer salary deferral plans. If that is the case, all is not lost. You can set up and manage your own individual retirement account (“IRA”). You cannot deposit as much annually into an IRA as other retirement plans. Your IRA contributions are limited to $5,000 in 2013.
With traditional IRAs, you generally can deduct the IRA deposits from your other income on your Federal 1040 income tax return. Just like with the salary deferral accounts, income on these pre-tax dollars is earned tax-free until withdrawn. Generally, all distributions from traditional IRAs are taxable to you when they are made.
Often a better option for younger workers is a Roth IRA. Although contributions to Roth IRAs are not deductible and are made with after-tax dollars, when distributions are made to you after age 59½, they are generally completely tax-free.
You usually are not thinking about retirement when you are younger. But this is one of the best times to think about your retirement. Pay yourself first. Put away something every month. Instead of buying a house that you can just barely afford, purchase a smaller home you can easily afford and bank the savings.
And if you save amounts in an IRA, 401(k) or other qualified plan, your savings could grow either tax deferred or tax-free. Just because you are younger doesn’t mean that you don’t have to do any retirement or other planning. A little planning early in your life can go a long, long way, save yourself a lot of money and minimize financial problems down the road.
By: Matthew M. Wallace, CPA, JD
Published edited March 17, 2013 in The Times Herald newspaper, Port Huron, Michigan as: How to retire a millionaire