Are you or a loved one under age 35? For most young adults, planning for retirement is one of furthest things from the mind. But it shouldn’t be, because young adults have a very valuable asset that those of us who are older, do not have. That valuable asset, is time.
Saving a little bit now when young, can pay huge dividends later, especially if the savings are in a tax deferred account. Does an 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 young adults.
With a salary deferral plan, you take part of your paycheck and deposit it into a plan account. Any of your wages that you deposit into one of these plan accounts is not income taxed to you when it is earned or deposited. The only taxes you have to pay on the contributions are the 6.2% Social Security tax and the 1.45% Medicare tax, which are withheld by your employer before your contribution to the plan account.
These contributions and any earnings on these contributions are only income taxed when withdrawn from the plan account, typically after you retire. These salary deferrals and their earnings are called pre-tax dollars since they have not yet been income taxed.
With some of these salary deferral plans, a number of larger employers even match all or a part of the salary deferral. If you or a loved one has an employer that does match employee contributions, take advantage of these matches. It is free money. And any employer matches deposited into one of these plan accounts goes into the account not only income tax free, but also without any Social Security or Medicare taxes paid or withheld. And it is only income taxed to you when you eventually withdraw it out of the tax deferred account. These employer salary deferral matches are also pre-tax dollars.
Since the amounts in these accounts are not income taxed until withdrawn, they build income without the need to pay any current income taxes. You can start making distributions out of these accounts after age 59½ without the 10% early withdrawal penalty. However, you do not have to start taking anything out of these accounts until after age 70½, at which time you must make minimum required distributions.
When you wait until retirement to take distributions, your income is usually lower. You would then pay less income taxes on the distributions than when you were working, because you now 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 total rate of return for all stocks in the Dow Jones Industrial Average was 11.15%. and the average rate of return the stocks in the S&P 500 was 9.57%. 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 $35,000 per year and deferred 20% of your income, you would be saving about $538 per month into your retirement account after payment of Social Security and Medicare taxes. If you started at age 22, at an 8% return, that $538 per month would have grown to $2.9 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 2018 of $18,500 per year into one of your retirement accounts at age 22. At an average rate of return of 8%, you would have $8.2 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 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 $5,500 in 2018. If you contributed the maximum of $5,500 per year starting at age 22, at an average rate of return of 8%, you would have over $2.4 million in your retirement account at age 67.
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 income 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 income tax-free so long as the contributions to the Roth IRA were made at least five years prior to the distribution.
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 salary deferral 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 issues down the road.
By Matthew M. Wallace, CPA, JD
Published edited January 7, 2018 in The Times Herald newspaper Port Huron, Michigan as: How a young adult can retire as a millionaire