you need to access your retirement account, you would likely be in a relatively low tax bracket. The lower income taxes you pay (compared with the taxes you would have paid on that money had you not sheltered it in a retirement account in the first place) should make up for most, if not all, of the penalty.
But what about simply wanting to save money for nearer-term goals and to be able to tap that money? If you’re saving and investing money for a down payment on a home or to start a business, for example, you’ll probably need to save that money outside a retirement account to avoid those early-withdrawal penalties.
If you’re like most young adults and have limited financial resources, you need to prioritize your goals. Before funding retirement accounts and gaining those tax breaks, be sure to contemplate and prioritize your other goals (see the earlier section “Setting and Prioritizing Your Shorter-Term Goals”).
Taking advantage of retirement accounts
The sooner you start to save, the less painful it is each year to save enough to reach your goals, because your contributions have more years to compound. Each decade you delay saving approximately doubles the percentage of your earnings that you need to save to meet your goals. If saving 5 percent per year in your early 20s gets you to your retirement goal, waiting until your 30s to start may mean socking away approximately 10 percent to reach that same goal; waiting until your 40s means saving 20 percent. Start saving and investing now!
Surveying retirement account choices
If you earn employment income (or receive alimony), you have options for putting money away in a retirement account that compounds without taxation until you withdraw the money. In most cases, your contributions to these retirement accounts are tax-deductible. This section reviews your options.
Company-based retirement plans
Larger for-profit companies generally offer their employees a 401(k) plan, which typically allows saving up to $19,500 per year (for tax year 2021). Many nonprofit organizations offer their employees similar plans, known as 403(b) plans. Contributions to both traditional 401(k) and 403(b) plans are deductible on both your federal and state taxes in the year that you make them. Employees of nonprofit organizations can generally contribute up to 20 percent or $19,500 of their salaries, whichever is less.
There’s a benefit in addition to the up-front and ongoing tax benefits of these retirement savings plans: Some employers match your contributions. (If you’re an employee in a small business, you can establish your own SEP-IRA.) Of course, the challenge for many people is to reduce their spending enough to be able to sock away these kinds of contributions.
Some employers are offering a Roth 401(k) account, which, like a Roth IRA (discussed in the next section), offers employees the ability to contribute on an after-tax basis. Withdrawals from such accounts generally aren’t taxed in retirement.
If you’re self-employed, you can establish your own retirement savings plans for yourself and any employees you have. Simplified Employee Pension-Individual Retirement Accounts (SEP-IRAs) allow you to put away up to 20 percent of your self-employment income up to an annual maximum of $58,000 (for tax year 2021).
Individual Retirement Accounts
If you work for a company that doesn’t offer a retirement savings plan, or if you’ve exhausted contributions to your company’s plan, consider an Individual Retirement Account (IRA). Anyone who earns employment income or receives alimony may contribute up to $6,000 annually to an IRA (or the amount of your employment income or alimony income, if it’s less than $6,000 in a year). A nonworking spouse may contribute up to $6,000 annually to a spousal IRA.
Your contributions to an IRA may or may not be tax-deductible. For tax year 2021, if you’re single and your adjusted gross income is $66,000 or less for the year, you can deduct your full IRA contribution. If you’re married and you file your taxes jointly, you’re entitled to a full IRA deduction if your AGI is $105,000 per year or less.
Annuities: Maxing out your retirement savings
What if you have so much cash sitting around that after maxing out your contributions to retirement accounts, including your IRA, you still want to sock more away into a tax-advantaged account? Enter the annuity. Annuities are contracts that insurance companies back. If you, the investor (annuity holder), should die during the so-called accumulation phase (that is, before receiving payments from the annuity), your designated beneficiary is guaranteed reimbursement of the amount of your original investment.
Annuities, like IRAs, allow your capital to grow and compound tax-deferred. You defer taxes until you withdraw the money. Unlike an IRA, which has an annual contribution limit of a few thousand dollars, an annuity allows you to deposit as much as you want in any year — even millions of dollars, if you’ve got millions! As with a Roth IRA, however, you get no up-front tax deduction for your contributions.
