By investing through a retirement account, you not only plan wisely for your future but also get an immediate financial reward: lower taxes, which mean more money available for saving and investing. Retirement account contributions generally aren’t taxed at either the federal or state income tax level until withdrawal (but they’re still subject to Social Security and Medicare taxes when earned). If you’re paying, say, 30 percent between federal and state taxes (see Chapter 4 to determine your tax bracket), a $4,000 contribution to a retirement account lowers your income taxes by $1,200.Modest income earners also may get an additional government tax credit known as the Retirement Savings Contributions Credit. A maximum credit of 50 percent applies to the first $2,000 contributed for single taxpayers with an adjusted gross income (AGI) of no more than $19,750 and married couples filing jointly with an AGI of $39,500 or less. Singles with an AGI of between $19,750 and $21,500 and married couples with an AGI between $39,500 and $43,000 are eligible for a 20 percent tax credit. Single taxpayers with an AGI of more than $21,500 but no more than $33,000, as well as married couples with an AGI between $43,000 and $66,000, can get a 10 percent tax credit.
Your employer may match some of your contributions. This cash is free money from your employer, and it’s use it or lose it, so don’t miss out!
Investment returns compound tax-free. After you put money into a retirement account, you get to defer taxes on all the accumulating gains and profits (including interest and dividends) until you withdraw the money down the road. Thus, more money is working for you over a longer period of time. (One exception: Roth IRAs offer no upfront tax breaks but permit tax-free withdrawal of investment earnings in retirement.)
Grappling with retirement account concerns
There are legitimate concerns about putting money into a retirement account. First and foremost is the fact that once you place such money inside a retirement account, you can’t generally access it before age 59½ without paying current income taxes and a penalty — 10 percent of the withdrawn amount in federal tax, plus whatever your state charges.
This poses some potential problems. First, money placed inside retirement accounts is typically not available for other uses, such as buying a car or starting a small business. Second, if an emergency arises and you need to tap the money, you’ll get hit with paying current income taxes and penalties on amounts withdrawn.
You can make penalty-free withdrawals of up to $10,000 from IRAs for a first-time home purchase or higher educational expenses for you, your spouse, or your children (and even grandchildren).
Some company retirement plans allow you to borrow against your balance. You’re essentially loaning money to yourself, with the interest payments going back into your account.
If you have major medical expenses (exceeding 10 percent of your income) or a disability, you may be exempt from the penalties under certain conditions. (You will still owe ordinary income tax on withdrawals.)
You may withdraw money before age 59½ if you do so in equal, annual installments based on your life expectancy. You generally must make such distributions for at least five years or until age 59½, whichever is later.
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 section “Setting and Prioritizing Your Shorter-Term Goals” earlier in this chapter).
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 upfront 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
