During your working career, you are mostly worried about the current expenses you and your family have to bear. Life is fast-paced these days and a majority of people seem content to get through their daily routine. This doesn’t leave much time to plan ahead. However, if you want to have a comfortable retirement, it is better to get started early rather than later.
Retirement may seem far off when you are starting your professional career in your early 20s. You may have just finished a university degree and might be looking forward to landing your first “real” job or taking a big step in life by moving out of your childhood bedroom. Instead of thinking about retirement, you are thinking about exciting career opportunities. You could be burdened by the responsibility of paying off your student loans.
This is a stage in life when your situation seems in a constant flux and it’s rather difficult to envision a stable retirement spent on your favorite hobbies and travelling to your beloved destinations. Yet, the earlier you start planning your retirement, the greater the chances are you will have a better nest egg when you get there. Even small savings now can be compound by the investment income they generate.
Anyone new to retirement savings might have their heads spin when going through the countless options available. Although each strategy has its benefits, not every approach is created equally. To help you decipher through the jargon and make every penny work harder for creating a beautiful nest egg, we will discuss some retirement savings strategies.
There are generally three principal retirement savings categories in which you can channel your retirement money: after-tax, tax-free or tax deferred.
The after-tax retirement savings category funnels your savings into an account after you have paid taxes on the money and in which your income is taxed annually. Your may invest in such a scheme through vehicles such as mutual funds, money markets, brokerage accounts, bonds or stocks.
This foremost advantage of this type of savings account is you can withdraw money from it at any time without incurring any additional tax liabilities or being slapped penalties by the IRS. This strategy is excellent for individuals who need a little flexibility in their retirement savings and who may want to retire before turning 60.
The best time to invest in this category is soon after graduation when your income is still substantially lower than where it will be during the peak of your career. There is another benefit in putting your extra earnings in such savings. This retirement savings category can serve as your emergency fund which you may not have after completing your education as the money you might have to draw in an emergency will not be subject to extra taxes. Another great time is when you have a big family with many children who help draw down your income tax liability due to all the tax credits you are entitled to claim.
The second category of retirement savings is money you put away for retirement after paying taxes on it, but the income from those savings can grow tax free (Roth accounts). You can have a Roth IRA (Individual Retirement Account) or a retirement savings account via your workplace Roth 401(k). In this case, the money you put in is already taxed so you can pull the capital you invested at any time without incurring any penalties (as long as you leave the investment income generated from the capital in the plan).
This type of retirement savings is advantageous over the third type of retirement savings (tax deferred) as you will only be taxed on the investment income when you withdraw the money from savings as the capital has already been taxed. You can also leave the money in the account even after turning 70 and a half, unlike traditional tax deferred accounts.
This permits retirees to continue to let their savings grow even after retirement and increase the compounding effect of the investments. The money can be even passed on to heirs without being touched by a deceased retiree. Once you do get to your retirement, this is the plan you want to withdraw from last as there are no penalties imposed by the government to let it keep growing tax-free indefinitely and only limited by your lifespan.
A majority of people contribute to tax deferred retirement savings accounts via traditional IRAs and workplace 401(k) or 403(b). The reason is this saving category allows individuals to significantly decrease their current tax bills and defer taxes till after retirement. This category has the most strict withdrawal rules and a 10% penalty is imposed by the IRS if any amount, whether capital or investment income, is taken out of the plan before you are 59 and a half years old. This category, therefore, offers the least flexibility in terms of withdrawing options.
Contributions to this category are best timed when your personal situation places you in high tax brackets as the amount invested in this retirement account is directly deducted from your income, substantially reducing your current tax burden. Deferring the taxes till retirement is an excellent idea as at the time of withdrawal your income may not be as high and you will pay taxes based on lower marginal tax rates.
Each category has its pros and cons. One may offer immediate tax relief while another provides greater flexibility. Since it is extremely difficult to predict the exact path of your career and retirement circumstances, it is best to invest in all three categories.
Asharp Bookkeeper