Don’t Forget to Max Out Your Retirement Savings
You know you should be saving for retirement, but did you know that your qualified retirement accounts could provide an opportunity to save more? Read on for three reasons why you should consider maxing out your qualified retirement savings contributions this year.
1. Boost your savings with special features
Many qualified retirement plans like 401(k)s and IRAs have built-in features that can be beneficial for retirement planning.
First and foremost is a tax deduction on Traditional 401(k) and IRA contributions. Not only do you not pay taxes on the income that’s devoted to your retirement savings: because your contributions effectively reduce your taxable income, they could put you in a lower tax bracket. While any growth you enjoy in the account will be taxed as ordinary income when you make withdrawals in retirement (more on that in a moment), the tax savings today can be significant. However, please note that contributions to Roth 401(k)s and IRAs are made on an after-tax basis, meaning that the tax benefits for these accounts come later.1
Additionally, many employers offer a match for 401(k) contributions. This benefit is essentially an additional boost to your salary and automatically increases the contributions to your account. Here’s how: if your employer offers a 3% match on contributions up to, say, $15,000, that means you’re getting an extra 3% in contributions (in this case, $450) in your first year alone. Due to the power of compound interest, which we’ll cover in the last section, that extra 3% every year can pack a huge punch when it comes to long-term growth.
Between tax savings and extra contributions through employer matches, qualified retirement accounts can have an immediate, positive impact on your financial planning.
2. Enjoy the benefits of tax-deferred growth tomorrow
Once you’ve started saving in a qualified retirement plan, your earnings will grow tax-free until you start making withdrawals. Traditional 401(k) and IRA accounts require that any income drawn on the account in retirement is taxed at the prevailing income tax rate; for Roth 401(k)s and IRAs, which are funded with after-tax income, your eventual withdrawals are not taxed.
Please note that to qualify for tax-free and penalty-free withdrawals, a Roth IRA must be in place for at least 5 tax years, and the distribution must take place after age 59.5 or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Before taking any specific action, be sure to consult with your tax professional.
For both Traditional and Roth retirement accounts, the intervening years of tax-free growth can be incredibly powerful. Any money that would have gone to capital gains or income taxes can be reinvested completely instead — providing you with an even greater asset base for potential long-term growth.
Of course, the actual growth rate of your account will vary depending on a number of factors, including market and economic conditions, your allocation, and timing. But the ability to bypass the cost of taxes over time can be significant.
Consider this example: let’s say you start saving $15,000 per year in your 401(k), with an 8% annual return and no employer match. In 25 years, your 401(k) will have a value of about $1.55 million. On the other hand, if you were to pay 1% as taxes every year, lowering your effective growth rate to 7% per year, the ending value of your 401(k) would be 1.33 million!2
3. Start now to maximize the power of compounding
The long-term effect of just 1% in growth lost every year to taxes speaks to the power of compound interest. This is why it’s so important to save early and save often: it gives you the greatest possible opportunity to benefit from this incredible financial tool.
For example, consider a 30-year old who hasn’t started saving for retirement yet. What’s the difference between starting today and starting in 5 years, assuming he or she will retire at age 65? Using the same variables as the example above, starting today will generate a 401(k) with a value of about $3.96 million in 35 years (assuming 8% average annual growth).
Of course, this example is for illustrative purposes only and isn’t indicative of any particular investments. It also assumes reinvestment of dividends with no consequence of fees or taxes. Your actual results will vary. Also note that past performance is not a guarantee of future results.
Start saving in 5 years instead, and the projected account value plummets to $2.51 million — a difference of over 36%.3 The drop isn’t just because of the lost contributions, but because of the lost time for growth.
Don’t underestimate the power of compounding: start saving as early and as diligently as possible — and even if you’re behind, it’s never too late to start. The more time you give yourself, the greater your opportunity for a financially healthy retirement.