By: Daniel Woolston, Supervising Attorney at Lexington Law
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If you’re under the age of 30, chances are you’re not thinking about retirement. Why would you? It’s a long way off, you’re just getting started in your career, and you have your whole life ahead of you. For all these reasons, however, it’s the perfect time to get started on retirement savings. You can make minimal contributions that will grow over time and cushion you when you retire.
While many of today’s retirees live on the money they receive from Social Security, there’s no guarantee that any of that money will be available for future generations when they retire. Projections show that the Social Security trust fund could be depleted as early as 2034. In other words, everyone who will still be under the age of 55 in 2034 should be forming their own retirement contingency plan. There are ways to save for retirement other than hoarding cash under your mattress for the next 20 years, and they all offer better returns on your investment. Here are several different ways to save for retirement and prepare yourself for the future.
If you’re employed full-time by a company that offers any type of benefits, chances are you’ve been offered the opportunity to contribute to a 401(k) (named after the section of the tax code under which it falls). It’s important to take advantage of this offering, especially if you haven’t yet begun to save, and even more so if your employer offers to match all, or a portion of, your contribution.
401(k) contributions are made before income taxes are taken out, so you’re not taxed on any money you contribute to it. In fact, you’ll receive a tax deduction for any 401(k) contributions made during the tax year.
The money you make from your 401(k) isn’t taxed until you reach retirement age and begin to make withdrawals from your account. Then it will be taxed as normal income at your current tax rate. This is a good option for those who are employed full-time and plan to be for a while (as opposed to having a goal of starting your own business at some point.)
An IRA is an Individual Retirement Account that you can set up regardless of your employment status. There are many different ways to open an IRA, and you can choose whether to manage it closely or to take a more hands-off approach. Your investment will continue to grow either way.
For an IRA, the money you contribute will come from your pre-tax income, so you won’t have to pay taxes on it. However, when you reach retirement age and begin making withdrawals, that money will be taxed as normal income. If you find yourself in a tough financial spot, you can withdraw the money early, but you can expect to be heavily penalized. That’s because retirement accounts are meant to remain untouched until you are actually ready to retire.
An IRA can be a good option for those who are making a sizeable income already and are ready to make large contributions to a retirement account. Additionally, if you had a 401(k) at a previous employer, you can choose to roll that money into an IRA.
A Roth IRA is very similar to a regular IRA, but the money you invest is after-tax income, so you pay taxes on it on the front end. However, when you’re ready to withdraw that money during retirement, you’ll be able to do so tax-free. If you have found your income growing steadily throughout your career, and you plan to keep doing so, then this may be a better option. Here’s why: If you fall into the lowest-income tax bracket at the time of your retirement contribution, and you fall into a much higher tax bracket when you retire (which is likely, as wealth generally grows as we age and advance in our careers), then you may end up paying a high income-tax rate on your withdrawal. With a Roth IRA, this wouldn’t be a concern, as you’d have already been taxed on your contribution. However, with both accounts, there are rules as to how much you can contribute, so consult a financial advisor to find out which one would work best for you.
For those who own or work for small businesses, or are self-employed, a Savings Investment Match Plan for Employees (SIMPLE) IRA is a good option. This type of account requires a matching contribution from your employer (whether that’s yourself or a company you don’t own, but are employed by), and is taxed under similar rules as a traditional IRA. You’ll contribute pre-tax dollars, but you will be taxed when you begin to withdraw the money.
A Simplified Employee Pension (SEP) IRA is similar to a SIMPLE IRA, but the difference is that the employer is not required to contribute any money to the account in any given year. Any money contributed, however, must be the same percentage for each employee, meaning that the employer cannot choose to match five percent for one employee and only three percent for the others. Any contributions made by the employer (including individuals who are self-employed) are tax deductible.
Other Retirement Plans
There are other types of retirement plans as well, though some may be less well known:
- SARSEP Plans (Salary Reduction Simplified Employee Pension)
- Payroll Deduction IRAs
- Profit-Sharing Plans
- Defined Benefit Plans
- Money Purchase Plans
- Employee Stock Ownership Plans (ESOPs)
- Governmental Plans
- 457 Plans
- 409A Nonqualified Deferred Compensation Plans
For more information about lesser-known retirement plans and how they are taxed, visit the IRS’s website.
While there is really no such thing as the “best” retirement account, there is such a thing as the one that works best for you, your financial situation, and your family (or future family), which is why so many different ways to save for retirement exist. For more information about setting yourself up for a successful financial future, and to get your credit back on track through credit repair, call Lexington Law at 1-833-333-2281.