“Some people spend more time planning a two-week vacation than they do retirement planning.”
Corporate 401(k) retirement plans now make up the largest source of retirement savings for most individuals. The days of being able to depend on a Defined Benefit pension from an employer have long passed and the vast majority of workers must depend on their own savings and investing for their retirement income.
Yet most workers believe that saving 6% of their salary for 35 years will replace 100% of their income during a 35 year retirement. Fortunately, now that we know we can no longer depend on anyone else for our retirement funding, we can start planning now for how we will generate income in retirement.
The first step in planning a vacation is deciding what the destination is, once that is agreed upon the next step is to figure out what vehicle to take to get there. It’s no different in retirement planning, choosing the proper vehicles to save and invest in can make a big difference in the efficiency of the trip and the destination.
Retirement Savings Accounts You Should Consider
All these accounts allow your money to grow tax-free. You pay tax when you withdraw the money, except for Roth IRAs, where no tax is due at withdrawal. If you withdraw money before you reach age 59 1/2, in most cases you will have to pay a 10 percent penalty in addition to regular income tax.
401(k) or 403(b) offered by your employer. If your employer offers a corporate retirement plan there are several good reasons for making that your favored retirement savings vehicle. First, for most workers a 401(k) or 403(b) will allow the largest annual contribution. ($18,000 for 2016 and an additional catch-up contribution of $6000 if the worker is over 50) Second, most employers offer some sort of salary matching contribution that provides a risk-free return on your contributions before they are even invested. And most importantly, the contributions are automatic allowing you to “pay yourself first” and dollar cost average into your investments. (Dollar cost averaging allows you to buy the same dollar amount of an investment no matter the fluctuation in the price of the investment.)
Traditional IRA. Anyone can contribute up to $5,500 a year to an IRA ($6,500 if you’re over 50) The money grows tax-free until required minimum distributions (RMDs) begin after age 70 1/2. You can contribute to both an IRA and a 401(k), but if you’re covered by a retirement plan at work, you may not be able to deduct the full amount of your IRA contributions from your taxable income. Start contributing early to an IRA to make the power of compounding work for you, the earlier the better.
ROTH IRA. With a Roth IRA, you are contributing after-tax dollars, and you get no tax deduction for your contribution. The money you earn grows tax-free, and you pay no tax on withdrawals after you reach age 59 1/2. Plus, unlike with regular IRAs, there are no required minimum distributions (RMDs) at age 70 1/2, which can also make a ROTH IRA a powerful estate planning tool.
Health Savings Account (HSA). Those with certain high-deductible health insurance plans can save money tax-free in a HSA. You can contribute up to $3,350 a year for an individual or $6,750 for a family (2016 limits). If you’re 55 or older, you can contribute $1,000 more. You can withdraw money from your account to pay qualified medical expenses, and the account is portable if you change employers. If you don’t spend the all the money in one year, it can be kept in the account to accumulate and be invested in mutual funds. Excess accumulations may be used to pay health care costs in retirement.
Using some or all of the accounts in your retirement planning will allow you to grow your savings tax-free until retirement, maximizing the effect of compounding.