Saving accounts, bonds, stocks, and real estate are all places where you can store your savings. Any investment can go down or up, but if you carefully balance your savings portfolio, you should see its value grow over the years.
However, these savings come from after-tax funds. First, you pay taxes and expenses. Only then can you save the remaining portion.
The government, however, aims to encourage people to save for the future. It hopes that everyone will set aside some money every month so that they have funds to sustain their lives when they reach retirement age. Therefore, it offers tax incentives for certain savings plans. You can save first and then pay taxes on the remaining amount. The result should be a higher savings rate and lower tax burden.
However, the purpose of all these plans is to save for retirement. The tax authorities are not concerned about whether you want to save money to buy a bigger house or a newer car. They care about preparing for the day you retire. When you invest your savings in a retirement fund, you lock that money in for a long period. Overall, the risk you take is relatively smaller. You cannot enjoy very high returns, nor can you withdraw funds as needed. But you should find that these funds accumulate over the years until you truly need them.
Retirement funds come in various forms.
Pensions, or defined benefit plans, are now rare. Companies contribute to a pension fund on behalf of their employees and promise to pay a fixed return regardless of the fund’s performance. If the pension fund’s investments do not perform well enough to fulfill the commitment, the company must make up the difference.
This means that companies face significant risks. Those that offered pensions to employees, especially in industries like the automotive sector, quickly found themselves responsible for large amounts. In early 2020, General Motors agreed to inject $570 million into its pension fund to ensure it could fulfill previous pension commitments to retirees.
Defined benefit plans offer more security and predictability, but they shift the risk to employers. Today, most employers are shifting this risk back to employees. Private companies usually offer defined contribution plans.
In a defined contribution plan, employees contribute a fixed amount to their retirement fund each month. Fund managers decide how these savings are invested, and the funds remain locked in until retirement. Savers do not know exactly how much they will have in retirement until they reach closer to retirement age. If the market performs well, their retirement income will be higher; if it performs poorly, it will be lower.
Defined contribution plans do not tell you how much you will receive in retirement, but they tell you how much you need to save each month – and this savings method is relatively painless. If your employer offers a 401(k) plan, it deducts retirement savings directly from your salary. This money does not enter your bank account, so you do not feel like you are sacrificing current spending power for future expenditure.
401(k) plans also come with several additional benefits, and these benefits are quite valuable.
The first benefit is that the savings you contribute to a 401(k) come from pre-tax income. You are not saving after paying taxes on your full income but rather saving first and paying taxes on the remaining portion.
Not only can you save, but you can also reduce your tax bill. In fact, the government is effectively paying you to save for the future.
Your employer may also contribute to your retirement savings. Some employers offer matching contributions. For every dollar you contribute to your 401(k), they will add an additional amount.
These matches are rarely at a 1:1 ratio. Companies often set limits on the matching contributions and may have vesting rules. If you leave before the vesting period ends, the company can reclaim some of the matching contributions.
These contributions provide employers with a way to increase compensation and help retain employees. If they are investing in their employees’ career development, they want those employees to stay with the company.
However, 401(k) plans have limits on how much you can save, and these limits usually increase every year. In 2021, the annual contribution limit for employees was $19,500. If you are 50 or older, you can add an additional $6,500 as a catch-up contribution. Employer matching contributions can increase the total to $58,000 or $63,500 (not exceeding 100% of income) for individuals aged 50 and above.
Withdrawing these savings before age 59.5 will lead to penalties. Besides paying income tax on the withdrawn funds, you will also have to pay an additional 10% penalty tax. The government wants you to keep the money for retirement and retain these savings until retirement.
Despite these restrictions, experts generally recommend saving as much as possible in a 401(k). Take full advantage of employer matching benefits and do not leave the money your employer is willing to give you with them. Also, maximize the tax benefits as much as possible.
Saving with pre-tax income can help reduce your tax burden, but you will still have to pay taxes on this money in the end. You will pay taxes once you withdraw the money in retirement when your income is lower, and your tax rate is also lower. However, if you expect to have higher income after retirement and be in a higher tax bracket, saving with after-tax income might be more cost-effective.
In saving with after-tax income, you pay taxes on your income first and then invest a portion into your retirement account. When you withdraw these funds in retirement, you receive them tax-free.
This is what a Roth retirement plan allows you to do.
The contribution limit for Roth 401(k) is the same as for traditional 401(k), but early withdrawals have different penalties. Since you save with after-tax income, you do not have to pay income tax on the principal amount withdrawn. However, you still have to pay a 10% penalty and taxes on the earnings portion.
Both traditional 401(k) and Roth 401(k) allow you to take out loans against the savings in your retirement account. As long as you repay on time, these loans are not penalized. Defaulting on the loan will be considered an early withdrawal by the IRS, triggering tax payments and penalties.
Whether you use a traditional 401(k) or Roth 401(k), you should plan to grow these savings until you are ready to retire.
401(k) plans are usually designed for employed individuals. Self-employed individuals can use a “Solo 401(k)” or “Self-employed 401(k).” Operationally, it works like any other 401(k) plan, except that the matching contributions come from the same source – when you are self-employed, you are both the employer and the employee.
However, 401(k) is not the only way to save for retirement. Individual retirement accounts (IRAs) allow savers to set aside money for the future on their own terms. They are not tied to the employer’s 401(k) and give individuals the freedom to choose their own funds.
Like 401(k), IRAs also have traditional and Roth types, but with much lower contribution limits. The total annual contribution to an IRA cannot exceed $6,000 and $7,000 for individuals aged 50 or above. The same early withdrawal penalties apply to IRAs.
Do not consider IRAs as an alternative to 401(k) but rather as a way to increase savings rates on a tax-advantaged basis.
401(k) plans and IRAs provide you with a gradual way to save. This is what you should do, and the purpose of these retirement plans is to encourage it. By allowing you to defer taxes and receive matching funds, the IRS incentivizes people to save for the future.
But what do you do after you have saved this money? How should you use it when you are preparing for retirement and need to spend it?
If you have pensions or other retirement funds, they will begin to disburse funds themselves. Each month, you will receive a portion of the money you have saved. If you wish, you can also opt for a lump-sum payment.
If you have not put your savings into a retirement fund, it is not too late. You can still purchase an annuity. You can withdraw some or all of your savings, hand it over to a financial institution, and in return, receive monthly income.
You can purchase an annuity with a lump-sum payment, or like a retirement fund, through multiple annual installments. Similarly, you do not need to pay taxes on dividends, interest, or capital gains before you start receiving annuity payments.
Annuities can be quite complex. You need to consider what additional conditions or terms you wish to attach. You also need to decide whether an annuity is worthwhile or if converting your savings into income yourself would be better. Either way, they offer another way to save for the future.
Saving is crucial. You need to save for the future, emergencies, and unexpected expenses. You should spend less than you earn and save for tomorrow.
If you have not started saving yet, begin by assessing your income and expenses, finding areas where you can cut back. Pay off credit card bills – the most expensive way to borrow money next to high-interest loans.
Now is the time to choose a savings plan and develop the habit of saving money into it each month.
Throughout this series of articles, we have discussed why you should save money, how to save money, tracking your expenses, and where to save your savings appropriately.