Investing For Dummies. Eric Tyson
wealth. That would reduce the amount of new funding required.
Each decade you delay saving approximately doubles the percentage of your earnings that you need to save to meet your goals. For example, if saving 5 percent per year in your early 20s gets you to your retirement goal, waiting until your 30s to start may mean socking away 10 percent to reach that same goal; waiting until your 40s, 20 percent. Beyond that, the numbers get truly daunting.
If you enjoy spending money and living for today, you should be more motivated to start saving sooner. The longer that you wait to save, the more you ultimately need to save and, therefore, the less you can spend today!
Checking out retirement account options
If you earn employment income (or receive alimony), you have options for putting money away in a retirement account that compounds without taxation until you withdraw the money. In most cases, your contributions to these retirement accounts are tax-deductible.
Company-based plans
If you work for a for-profit company, you may have access to a 401(k) plan, which typically allows you to save up to $19,500 per year (for tax year 2020). Many nonprofit organizations offer 403(b) plans to their employees. As with a 401(k), your contributions to a 403(b) plan are deductible on both your federal and state taxes in the year that you make them. Nonprofit employees can generally contribute up to 20 percent or $19,500 of their salaries, whichever is less. In addition to the upfront and ongoing tax benefits of these retirement savings plans, some employers match your contributions.
Older employees (defined as being at least age 50) can contribute even more into these company-based plans — up to $26,000 in 2020. Of course, the challenge for many people is to reduce their spending enough to be able to sock away these kinds of contributions.
If you’re self-employed, you can establish your own retirement savings plans for yourself and any employees that you have. In fact, with all types of self-employment retirement plans, business owners need to cover their employees as well. A simplified employee pension individual retirement account (SEP-IRA) allows you to sock away about 20 percent of your self-employment income (business revenue minus expenses), up to an annual maximum of $57,000 (for tax year 2020). Each year, you decide the amount you want to contribute — no minimums exist.
Owners of small businesses shouldn’t deter themselves from doing a retirement plan because employees may receive contributions, too. If business owners take the time to educate employees about the value and importance of these plans in saving for the future and reducing taxes, they’ll see it as a rightful part of their total compensation package.
One-person small business owners can also consider the individual or solo 401(k). You can put away the same amount of money as in a SEP-IRA as an employer contribution and then also contribute as an employee up to the employee limits for a 401(k) plan as detailed earlier in this section. If you have employees, these plans can get complicated quickly because you will generally need to cover them in the plan and meet other “discrimination testing” requirements. Speak with a tax advisor if you need more information.
IRAs
If you work for a company that doesn’t offer a retirement savings plan, or if you’ve exhausted contributing to your company’s plan, consider an individual retirement account (IRA). Anyone with employment income (or who receives alimony) may contribute up to $6,000 each year to an IRA (or the amount of your employment or alimony income if it’s less than $6,000 in a year). If you’re a nonworking spouse, you’re eligible to put up to $6,000 per year into a spousal IRA. Those age 50 and older can put away up to $7,000 per year (effective in 2020).
Your contributions to an IRA may or may not be tax-deductible. For tax year 2020, if you’re covered by a retirement plan at work, you’re single, and your adjusted gross income is $65,000 or less for the year, you can deduct your full IRA contribution. If you’re married and you file your taxes jointly, you’re entitled to a full IRA deduction if your AGI is $104,000 per year or less.
CONSIDERING ROTH 401(K) AND 403(B) OPTIONS
Some companies and organizations with traditional retirement savings plans like 401(k)s and 403(b)s also offer a Roth option for these plans. As with a Roth IRA, a Roth 401(k) or Roth 403(b) enables participants to contribute money on an after-tax basis into an account that allows for tax-free compounding of investment returns and tax-free withdrawals after age 59½. Self-employed people also can consider a similar account, known as the individual Roth 401(k). The contribution limits to these Roth accounts are the same as for the regular versions.
So, why might you want to contribute to a Roth 401(k), Roth 403(b) or individual Roth 401(k)? You may currently be in a relatively low tax bracket and won’t save much on current taxes by contributing to a traditional retirement account that offers upfront tax breaks but does tax withdrawals. This could be the case for someone new to the workforce and early in his career. Thanks to the Tax Cuts and Jobs Act, which took effect in 2018, federal income tax rates are relatively low in the United States now.
Those who are later in their careers might also consider these accounts if looking ahead to their retirement years; they are likely to be in a high or higher tax bracket. This might be the case for folks who have accumulated significant balances in tax-deferred retirement accounts.
Annuities
If you’ve contributed all you’re legally allowed to contribute to your IRA accounts and still want to put away more money for retirement, consider annuities. Annuities are contracts that insurance companies back. If you, the annuity holder (investor), should die during the so-called accumulation phase (that is, prior to receiving payments from the annuity), your designated beneficiary is guaranteed reimbursement of the amount of your original investment.
Annuities, like IRAs, allow your capital to grow and compound tax-deferred. You defer taxes until you withdraw the money. However, unlike an IRA that has an annual contribution limit of a few thousand dollars, you can deposit as much as you want in any year to an annuity — even millions of dollars, if you’ve got it! However, as with a Roth IRA, you get no upfront tax deduction for your contributions.
Choosing retirement account investments
When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps