There are dozens of excuses for not saving for retirement, and they all sound good. You may have a few of your own. But you know you should. Here are four good reasons to save for retirement:
- You don’t want to rely on Social Security.
- You don't want to be a burden on your children.
- You have access to a tax-deferred retirement account that will reduce the taxes you pay.
- The compound effect of investing in that account over time can give you a more comfortable and happier retirement.
Sound good? Consider those four factors in greater detail.
- Tax-deferred savings can be the key to a comfortable retirement, and these types of accounts soften the blow to your disposable income.
- Over time, you'll enjoy the benefits of the compounding effect.
- If you can afford the immediate impact on take-home pay, the Roth IRA can be an even better retirement savings option.
Relying on Social Security
Social Security wasn't designed to be anyone's sole income in retirement. According to the Social Security Administration, its payments replace about 40% of the average wage earner’s income after retiring. And, it adds, most financial advisors say retirees will need about 70% of their work income to live comfortably in retirement.
So there's a rule of thumb: Even with Social Security, you need to come up with about 60% of the income you'll need to live comfortably after you retire.
Living With Your Children
If you have children, you probably wouldn’t mind spending as much time with them as you possibly can. However, you probably also want that to be at your discretion. Having to live with the kids because you can't afford to live independently isn’t how most people want to spend their retirement years.
The estimated percentage of retirement costs that Social Security covers.
Unless you win the lottery or get a big inheritance, you need to save enough to cover your expenses during your retirement years.
Saving in a Tax-Deferred Retirement Account
The number of investment opportunities out there is infinite, but when it comes to retirement, your initial focus should be on the ones that were created with retirement savings in mind, and that is the tax-deferred retirement account. While saving is generally a good thing, the compound effect of saving in a tax-deferred account cannot be overstated. Why?
- It reduces the amount of taxes you owe on the income for each year you invest in it.
- It allows you to defer or even avoid the taxes you owe on the earnings that accrue on your investments.
- It produces earnings on earnings, creating a compounding effect not available in a regular savings account.
If you work for a company, you may have access to a company-sponsored retirement account such as a 401(k) plan. It could be your best possible deal for retirement savings if the company matches a portion of your contribution. The average company match in 2019 was 4.7% while some companies offer more and others nothing at all.
If you are self-employed, run your own business, or your employer doesn't offer a plan, you still can contribute to a tax-deferred retirement account. You can open a traditional IRA or a Roth IRA at any financial services company or bank.
In either case, there are annual limits on the amount you can contribute:
- For IRAs: The annual maximum contribution for tax years 2020 and 2021 is $6,000. If you are age 50 or over, you can add another $1,000 a year as a "catch-up contribution.
- For 401(k) plans: The annual limit for the tax years 2020 and 2021 is $19,500, with a $6,500 catch-up contribution.
How a Retirement Plan Works
Whether it's an IRA or a 401(k), you can either enjoy the immediate tax break of a traditional IRA or 401(k) or the post-retirement tax break of the Roth IRA or Roth 401(k) plan. (Many, but not all, companies offer a Roth option in their 401(k) plans.)
Here is an example:
- Adam earns $50,000 per year.
- His federal income tax rate is 22% based on the tax bracket for 2020.
- He gets paid on a weekly basis.
- He contributes 10% of his salary to his 401(k) account each pay period.
- Adam’s weekly contributions to his 401(k) will be $100.
- His paycheck would be reduced by only $78.
If he invested nothing, Adam would make $962 a week and take home about $750. If he invests $100 a week in a tax-deferred account, he will take home about $672 a week. He takes home $78 less, but he has $100 more in his account. (This assumes his company contributes nothing to the account. Many but not all companies match a portion of the employee's savings.)
As his salary grows, his contribution will grow. As his contribution grows, his balance will grow and will benefit from the compounding effect of tax-deferred saving.
Tax Savings Over Time
Say you contribute $15,000 to your 401(k) account each year, which earns a rate of return of 8%. Assume your tax rate is 24% and you invest these contributions for a 20-year period. The estimated net results, compared with the effect of adding these amounts to your regular savings accounts instead of a 401(k), would be as follows:
- By adding the amounts to your tax-deferred account instead of your regular savings account, you save $47,073 in taxes over the 20 years.
- If you add your savings to a regular savings account, the earnings that accrue on those amounts are taxed in the year those amounts are earned. This reduces the amount you have available to reinvest by the amount of taxes you must pay on these amounts.
The Compound Effect
Assume you invest $50,000, and it accrues earnings at a rate of 8%. This produces earnings of $4,000. If your tax rate is 22%, that amounts to $880 that is paid to the tax authorities, leaving $53,120 to reinvest. Not only would you pay less in taxes, but the value of your investments would be even greater as a result of the compound effect of tax-deferred growth:
- About $630,000 if you saved the amount in a tax-deferred account
- About $580,000 if you saved the amount in an after-tax account
These numbers are compelling and get even more so if the earnings period is longer and the amount saved greater.
About the Roth IRA
All of the above is about the benefits of tax-deferred retirement savings accounts. But if you have the option of contributing post-tax income to a retirement account, it is well worth considering. That, by definition, is the Roth IRA.
The money you contribute to a Roth IRA is taxed upfront, not after you withdraw it. That may seem like a big hit on your disposable income. But the money in a Roth account is tax-free when you withdraw it after retirement. That is, not only do you owe no taxes on your contribution; you owe no taxes on the investment income your money has earned.