There are dozens of excuses for not saving for retirement, and they all sound good. You may have a few of your own. However, there are many reasons why the longer you wait to start saving for retirement, the more financially difficult it will be in the future. Let's consider four primary reasons to start saving now.
- Social Security benefits are not guaranteed, and you may find greater financial comfort having a personal retirement account instead of relying on public policy.
- By not saving for retirement, you may become a burden for your dependents.
- There are many immediate tax benefits for saving for your retirement.
- The earlier you start saving for retirement, the sooner you can begin capitalizing on the effects of compounding returns.
- You can begin saving for retirement by leveraging your company's 401(k) plan or by opening an IRA.
1. You Shouldn't Rely 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. Most financial advisors say retirees will need about 70% of their work income to live comfortably in retirement. Even with Social Security, you need to come up with about 60% of the income you'll need to live comfortably after you retire.
In addition to not wanting to rely on public policy as your retirement plan, saving for your own retirement affords you the opportunity to create the retirement you want. Setting aside a greater amount of money now may require lifestyle sacrifices. However, by doing so today, you'll be more likely to live out of the lifestyle you want in the future.
2. You May Not Want to Burden Your Dependents
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.
In addition to you not wanting to make lifestyle sacrifices, consider the implications it may have on your children if you need to rely on them. They may miss out on financial opportunities of their own and have extra strain put on their own family as a result of needing to provide you financial aid.
3. You May Miss Out on Tax Benefits
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 switch jobs, you can rollover your 401(k) account from your previous employer to your new employer.
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 Q1 2021 was 4.6% 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 year 2022 is $6,000. The annual maximum contribution for tax year 2023 is $6,500. 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 2022 is $20,500, rising to $22,500 for 2023. For individuals age 50 or older, there is also a $6,500 catch-up contribution for 2022, rising to $7,500 for 2023.
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 2023.
- 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 savings.
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.
4. You May Miss Out on the Effects of Compounding
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. For this reason, it is often imperative that investors begin saving for retirement as early as they can. Though it is often difficult to set aside money especially during the early phases of one's career, the compounding implications and potential benefits often far exceed the sacrifice.
Special Considerations: 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.
What Are the 2022 and 2023 Contribution Limits for 401(k) Accounts?
The 2022 IRS contribution limit for a 401(k) is $20,500, and the 2023 IRS contribution limit for a 401(k) is $22,500. For 2022, individuals who are 50 and over are allowed to contribute an additional $6,500 per year. This catch-up contribution limit is increased to $7,500 for 2023.
What Are the 2022 and 2023 Contribution Limits for IRA Accounts?
For 2022, individuals can contribute up to $6,000 in either a traditional IRA account or a Roth IRA account. If you are 50 and older, you can contribute up to $7,000. These limits have increased for 2023 to $6,500 of standard contributions with the additional $1,000 catch-up contribution for those 50 and older.
What Is the Difference Between a Traditional IRA Account and a Roth IRA Account?
The difference between a traditional IRA account and a Roth IRA account comes down to taxation. Traditional IRA accounts are funded with pre-tax dollars and are taxed when the account makes distributions. Roth IRA accounts are funded with after-tax money and the contributions are not taxed when distributed.
The Bottom Line
Saving for retirement can seem like a daunting task and one that you might think you don't need to be concerned with right now, especially if retirement is far off. However, the longer you wait, the more difficult it is to ensure that you will have a comfortable retirement.
The sooner you start, the better. And there are many ways that make saving for retirement easy, that allow for tax-deferred savings, matching contributions from your employer, and compounding. 401(k) plans and IRA accounts are just two of the ways individuals can easily save for retirement.