No matter how young or old you are, everyone should be thinking about retirement. We know it’s hard when you’re in your 20s or 30s because 59 ½ – 65 years old seems so far off, but it will be here before you know it.
The earlier you save for retirement, the more money you’ll have to enjoy your golden years. Plus, when you save early, you give your money more time to grow, which is like passive income – you don’t have to work for it, yet you grow your retirement account fast.
Understanding how retirement funds work, how to save for retirement, and the tax consequences of each account is important.
Everyone wants to know a magic number. How much do you need for retirement?
The answer differs for every person.
If you need a rule of thumb, figure you’ll need 80% of your gross annual income per year when you retire. Let’s say you make $75,000 a year. This means you should have $60,000 for every year of retirement. If you retire at 65 and live to 85, that’s $1.2 million before any compounded earnings or dividends.
Of course, how much you need for retirement depends on many factors including:
These are all questions you should ask yourself. Everyone has different scenarios. For example, one person may want to retire at 65 years old, downsize to a much smaller house, travel the world, and is generally healthy.
Another person may want to retire at 70 years old, stay in the house he/she is in now, and spend his/her time with the grandchildren while managing his/her health, which causes them some trouble and has hefty expenses.
Each person has different retirement needs and funds to cover those needs. You may not know 100% what you want to do in retirement, but a little pre-planning can go a long way.
Think about the lifestyle you want to lead and decide if 80% of your annual income would be enough to live that lifestyle.
Once you know how much to save for retirement, you must learn where to save for it. Retirement accounts are what’s called tax-advantaged and fall into one of two categories:
Most people have two options for retirement accounts:
If your employer sponsors a 401K, there’s a good chance they also offer an employer match. This means they’ll match a portion of your contributions each year, aka give you free money.
This is usually a part of your benefits package and/or compensation, so you don’t want to give it up!
For example, let’s your employer matches 100% of your contributions on up to 3% of your salary. You make $100,000 per year, so you should contribute at least $3,000 per year to double your annual contributions to $6,000 with your employer’s contribution.
Each retirement account option has its pros and cons. Understanding the good and bad of opening an employer-sponsored retirement account can help you decide where to put your money.
Pros:
Cons:
IRAs have their good and bad sides too. Here’s what you should know.
Pros:
Cons:
You can withdraw from your 401K or IRA at age 59 ½ to avoid penalties. If you withdraw funds sooner, you’ll pay a 10% penalty plus the taxes owed on any withdrawals.
Even if you wait until age 59 ½, you’ll pay taxes on any money you withdraw from a traditional retirement account. Roth retirement accounts don’t pay interest on withdrawals because the contributions were after-tax.
Sometimes we need to access our retirement funds regardless of the 10% penalty. Fortunately, there are a few situations that you can tap into your funds and not pay the penalty. You’ll always pay taxes on withdrawals of traditional retirement funds, though and it’s at your current tax rate.
Here are some reasons to tap into your retirement funds if your financial advisor suggests it.
If your medical expenses make up more than 10% of your income (IRA) or 7.5% of your income (401K), you may be able to use your retirement funds to cover the expenses without penalty.
If you want to go to school and don’t have the funds, you can tap into your IRA (not 401K) to cover the expenses. You won’t pay the penalty, but you will pay taxes.
You can withdraw up to $10,000 for a first-time home purchase. The IRS considers you a first-time homebuyer if you’ve never owned a home or if you haven’t owned a home in the last 3 years.
Some 401K accounts (not IRA and not all 401Ks) allow a hardship withdrawal. Each sponsor has different requirements for what counts, and some will still charge the 10% penalty.
When you pay taxes on retirement funds depends on the type of account you open.
Traditional Retirement Accounts
With traditional retirement accounts, you make contributions before tax. In a 401K, you get the tax break right away because your employer withdraws the contributions before taxes, taxing you only on the money after your retirement contributions.
If you contribute to an IRA, you’ll get the tax break at tax time. You can write off your IRA contributions up to $6,000 each year ($7,000 if you’re over 50 years old).
Roth Retirement Accounts
With Roth retirement accounts, you make contributions after taxes. This means you don’t get a tax break in the year you contribute, but your contributions and earnings grow tax-free. You can also withdraw your funds (contributions and earnings) and pay no taxes.
*Bonus Tip: You can withdraw contributions from a Roth 401K or IRA without paying taxes before age 59 ½ and not pay taxes. If you withdraw earnings, though, you’d pay taxes. It’s not recommended to withdraw funds early because it depletes your retirement funds, but if it’s an emergency, the money is there.
Everyone should save for retirement, whether you’re 20 years old or 50 years old. It is never too early or too late to save for retirement. If your employer offers an employer match, take advantage, and try to avoid taking your retirement funds until you are truly retired to make your money last.
This article is provided by EveryIncome.