While there is some method behind the magic of retirement accounts, the phenomenal growth of your savings may seem mystical without too much of your own doing. It’s never too late to start, but if you aren’t taking advantage of these lucrative options by making regular contributions, you are missing out on tax-free growth of your retirement nest egg.
There are many retirement accounts to choose from. Employer sponsored plans, like 401(k) and 403(b) plans, Individual Retirement Accounts (see What Are the Benefits of an IRA) including traditional, Roth, and Education, now called Education Savings Accounts, only name a few. Each offers unique benefits that can help you prepare for those anticipated “golden years.” Retirement savings accounts prevail because they combine the benefits of four enormously successful principals of saving:
Tax-free compounding interest is one of the most significant benefits of investing through a retirement plan. Compounding is a cumulative effect of interest accruing over time. Consider that if you start making contributions early on, your earnings can compound for 20 or more years. The more you contribute, the faster it grows. Earnings also compound more rapidly because they are growing tax free, and thus able to accumulate without taxation on dividends or capital gains until withdrawal.
Consistent saving through regular contributions can have a substantial impact on increasing your wealth. When contributions are deducted directly from your paycheck, as with employer-sponsored plans, saving is a lot less painful. You often overlook the missing funds, yet are making significant progress towards growing your retirement. Many tend to put off saving for retirement, and allow precious time to pass without the benefit of their money compounding. Money in your hands is often spent quickly. Pocketing that extra cash can be very costly in the long run. This is especially true with employer-sponsored plans that offer matching contributions. The typical match is between 50%-100% for contributing between 3%-6% of your salary. You benefit from matching contributions at no cost, and upon completion of your company’s vesting period, the total amount including matched funds belongs to you.
Contributions to specific retirement accounts, primarily employer-sponsored plans such as 401(k)s and 403(b)s are made pre tax and reduce your overall taxable income. The higher your tax rate, the more you profit from this benefit. The end result can sometimes supply the same amount of money in your pocket having invested what you would have paid in taxes. If you are not covered by an employer retirement plan, contributions made to a traditional IRA are tax deductible Tax deferred growth is another key advantage to investing in retirement accounts. With typical investments, you must pay capital gains tax when assets are sold at a gain or dividends are distributed (see Capital Gains Tax). Through tax-deferred retirement accounts, you pay no tax until you make withdrawals. By the time many qualify to take distributions, they have the added advantage of being in a lower tax bracket. The powers of compounding will more than make up for tax paid on withdrawals, especially if your tax rate has been reduced.
The only thing better than tax deferral is outright tax evasion (legal, that is). Roth IRAs offer this enormously lucrative advantage. With a Roth IRA you contribute after-tax dollars unlike the pretax contributions made to a 401(k). However, while taxed on withdrawals from a 401(k) or a regular IRA, Roth withdrawals are generally tax-free after age 59 1/2. So, if you qualify, it pays to begin making contributions now. Imagine reaching retirement and being able to withdraw your profits without having to give uncle Uncle Sam any cut.
One word of caution. All tax-deferred accounts carry a heavy penalty for withdrawing money before age 591/2. While some offer specific exceptions, such as if the money is being utilized to buy a home, or pay for a college education, if you don’t meet the exceptions, you can pay a 10% penalty on funds withdrawn on top of your ordinary income tax rate for the distribution.
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