Are you currently saving for retirement? If not, do not worry, you are not alone. Saving for retirement is a big step, and a very important one. And in order to do it properly, you must have an understanding of the options available to you and how to use them effectively. Did you know that Uncle Sam provides tax benefits for retirement plan contributions? That is one benefit you definitely do not want to skip and miss out on. Also, one mistake many individuals make is waiting too long to begin contributing to their retirement planning. It is never too early to start, no matter your income level! By starting early, your contributions have more time to compound and grow, thus potentially providing you with a much larger nest egg when it comes time to retire. This should be one of your top financial goals, after paying off and consumer debt that you may be carrying.
How can retirement accounts help lessen the amount of money you owe to good ole Uncle Sam? Let’s hypothetically say you are in the 35% tax bracket: for every $1,000 you contribute to your retirement plan, you are potentially saving approximately $350 in taxes for the year you make the contribution. One additional benefit: if it is an employer sponsored program, they may even contribute on your behalf by matching a portion of your contribution, thereby giving you extra investment dollars, free!
On average, most individuals need approximately 75% of their annual pre-retirement income, adjusted for inflation, throughout retirement to maintain their standard of living. And now, with future of social security in question, this is a very important detail you cannot afford to overlook. BY planning properly and early, you can make sure that you will be able to retire when you want to, and not have to continue working to support yourself indefinitely.
Many individuals have the ability to establish more than one type of retirement account for their planning. If this is you, I recommend that you prioritize the accounts for contribution in order by what they provide to you in return. If you employer matches your contributions to a given amount, this account needs to be at the top of the list. Why throw away free money? Next on your list should be any other employer sponsored or self employed plans that provide a tax deductible contribution. Finally, contribute to an Individual Retirement Account if you have one.
401(k) Plans: What you need to know
Most for profit companies and corporations offer 401(k) plans, which currently allow you to contribute up to $16,500 (2011) of your income annually if you are under the age 50, and allow an additional $5,500 catch up provision amount for those individuals age 50 and older. In addition to the elective deferrals made by employees, an employer may also offer their employees matching 401k contributions. Usually an employer's match is limited to a percentage of an employee's pre-tax contribution. There can be employer imposed contribution limits to 401k plans. The contribution limit for employers is set at 6% of the employee's pre-tax compensation. Some employees may be subject to a second contribution limit. If you're classified as a "Highly Compensated" employee, then you may be subjected to contribution limits based on your employer's overall 401k participation rates. If your salary is above $110,000 in 2011, then you may need to contact your employer to see if any additional limits apply to you.
Your employer may also allow you to contribute after tax contributions to your 401(k), also known as Roth contributions. This allows you to contribution over the stated pre-tax contribution limits of $16,500 allowing you to invest a total of $49,000 a year into the plan. Although these contributions are not tax deductible, their growth may have tax benefits to you in the future. The rules regarding 401(k) plans are complex, so please be sure to consult with your plan administrator for all the fine details.
403(b) Plans: the Retirement Plan for Non-Profit Organizations
Just like their for profit counterparts, 403(b) plans offer federal and state tax deductible contributions. These plans are offered to employees of non-profit organizations and currently have the same contributions limits as the 401(k). Please make sure to consult with your plan administrator or tax advisor about your eligibility requirements and contribution limits.
Individual Retirement Accounts (IRAs)
Anyone individual with earned income (or alimony) can establish and contribute to an IRA. Currently in 2011, you are allowed to contribute up to $5,000 if you are under the age of 50, and $6,000 if you are 50 or older. Also, if you happen to be a non-working spouse, you may be eligible to contribute into a spousal IRA. Some and potentially all of your contributions to your IRA can be tax deductible, however there are certain rules regarding deductibility. Please refer to your tax adviser or www.irs.gov for deductibility eligibility and limits.
A new form of IRA now offered is the Roth IRA. Although contributions are still limited to the same as a traditional IRA, there is a limit to who can contribute. Currently, only single taxpayers with and adjusted gross income (AGI) of $99,000 or joint filers with an AGI of $156,000 can contribute up to the maximum allowable amount. Contributions to a Roth IRA are not tax deductible, however earnings and growth of your contributions are shielded from taxes, and qualified withdrawals from the accounts are free income tax. In order to be eligible for a qualified withdrawal from a Roth IRA, you must be at least 59 ½ in age and have held the account at least five years. An exception to this rule is allowed for first time homebuyers, who are allowed to make a one time withdrawal up to $10,000 toward the down payment of a first time principal residence purchase.
IRAs also have one additional feature investors need to be aware of: the Required Minimum Distribution (RMD). You cannot keep funds in a traditional IRA indefinitely. Eventually they must be distributed. If there are no distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required. The requirements for distributing IRA funds differ, depending on whether you are the IRA owner or the beneficiary of a decedent's IRA. If you are the owner of a traditional IRA, you must generally start receiving distributions from your IRA by April 1 of the year following the year in which you reach age 70½. April 1 of the year following the year in which you reach age 70½ is referred to as the required beginning date. Please refer to www.irs.gov for all the details regarding RMDs for IRAs.