The beginning of a new year provides an opportunity to look back and review what worked in the past and find opportunities that can help us live better in the future. A big part of that is building up your savings to eventually help you achieve financial independence. Everyone who aspires to build wealth should start saving as soon as possible. Compounding interest is more powerful the longer you can allow the money to work for you. It is not uncommon to receive year-end bonuses and pay raises, so this is the perfect time to discuss how to save for retirement in the most effective way possible. Here are some of the best ways to save for retirement:
Individual retirement accounts: One of the simplest ways to save for retirement is to set up an IRA. You can contribute $5,500 annually, or $6,500 if you are 50 or older. The government also provides an incentive for you to save for the future. Money saved in an IRA receives tax-favored growth. There are two different types of IRAs:
Traditional IRA. The money you deposit in a traditional IRA grows tax-deferred. This means that no taxes will be paid on the money you contribute or the investment growth until withdrawals are taken from the account. You will generally need to wait until after age 59 1/2 to take penalty-free distributions. In most circumstances you will also get a tax deduction for any contribution made to the account.
Roth IRA. Roth IRAs also offer tremendous tax benefits, but in a slightly different fashion. The money you deposit in a Roth IRA grows completely tax-free. This means that if you invest $5,500 this year and the account grows for the next 20 years to $33,000 (9 percent annualized growth), the $27,500 investment returns would be completely tax-free, assuming certain requirements are met. Roth IRAs also do not have required minimum distributions after age 70 1/2 like a traditional IRA does. However, if you earn over $118,000 as an individual or $186,000 as part of a married couple in 2017, the government limits your ability to make Roth contributions. Also, there is no current-year tax deduction for contributions made to a Roth account
Employer plans: There are several key benefits to participating in your employer's plan. Most workplace retirement accounts provide tax savings and tax-favored growth, some creditor protections and, most importantly, there's often an opportunity to get employer matching and profit sharing contributions. If your employer offers matching contributions, you are leaving free money on the table if you do not participate.
Simple IRA. These plans are typically offered by small businesses. A simple IRA provides many of the same benefits as an IRA with the added bonus of larger contribution limits of up to $12,500 for those under 50 and $15,500 for participants 50 and older. These plans also typically offer employer contributions of up to 2 or 3 percent of the employee's compensation.
401(k) and 403(b) plans. These plans are the standard for most employees. They allow participants to contribute up to $18,000 in 2017 and $24,000 for those age 50 and older. Both plans also allow employers to add a Roth option, which has no income limitations the way a Roth IRA does. The Roth account will only contain your personal salary deferrals, and any employer contributions will be put in a traditional tax-deferred account. These workplace plans also offer creditor protections that IRAs don't have. The combination of employer matching, larger contributions limits, Roth availability and additional creditor protection makes 401(k)s and 403(b)s a huge asset when it comes to building financial independence.
457(b) plans. These accounts are very similar to 401(k)s and 403(b)s with a few unique perks. They offer the same contribution limits as a 401(k) plan, with the added benefit of no early withdrawal penalties. While most retirement plans require you to reach 59 1/2 to avoid the 10 percent early withdrawal tax penalty, 457(b) plans don't have a penalty for withdrawals prior to age 59 1/2. However, use this option responsibly, since you will need that money at retirement. Additionally, 457(b) plans have more generous catch-up contribution limits for older employees. For three years prior to the normal retirement age retirees can stash twice the annual limit, or a total of $36,000 per year, in their 457(b) plan.
Plans for the self-employed: People who are self-employed seldom have access to a 401(k) plan. But there are a variety of opportunities for small business owners to save for retirement.
SEP-IRA. This is one of the easiest and most versatile plans that a small business can set up. These accounts can be created until the due date of your business's income tax return, including extensions, which might make it possible to reduce taxable income from a prior tax year. All contributions are made directly by the small business and are tax deductible up to 25 percent of the employee's compensation up to $53,000 for 2016 and $54,000 in 2017.
Solo-401(k). This plan has the same benefits as a 401(k), but is designed for small businesses that have no full-time employees other than the business owner and his or her spouse. Many small businesses do not set up a 401(k) plan because of the annual tax filing and nondiscrimination testing requirements. Solo 401(k) plans generally avoid the filing requirements until the plan assets reach $250,000, and nondiscrimination testing won't kick in unless you hire employees. The owner and spouse can make annual salary deferrals of up to $18,000 ($24,000 for those 50 and over), plus as much as 25 percent of compensation from self-employment up to the annual maximum of $54,000 for 2017.
Saving for retirement is a long-term goal that requires years of planning and an understanding of deferred gratification. The dedication and discipline of contributing is the hardest part, but it can be made easier if you use the retirement planning tools and accounts that the government provides to encourage saving. Entering a new year provides the perfect opportunity to challenge yourself to fully fund a retirement account.
Brian Preston and Bo Hanson are fee-only financial planners who host the podcast, "The Money-Guy Show".
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