Welcome to Get Smart about Investing. Clearly society has been, and continues to be, facing some significant challenges when it comes to the financial security of individuals during retirement. People are living longer, company pension plans are being eliminated and to make things worse, most people are not saving enough money on their own. In an effort to try and address these problems, the government has created retirement accounts to provide an incentive for individuals to save for retirement.
There are several types of retirement accounts and we will look at each in detail; but let’s take a look at the overall context, from an investing perspective. You can certainly invest money on your own for retirement; but you will have to pay taxes on any realized gains each year. If you earned $3,000 in interest from a bond investment, you would have to pay taxes on it. If you had a $10,000 gain from a mutual fund sale, again, you would have to pay taxes on it. As you are investing over longer periods of time, the impact of taxes can be significant and really erode the growth of your investments. In addition, being taxed on gains each year discourages many individuals from investing. To address this, the government created retirement accounts within the tax code as a way to encourage individuals, through certain tax benefits, to save and invest for retirement.
With pensions disappearing, company retirement accounts have become very common at most companies. The 401(k) account is the most common type of company retirement account, but you may come across some other types as well. A 403(b) or tax-sheltered annuity (TSA) is very similar to a 401(k), but it’s for employees of not-for-profit schools, hospitals or charities. Some government workers have access to 457 plans, which also work in a similar way. The different names reflect the different sections of the IRS tax code that describe the rules of each plan.
The best way to illustrate the benefits of a company retirement plan is by looking at a specific example. If your salary is $100,000 and you contribute 10 percent to a company retirement account, what that means is that $10,000 comes off the top of your salary before taxes and is saved for retirement. This is also known as pre-tax savings. The fact that the contributions are made before taxes provides two benefits. First, you are able to save more money. If you had tried to save the $10,000 after you got your paycheck, perhaps it only would have been worth $7,000 because some of it would have gone to the government in the form of taxes. Second, your taxable income is reduced by whatever you put in. In this case, instead of starting your tax calculation based on $100,000 of income, you are going to start using just $90,000. This means you are in a lower tax bracket and pay less in taxes today.
Once the money is in the company retirement account it can be invested and because it’s inside a company retirement account, you do not have to pay any taxes on your gains each year. The only time you pay taxes is when you take the money out of the accounts, usually when you retire. Because you are not paying taxes on the gains each year, your money can grow faster. This is also known as tax-deferred growth. The logic of these accounts is that most people are in higher tax brackets during their working years than they will be when they retire; so you are putting off paying taxes at a higher rate now in order to pay taxes at what probably will be a lower rate later.
In addition to the tax benefits, there are often additional benefits that the company provides in the form of a company match. Not all companies provide a match; but if available, it can serve as an added incentive to save for retirement. Basically, this is like free money from the company. If a company provides a 50 percent match on the first $3,000 you contribute, that means that if you contribute $3,000, the company contributes an additional $1,500 for a total of $4,500 that is put aside for your retirement. In this example it would be a free 50 percent return on your money without any investment risk. Now, you typically only get this match if you contribute money. There are too many employees who are not participating in their company’s plan or contributing enough money to take full advantage of these benefits. Saving enough for retirement is difficult. Try to do whatever you can to maximize any additional benefits your company provides.
Keep in mind that the reason that the government gives you these tax breaks is to make sure you are saving money for retirement. They don’t want to give you any benefits if you are going to use the money for other purposes; so to discourage you, they have created a rule that if you take any money out of a company retirement account before you are 59-years old, you have to pay taxes plus a 10 percent penalty on whatever you take out.
I’m Greg McGraime and Now You Know!