The Basics of Retirement Savings Vehicles
When it comes to investing for retirement, there are many things that we have little or no control over, such as stock market returns and tax policy changes. Given the importance of these things to the ultimate length and affluence of your retirement, our impotence in these matters is…unfortunate. If we could magically boost our returns by a percentage point or two each year, retirement planning would be so much easier!
Fortunately, we are not entirely powerless. Although we can’t dictate 20% annual returns on our investments, we can utilize an intelligent asset allocation strategy to maximize our returns for a given degree of acceptable risk. Likewise, we can’t exclude ourselves from the burden of taxes, but we can take advantage of certain features of the tax code to minimize their impact.
This is particularly poignant when it comes to retirement planning because the government has created a variety of investment vehicles that allows you to avoid — or at least defer — many taxes that can significantly reduce your retirement nest egg. In essence, the government is offering huge tax subsides on retirement savings. If you have any interest in enjoying your golden years, you should do everything possible to take advantage of one of the most generous benefits offered to middle-class Americans.
If you are currently employed, there is a good chance that you already have a retirement plan available to you. If you work in the private sector, that retirement plan will likely be the popular 401(k) plan. If you work at a public school or a non-profit organization, then you probably have the 401(k)’s close relative, the 403(b) plan. State and local government workers may also have access to 457(b) plans.
Despite their varying numbers, all of these plans act in a similar manner. These investment vehicles allow savers to defer income taxes until the money is withdrawn. This is a significant benefit given that most people are in a lower marginal tax bracket in retirement. In addition, these plans allow you to completely avoid taxes on interest, dividends, and capital gains, which act as a significant, if often unrecognized, drag on long-term investment performance.
In the past several years, many employers have begun offering so-called “Roth” versions of these accounts. These Roth retirement plans are essentially the mirror image of their traditional brethren. Instead of the benefit of upfront tax deferral, Roth contributions are made with after-tax dollars, but money placed in designated Roth accounts are exempt from all further income taxes.
Even if you don’t have the benefit of an employer-sponsored retirement plan, the government has created a retirement account that allows you to receive many of the same benefits as a 401(k) or 403(b) plan: the Individual Retirement Account, better known as the IRA. Just like those other plans, the IRA has both a traditional, tax-deferred option and a Roth version that provides tax-free growth on after-tax contributions.
The main benefit of an IRA is that it isn’t tied to any employer, which means you have the freedom to choose your provider. When it comes to an employer-sponsored plan, you have very little choice; you are stuck with the options given to you. Unfortunately, many employers are doing their employees a disservice by providing them with a poor selection of mutual funds, often laden with high expense ratios and other administrative fees, that negate many of the tax benefits of the retirement account itself. This is not a problem with IRAs, which can be opened at nearly any bank, brokerage firm, or mutual fund company. With so much competition, it is relatively easy to find a provider with rock-bottom costs.
Of course, IRAs are not cure-alls. Most notably, contributions limits are very low relative to other plans. In 2013, IRA contributions are limited to just $5,500, while investors can save as much as $17,500 in a 401(k) and 403(b) plan. Furthermore, if your income is too high, you may not be eligible to fund a Roth IRA or deduct contributions into a traditional IRA. However, assuming that you meet certain restrictions, you can use IRAs as an additional retirement vehicle in order to supercharge your savings.
With the combination of an employer-sponsored plan and an IRA, you could potentially contribute as much as $23,000 per year into various retirement accounts. In addition, if you are at least 50 years old, you can use the “catch-up” provision to contribute an additional $5,500 into your employer-sponsored plan and $1,000 into your IRA. Your possibilities expand even further if you have a 457(b) plan or if you own your own business. In short, you probably have a lot of room in your various retirement accounts to save in a tax-efficient manner.
Tax planning is never easy, even with the availability of tax-advantaged retirement accounts. In fact, given their various rules, restrictions, and limitations, they can make retirement planning even more difficult. But their enormous benefits make them worth the costs, especially if you have some help. A licensed financial planner can provide such assistance in order to optimize the use of these accounts as part of an overall retirement strategy.