Savings accounts, bonds, stocks, and real estate are all places in which you can put your savings so that they’ll be safe for the future. Any investment can go down as well as up but if you balance your savings portfolio carefully, you should find that its value grows over the years.
Those savings, though, will come from post-tax dollars. First, you pay your taxes and cover your expenses. Then you get to save whatever is left over.
But the government wants to encourage people to save for their future. It wants everyone to put aside some money each month so that they’ll have something to live on when they reach retirement. So it makes some savings plans tax-preferred. First you save then you pay tax on whatever is left. The result should be both a higher rate of savings and a lower tax liability.
All of these plans, though, aim to save for retirement. The tax authority isn’t interested in helping you to save for a bigger home or a newer car. It wants to prepare you for the day you retire. So when you put your savings into a retirement fund, you’ll be locking them up for a long time. But in general, you’ll also be taking little risk. You won’t be able to enjoy huge rates of return. Nor will you be able to pull your money out if you need it. But you should find that it accumulates over the years until you do need it.
Retirement funds come in a range of different forms.
Pensions, or defined benefit plans, are rare these days. Companies make contributions to a pension fund on behalf of their employees. They then promise a return regardless of the performance of that fund. If the pension payments haven’t performed well enough to meet the obligation, the company makes up the difference.
That means taking on a lot of risk. Companies that had offered pensions to their employees, particularly in the automotive industry, soon found themselves with large obligations. At the start of 2020, GM agreed to move $570 million into its pension funds to ensure that it could pay retirees the pensions it had promised.
Defined benefit plans promise greater security and more predictability but only by moving the risk to the employer. Most employers now are giving that risk back to their employees. Private companies more usually offer defined contribution plans.
In defined contribution plans, employees put a set amount into their pension funds each month. Fund managers choose where to put those savings, and the money remains locked up until retirement. Savers won’t know how much they’ll receive when they retire until they grow close to their retirement age. They’ll have more to live on if the market performs well and less if the market performs poorly.
A defined contribution plan won’t tell you how much you’ll receive when you retire. But it will tell you how much you’ll be saving each month—and that saving will be relatively painless. If your employer offers a 401(k) plan, it will take your retirement savings directly out of your pay. You won’t receive that money in your bank account. So you won’t feel as though you’re giving up spending power now for spending power in the future.
A 401(k) plan will give you a couple more benefits though, and they’re very valuable.
The first is that the savings you put in a 401(k) plan come out of pre-tax money. Instead of being taxed on your full income, then saving from what’s left, you’ll first save then pay tax on what remains.
Not only will you save but you’ll also lower your tax bill. In effect, the government will pay you to save for the future.
Your employer might also pay you to save for the future. Some employers offer matching contributions. For every dollar you agree to put in your 401(k), they’ll add money of their own.
The match is rarely 1:1. Companies will usually cap the amount they’re willing to add and they might have vesting rules. Leave the company before the end of the vesting period and the company will be able to claw back some of the matching contributions.
The payments provide a way for employers to increase salaries. But they also provide a way for companies to hold onto their staff. If they’re investing in a team member’s professional growth, they want to make sure that those team members stay with the company.
There are limits to the amount that you can save in a 401(k) plan, though. The limits tend to rise each year. In 2021, total contributions from employees is $19,500 for the year. You can add another $6,500 in catch-up contributions if you’re aged 50 or older. Matching contributions can bring that amount up to $58,000 or $63,500 (and no more than 100 percent of income) for people aged 50+.
If you withdraw your savings before the age of 59.5, however, you will face penalties. In addition to the income tax on the funds, you will have to pay an extra 10 percent penalty tax. The government wants you to save your money for your retirement, and keep that money saved until retirement.
Despite that commitment, in general, experts recommend that you put as much into your 401(k) as you can. Max out the matching benefits so that you don’t leave money with your employer that it’s willing to give to you. And take as much of the tax benefits as you can.
Being able to save from pre-tax dollars can help to reduce your tax bill. But you will still have to pay tax on that money. You’ll pay it after you retire, when your income is smaller and your tax rate lower. But if you expect to earn more after you retire, and to be in a higher tax bracket, it would pay to save from post-tax dollars.
First, you pay the tax on your income then you put some of what’s left in your retirement pot. When you take the money after you retire, you’ll receive those funds tax-free.
That’s what a Roth retirement plan allows you to do.
You’ll face the same limits on a Roth 401(k) as you would on a traditional 401(k) but the penalties for early withdrawal are different. Because you save money with post-tax dollars, you won’t have to pay income tax on the amount you withdraw. But you will still get a 10 percent penalty and you’ll have to pay tax on your earnings.
Both 401(k) plan and Roth 401(k) plans do allow you to borrow against the savings in your retirement pot. Those loans do not carry a penalty, unless you fail to pay them back in time. The IRS will regard a default as an early withdrawal and start demanding taxes and penalties.
Whether you’re saving with a traditional 401(k) or a Roth 401(k), you should plan to leave your savings to build until you’re ready to retire.
401(k) plans are usually available to employees. The self-employed can use a “solo 401(k)” or a “self-employed 401(k).” It works like any other 401(k) except that the matching payments come from the same source: when you’re self-employed, you’re both the employer and the employee.
But a 401(k) isn’t the only way to save for your retirement. An Individual Retirement Account, or IRA, allows savers to put money away for the future on their own terms. They don’t need to rely on their employer’s 401(k), and they’re free to choose their own fund.
Like 401(k) plans, IRAs can come in traditional and Roth forms but they have much lower limits. Total annual contributions to your IRAs cannot be more than $6,000, or $7,000 if you’re aged 50 or more. They also carry the same early withdrawal penalties.
Think of IRA plans not as replacements for your 401(k) but as a way to increase your savings rate on a tax-preferred basis.
401(k) plans and IRAs give you ways to save as you go. That’s exactly what you should be doing, and those retirement plans are intended to encourage you to do just that. By allowing you to put off your taxes and take matching funds, the IRS gives people incentives to put money aside for the future.
But what do you do once you’ve saved that money? How do you spend it when the time comes and you’re ready to retire?
If you have a pension or some other retirement fund, the fund itself will start to make disbursements. Each month, you’ll receive some of the money you’ve saved. You might also prefer to take a lump sum if you prefer.
But if you haven’t put your savings in retirement fund, it’s not too late. You can also buy an annuity. You can withdraw your savings—or a part of them—give them to a financial firm, and receive in return a monthly income.
It’s also possible to buy an annuity with a lump sum or, like a retirement fund, pay in installments over years. Again, you won’t pay the taxes on the dividends, interest or capital gains until you start to receive the disbursements.
Annuities can be complex. You’ll need to consider what sort of conditions—or riders—you want to attach your annuity. You’ll also need to decide whether it’s worthwhile or whether you wouldn’t be better off turning your savings into income yourself. But they’re another way to save for the future.